The Dark Side of FAANGs, Crash Warning at DEFCON One

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Market breadth — “a method used in technical analysis tries to determine the direction of the market. Positive market breadth occurs when more stocks are advancing than are declining and suggests that the bulls are in control of the market’s momentum. Conversely, a disproportional number of declining securities is used to confirm bearish momentum.”


“If I could avoid a single stock, it would be the hottest stock in the hottest sector”

Peter Lynch, Portfolio Manager of the Fidelity Magellan Fund 1977-1990

The Fab Five: FAANGs Equities (Facebook, Apple, Amazon, Netflix, and Google)

One of the golden rules of market analysis is found in true underlying breadth.  Looking at U.S. equities today, there’s burning question; how many stocks have really been invited to this party? Every day we hear about markets hitting new highs, despite the fact that the S&P has been wrapped around 2800 since January.   Above all, beneath the surface, there’s something far more disturbing.  Our Index of 21 Lehman Systemic Risk Indicators has risen to its HIGHEST level since the summer of 2015.

S&P 500 Index Price

July 20: 2800
June 13: 2800
Mar 13: 2800
Jan 16: 2800

Bloomberg terminal data

The Fatal Passive Overdose, BEWARE!

Since 1993, capital shifting into passive asset management is up 161x, this compares to only 7x for active management.  Nearly $7T is now positioned in passive asset management, over $2T of this money has arrived in the last five years.  Why does this matter?  Passive asset management is simple ownership of the market through index funds, the capital MUST be fully invested and has been the fuel behind the toxic run-up in FAANG equities.  Let us explain.

One Large Beast

Looking at the passive asset management orgy, there’s no better example than the Fidelity Magellan Fund.  Famously known as the largest mutual fund on earth in the 90s, what became of this beast is nothing short of remarkable.   With assets north of $100B back in the year 2000, today he sits as just a shell of his former at $17B.  The most shocking part of this story is found in the explosive asset formation in Fidelity’s S&P 500 (Passive) Index Fund.  Assets in this giant have climbed to more than $153B, with $21B forced into  FAANG equity ownership.  As a market-weighted, passive index fund there is no choice or selection process, this beast MUST own these FAANGs – a colossal failure of common sense indeed.  It’s NOT Fidelity’s fault, they’re just offering another index fund the mad mob wants to invest in.  This is just another example of a classic, late-cycle development often found in tired bull markets – the hot money chase indeed.  As more and more capital flows into passive index funds, more and more FAANG shares MUST be owned.  Returns appear far better than the rest of the market’s offerings, so even more capital flows in – it’s a toxic, self-fulfilling cycle – when broken the declines will be HISTORIC.

Largest Weekly Fund Capital flows into Technology Equities All-Time

Jan 2018: $2.4B
May 2018: $2.2B
Dec 2017: $1.9B
Nov 2017: $1.2B
Nov 2016: $1.0B
Jan 2012: $900m

EPFR data

While FAANGs Boom, the Rest of the Market is Left BehindIn early June, the number of NYSE stocks at their 52-week highs started to move sharply lower, breaking the trend (see above) with the price of the FAANGs equities (Facebook, Apple, Amazon, Netflix, and Google).  Since January, while Netflix and Amazon have gone up 67% and 38% respectively, while the number of NYSE stocks at their 52-week highs has declined from 341 to 177 in June – to now just 71!  Bottom line, the divergence between the few (just 5 stocks) FAANG equities, and all the rest of the market presents a crystal clear example of negative breadth. This growing disparity in the markets extends to real economic terms as well.

Profits in the Hands of the Few

According to an analysis conducted by the Wall St. Journal, in 1978 the percentage of profits coming from America’s 100 largest companies was near 46%, today we’re approaching 85%!  The inequality decade has some very ugly side effects, doesn’t she?  The clock is ticking here, G10 countries have VERY large aging populations.  Indeed there are some bills to pay.  In the U.S., Medicare will run out of money far sooner than most expected, and Social Security’s financial problems can’t be ignored either.  This month, the U.S. government said in a sobering checkup on programs vital to the middle class – Medicare’s available cash is dwindling at an alarming rate.   Per the LA Times, the report from the program trustees says Medicare will become insolvent in 2026 — three years earlier than previously forecast. Its giant trust fund for inpatient care won’t be able to fully cover projected medical bills starting at that point.  As populism continues to march forward, we expect the FAANGs to have a VERY large target on their back in the months and years to come.  Somebody has to pay for these mathematically unsustainable promises made by politicians, and we’re looking at you FAANGs.

Is that Your Fair Share Amazon?

Even with the dire straights of U.S. unfunded liabilities (Medicare, Medicaid, Social Security), only 12.9% of Amazon’s profits went to federal, state, local and foreign taxes from 2007 through 2015, per S&P Global Market Intelligence.  In ugly fashion, that’s half the average amount S&P 500 companies paid over the same period.  Look for populism’s surge to take a large bite out of Amazon in the near future.

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Jumping into Bed with a Greater Fool

At the very end of the day, an investment in FAANG equities today involves jumping into bed with the greater fool theory.   Sure, there’s always late cycle dumb money pushing prices higher, but 2018’s toxic ingredients have come together and forged an atrocious risk-reward in these overstuffed equities.

Wall St.’s Research, a Lesson in Crowded Trades

General George S. Patton once said, “if everyone is thinking alike, then SOMEONE isn’t thinking.”  Wall St.’s “brain trusts” have 182 buys on FAANG equities and just 7 sells, this gives a colossal failure of common sense new meaning.  Highly reminiscent of the late 1990s indeed.

Wall St.’s Change in 12 Month Price Target in 2018*

January vs. Today

Facebook $FB: $210 v $228
Amazon $AMZN: $1305 v $1930
Apple $AAPL: $189 v $199
Netflix $NFLX: $212 v $371
Goole $GOOGL: $1180 v $1270

*Consensus of over 35 analysts, Bloomberg data.  One of the biggest problems with Wall St. equity research is found in their favorite past time, performance chasing.  In terms of job security, they believe there is safety in numbers.  As a result, the sheep move in lockstep together.  Analysts tend to move up their price targets as the bull market picks up steam.  At the end of the day, often times the little guy is left holding the bag as price targets rise, and rise again.  More and more of the crowd gets sucked in at higher prices.  There’s little focus on risk-reward at nosebleed price levels.

Wall St., A Love Affair with the Few

“The market cap of the five biggest stocks in the S&P 500 is now almost exactly equal to the market cap of the smallest 282 S&P 500 companies. Both come to just under $5.1tn. Today’s chart of the day shows that a six-member FAANMG sector (FAANGs + Microsoft) would at this point be comfortably bigger than any of the 11 economic sectors into which the S&P is divided.”

-Financial Times

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FAANGs Crushing the Rest of the S&P 500

This speaks to fleeting market leadership and above all, a very unattractive risk/reward facing investors today. We’re talking about an indicator of market health here and for right now, even with all the glorious headlines, we’re looking at a sick patient.

In our view, the FAANG stocks are massively overvalued and thus ripe for a massive roll-over.  before year-end in our view.  Even a relatively minor downturn in the market as a whole could wreak havoc on the FAANGs.  And as stated earlier, the disproportionally high number of equities declining in price is hidden by the FAANGs.  What’s worse is that such a rollover would have massive implications for some of the market’s largest asset management firms.

Inflows of into Passive Management Funds and ETFs (Exchange-traded-funds)

There are 605 ETFs which hold FAANG equities as a top 15% position in the fund!!!!  This has to be the most crowded trade in the history of financial markets – just five stocks make up most of the ETF universe, lookout!

ETF Ownership of FAANG Equities

2018: 605
2017: 501
2016: 430
2015: 332
2014: 277
2013; 230
2012: 175
2011: 101
2010: 62
2009: 14
2008: 9

Just five stocks as a top 15 holding in 605 ETFs, think about that… ETFDB data

 In January Alone – Passive Asset Management Inflows
2018: $105B
2017: $68B
2016: $18B
2015: $22B
Each month as capital flows in, FAANGs must be purchased.
Dislocated from Reality

Around 20 years ago, nearly all of asset management was active. Fund managers would buy and sell equities using personal judgment and research.  In the last five years, trillions have flown into passive management, where managers place funds into market-cap-weighted ETFs and indices in an attempt to capture the momentum of the market, without doing research. While equally-weighted indices own all stock equally, market cap weighted-funds are more heavily weighted to larger-cap stocks (S&P (passive) Index Funds, for instance, are heavily weighted to FAANG stocks.  A closer look shows; 3.8% Apple, 3.1% Amazon, 3.1% Google A 3%, Google C 3%, 2% Facebook and nearly 1% Netflix.  That’s 16% of the index in just five stocks). Thus, the rise in passive management has made FAANG stocks more dislocated from reality, as passively-managed funds are disproportionately forced to own them. Thus, the explosion of capital into passive funds has been forcing more and more capital into fewer and fewer stocks.  This will end in tears – SELL Mortimer SELL!

Facebook’s Largest Holders
Vanguard 170m shares
BlackRock 147m shares
Fidelity 122m shares


UK Political Risk: Points to a May Summer Exit

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Resignations in May’s Cabinet will Topple Government in Our View

This weekend was punctuated by news of major resignations from within British Prime Minister Theresa May’s cabinet by Secretary of State David Davis and Foreign Secretary Boris Johnson. These came in response to Friday’s controversial “Chequers Agreement,” which many pro-Brexit figures saw as a betrayal and an arrangement that kept the UK far too close to the EU and its regulatory power.

Bearish Bets on the Pound Mounting
Net shorts are piling in, bets against Sterling on the rise.

Elections in the Offing?

This strong rebuke from two high-profile members of the “Leave” camp demonstrates in the strongest possible manner a continued dissatisfaction amongst more hard-line Conservative MP’s on the Prime Minister’s handling of Brexit. We believe this also foreshadows a “no confidence” vote within the next three months, the removal of Theresa May from office, and potentially a new round of General Elections.

Theresa May Exit Date Odds:
Betfair: 1/1 (by Sep. 2018)
SkyBet: 10/11 (by end 2018)
Ladbrokes: 4/6 (by end 2018)
Coral: 4/6 (by end 2018)
$markets: 5/6 (by end 2018)

“The betting on her exit date has moved very sharply from a 26% chance on Betfair [Sunday] morning that she’d be out this year to a 55% chance now [on Monday].”

UK General Election in 2018 Odds:
Betfair: 6/4
SkyBet: 13/8
Ladbrokes: 7/4
Coral: 7/4
$markets: 23/10

Pound Breaks its Recent Trend
We take a negative view on the GBP and UK Equity for the next six months. The Pound (GBP) has taken a significant hit recently on the back of uncertainty regarding the status of negotiations on the EU-UK post-Brexit agreement. The increased risk of a domestic government meltdown and a May exit will only serve to further compound this bearish trend.

No Confidence

A “no confidence” vote in the House of Commons from May’s own Conservative MP’s will have a substantial market impact, as it would hint toward a “harder,” more pro-Brexit successor. Such a person would almost certainly be more opposed to the UK remaining in the EU common market, causing even greater upset to the UK market due to greater trade worries.

If the Conservative Party (Tories) is unable to agree on a pick for Prime Minister following a successful “no confidence” vote, general elections will follow. We determine that the risk of a Labour victory will weigh on UK Equities and the Pound in such a scenario, as a government under big-government, high-tax Labour leader Jeremy Corbyn would prove unfavorable for markets. Such a scenario could also imperil the current state of affairs when it comes to Brexit negotiations, with substantial market impact.

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Populism’s Rage, Once Again has EU Banks in Pain

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Special thanks to ACG Analytics

Blog updated May 29, 2018 at 7:44am ET


Italy’s UniCredit Bank Equity
Italian banks led European financial stocks lower as the growing likelihood of new elections shook investor confidence. Banca Monte dei Paschi di Siena SpA, the habitually-volatile state-rescued bank, led declines with a drop of as much as 7.8 percent. The eight worst performers on the Bloomberg Europe Banks Index were all Italian lenders as of 12:07 p.m., with UniCredit SpA losing almost 4 percent and Intesa Sanpaolo SpAdown about 3 percent. At least a part of the pressure on equities came from the bond market. The yield on Italy’s benchmark 10-year sovereign bonds surged again on Monday to over 2.60 percent, it highest in nearly four years. – Bloomberg


Breaking: Italy Sells $5.7B of 183-Day Bills, Yield 1.213% 

Previous T-Bill Sales Below

May: +1.21%
April: -0.42%
March: -0.43%
Feb: -0.40%

– This is an incredible surge in the cost of short-term financing as of Tuesday Morning May 29, 2018.

Two Year Bond Plunge – Yield Surge in Italy
Italy 2 Year Bond Yields now through the US for the first time since November 2014.  

10 Year Bond Yields and Recent Change

US: 2.80% (-30bps)
Australia: 2.68% (-24bps)
Italy: 3.16% (+143bps)**
Canada: 2.30% (-23bps)
UK: 1.22% (-34bpss)
Spain: 1.64% (+47bps) **
France: 0.68% (-32bps)
Germany: 0.29% (-47bps)

Bloomberg data

Rough Weekend

As the cost of credit default protection is surging on Italian banks, the Five Star Movement’s (M5S) Luigi di Maio and Lega’s Matteo Salvini managed to reach an accord on their coalition’s program.  Likewise, the structure of a future cabinet and the candidate for the premiership are on the “Italy First” agenda. All that is left for the two is to seek out the mandate to rule from President Sergio Mattarella Over the weekend, discussions have taken a sharp turn for the worse as all sides failed to agree on a new finance minister.  Some in Lega party leadership insist on a Euroskeptic head of finance, others want a more centrist figure.  Together, the M5S and the League (Lega) have an impressive majority of 37% in the 630-seat Chamber of Deputies, though a slimmer edge in the Senate.  Their standing is up over 200% in recent years as the Populists have been able to steal political market share from center-left parties in Italy.  See our The Bear Traps Report with Larry McDonald; Tocqueville’s Italy – January 25, 2018_

Populists Surging in the Polls, Can You Wonder Why???
As you can see above, Italy’s raw deal on the Euro is an open wound – it can’t be swept under the rug for much longer.  It’s an #ItalyFirst moment indeed. 
A recent poll for the daily La Repubblica put support for the Trump-like Populist League (or Lega) at close to 22 percent, up from 17 percent in March, which would make it Italy’s second most popular party. Support for the League’s (Lega) largest rival,  5Star, stayed steady at 33 percent, while support for the incumbent center-left Democratic Party dropped from 19 percent to 18 percent.  Bottom line, populists now control 55% of the vote – Euroskeptic sentiment is on the rise.

“Italy First. Either this government gets started in the next few hours and we start working, or we might as well go and vote again and get an absolute majority.  Although it would be disrespectful to Italians if this government doesn’t get started because it’s unpleasant to someone in Berlin or Brussels.”

Lega Leader Salvini told a rally near Bergamo in northern Italy late on Saturday (Bloomberg reported).

” President, Sergio Mattarella said he could not countenance their  (Lega / Five Star) selection of an economics minister who he said threatened to take Italy out of the eurozone. He said even the threat of leaving the euro would have dramatic consequences on the markets, costing Italian families and investors money and its young people opportunities.” –

New York Times, reported Sunday evening, May 27, 2018

A Trump 2.0 in Italy

We believe the Salvini’s (Lega) surge in popularity is on par with Trump’s rise in 2016.  If the Lega star was a stock, you would want to be long of it.   Sunday evening, the leaders of the Five Star Movement were already discussing Mr. Mattarella’s impeachment, while Matteo Salvini, the leader of the League, who would not budge on his choice for a eurosceptic economics minister, and who has seen his popularity rise during the tortuous negotiations, is eager to go to early (new) elections. 

Near-Term Debt Coming Due, a High Mountain
Populists in Italy (Lega – 5Star) calling for the quick deportation of an estimated 500,000 immigrants (Sky News) from Italy, with $2.4T of debts and $2.0T of economic output, they question the financial sustainability of EU migration policy?  The cost of default protection on  Italy’s bonds is climbing the most since dark days of the European debt crisis.  Political uncertainty has unearthed risks inside the financial system of the southern European nation. The five-year Italian credit default swap rose about 42 basis points last week, the most since 2012, according to data compiled by Bloomberg. Populist leaders abandoned their attempt to form a government at the weekend after the president rejected their choice of a euro-skeptic finance minister, while Moody’s placed the country’s ratings on review Friday for a possible downgrade. 

“Italy has over $800B of debt maturities coming due between now at 2022, that’s nearly 40% of their total $2.4T debt load – some bills have to be paid here indeed.” – The Bear Traps Report, January 2018

Bonds for Sale – Italy Needs Friendly Capital Markets

Highly in need of friendly (wide open) capital markets, Italy needs easy access to financing.  If the beast inside the market continues to turn on Italy, this will place Mario Draghi’s ECB in a very difficult spot.  Italy still needs to sell bonds worth $130B in the markets this year, according to BofAML.  This figure will ONLY increase if populists get their way on an aggressive fiscal spending plan with tax cuts.  We MUST remember, there are rules within the ECB’s “capital key.”  The central bank cannot purchase large amounts of Italian debt relative to other EU countries.  These capital key limits will be stretched to high-stress levels in the coming months.  Draghi will need a sign off from Germany on additional capital key expansion for Italy. ” Angela, please get out the checkbook.”  The rise of “Germany First” populists in Deutschland presents political stress on the other side.  The AfD party has surged from 1% to 18% since 2013.  Populists in German (Afd) and Italy (Lega) both have their hands on a very large rubber band and they’re walking backward at an accelerated rate. 

Weekend Drama, Selection of New Finance Minister a Focus

According to Article 92 of Italian Constitution, it is the president who appoints ministers “following PM’s proposals,” (Lega wants Savona in a large way).

“Italy’s novice premier-designate Giuseppe Conte struggled to form a populist government throughout the weekend, stranded between a president who objects to a eurosceptic candidate for the economy ministry and a coalition ally threatening to force early elections.  Conte, 53, is working on a list of ministers to propose to Sergio Mattarella, 76, the head of state whose task it is to name the government team. The talks are likely later Sunday (May 27), according to an official of the anti-establishment Five Star Movement who asked not to be identified because the plans weren’t public. Economist Paolo Savona*, 81, a candidate for the economy ministry, said in a statement on an Italian website on Sunday that he was in favor of a European political union and urged full implementation of objectives in the 1992 Maastricht Treaty.  Efforts to form a populist government could be jeopardized by a tussle over Savona between the president and Matteo Salvini of the anti-immigrant League, which is Five Star’s junior partner, and lead to early elections possibly in the fall. The populists’ pledges of fiscal expansion and tax cuts would defy European Union budget rules, and the Italy-Germany 10-year yield spread reached the widest since 2014 on Friday.”  – Bloomberg

* Savona, a company executive and former industry minister, has come under fire both for repeatedly calling on the government to plan for a possible euro exit and for his criticism of what he sees as German dominance of Europe. Mattarella, a former constitutional court judge, insists on his right to appoint government ministers, without pressure from outsiders. In our view, we’re looking at a Savona moment.  If the new Italian government agrees with populists (Lega – 5Star) and chooses him as finance minister, it substantially raises the probability of a destructive EU conflict with Italy.  It would be gasoline on the “risk-off” fire.  If EU pressure prevents the populist agenda from moving forward, it will lead to a large surge in the polls for Lega – 5Star in the next round of elections (coming this year).  That’s bad news for markets as political pressure on the ECB is surging to it’s highest level in years.

Eurozone Debt Load

Italy: $2.2T
Spain: $1.0T
Germany: $860B
Ireland: $156B
Portugal: $150B
Greece: $60B

Bloomberg data

So, Draghi (ECB) expands the capital key / bond buying mechanism for Italy? And the others??

A Tale of Two Banks
Politics is driving asset prices here.  After months of House delay in sending a Dodd-Frank regulatory relief bill to the President’s desk, President Trump signed the legislation this week. As you can see above, KRE Regional Bank ETF has been pricing in the good news for months. The bill is identical to the version which passed the Senate in March and provides relief aimed at community banks, while raising the systemically-important financial institution (SIFI) threshold from $50 billion to $250 billion (although the Federal Reserve may still subject banks between $100-250 billion for enhanced supervision). Among other provisions, mortgages held by banks with under $10 billion in assets are automatically designated as “Qualified Mortgages,” and community banks which underwrite fewer than 500 mortgages a year will be largely exempt from Dodd-Frank mortgage rules. The amended law also provides regulatory relief for appraisal requirements in rural areas, as well as broader relief to community banks in having to furnish Home Mortgage Disclosure Act (HMDA) data and lengthens the examination cycle for well-capitalized banks from 1 year to 18 months. – ACG Analytics.

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A Placeholder President

Mr. Di Maio and Mr. Salvini presented the coalition’s Prime Minister (PM) pick to the President this week. The candidate, Giuseppe Conte, a law professor, is without governing experience. By selecting a political novice for the premiership, Di Maio and Salvini improved their chances of exerting influence on the likely future PM.

Deficit Spending and Tax Cuts

The coalition program plans to bolster the country’s spending by killing pension reform, introducing a flat tax, and by increasing expenditure on maritime migrant interception programs. While the major points of controversy were scrapped from the final proposal (the final version does not mention leaving the eurozone, or a plan to get bonds purchased as part of the ECB’s QE program), potentially fiscally worrisome measures remain.

Cost of Credit Default Protection, on the Rise
Clearly, the new governmental program will lead to a clash with Brussels.  The cost of credit default protection is surging in banks with heavy exposure to Italy.  We haven’t seen this kind of credit risk divergence between EuroZone and US banks in six years.  Our Index of 21 Lehman Systemic Risk Indicators is rising at the fastest pace since 2012.  See our full report on The Bear Traps Report with Larry McDonald; Tocqueville’s Italy – January 25, 2018_

Cost of Credit Default Protection (Updated April 29, 2018)

Deutsche Bank: 306 (+101)
Intesa Sanpaolo: 397 (+225)
UniCredit: 396 (+230)
CommerzBank: 224 (+80)
Santander: 244 (+140)
Soc Gen: 180 (+87)
BNP: 178 (+88)
UBS: 102 (+28)

*(change since April), sub CDS, in basis points, Bloomberg data

Keeping Financial Commitments

The agenda is likely to divert Italy from abiding by EU fiscal regulation (i.e. the Fiscal Compact). France has already issued a preemptive warning with French Economy Minister Bruno Le Maire stating: “The stability of the eurozone will be at stake if a populist new government in Italy fails to keep its financial commitments.”

Italy’s 50 Year Bond Price Plunge
Italy’s 50 Year Bond plunged 12 points last week. In October 2016, ‘Italy’s $5.6 Billion Sale of 50-Year Bonds Beats Peers’.  Italy sold five billion euros ($5.6 billion) of the securities, exceeding deals by Spain and France for similar-maturity bonds. The country became the latest in Europe to issue super-long bonds, following debt agencies in Belgium, France, Ireland and Spain taking advantage of historically low-interest rates made possible by the European Central Bank’s 1.7 trillion-euro stimulus program. The ECB, whose asset purchases were expected to run to at least March 2018 (now at least March 2019), has acquired more than 900 billion euros of debt just from the Italian, Spanish and French governments. Political risk continues to fuel market volatility and uncertainty in the sovereign bond market, especially with regard to, short-term security issuance aimed at covering the state suppliers and tax rebates–which, if implemented, could cost the Italian taxpayers more than 5% of the Italian GDP.

Stocks in Italy, 10% off their April Highs
Equities in Italy are approaching key technical levels.

Italy’s Baa2 Rating May Be Cut by Moody’s
Moody’s says the key drivers for the placement are the significant risk of a material weakening in Italy’s fiscal strength and the chance that the structural reform effort stalls. Italy’s long-term and short-term foreign-currency bond and deposit ceilings remain unchanged at Aa2 and P-1, respectively.  “What’s the point of going to vote if it’s the ratings agencies that decide?” Luigi Di Maio, head of Five Star said Sunday in frustration.  He believed financial stress in markets played a roll in the veto of their proposed Finance Minister Paolo Savona.

No Strings Attached

The coalition agreement is not a legally binding treaty—the two populist heavyweights could resort to resuscitating the more radical among the scrapped measures in the future.  Even though the coalition partners left out of their final program some more drastic measures, there was an original proposal which contained a draft to explore ways of leaving the euro (as well as recommended ECB debt jubilee, or forgiveness).  Calling for the new government to stick to a responsible budgetary policy, the vice-president of the European Commission, Valdis Dombrovskis, noted that Italy’s borrowing was proportionally the highest of any euro-zone state except Greece.

Regime Change: Eurozone Equity Market Vol Crosses the U.S.
For the first time in a year, we’re seeing the cost of equity volatility protection in Europe surge through that of the U.S.  This is impressive since this year’s (White House trade and Fed interest rate) drama in equity markets has been U.S. centric. This speaks to a regime change in risk management to a more Europe leading focus moving forward. In the 2010-12 period, for months European credit risk moved well ahead of U.S. equity volatility.  A solid leading risk indicator indeed.

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A Back Away from High Drama, for Now?

The program has already inflicted High Drama on EU member states, especially within the eurozone. While M5S and Lega claim that the mini-BoTs proposal is not a veiled attempt at introducing a shadow parallel currency, many seem to doubt the honesty of their intentions.  We witnessed this dangerous political gamesmanship during the early stages of the Greece crisis in 2010.  When tensions are high, populist politicians in some cases leak sensitive parts of their agenda.  Almost as a trial balloon, they are testing both the markets and EU political leadership’s reaction process.  EXPECT A LOT MORE OF THIS TO COME.

The Di Maio-Salvini-Mattarella meeting will provide clarity on the new M5S-Lega administration, and reveal details on the coalition’s future program. It is not certain that the new government will actually move to implement all of the policies enumerated in the contract. With a small majority in parliament, it will be very difficult for the future government to pass radical legislation. Furthermore, President Mattarella retains the right to veto proposals.

Euro, Broke the Uptrend Line going back to 2014
Deutsche Bank bailout rumors, falling PMIs (economic data), Populism in Italy and government stability problems in Spain have all taken the Euro down to 1.16 from 1.25.  Spain’s opposition socialist party has filed a no-confidence motion against the prime minister, Mariano Rajoy, a day after his governing People’s party was found to have benefited from an illegal kickbacks-for-contracts scheme.

Full Term?

The new cabinet could be sworn in before the end of this week. The process would be finalized by a vote of confidence in both the Senate and the Chamber of Deputies. ACG Analytics does not believe that a M5S-Lega government can survive for a full term—the arrangement is likely to have a limited shelf-life, as the notable policy differences between the two parties and inevitable backstage influence of Berlusconi’s Forward Italy party on Lega is certain to exacerbate the tension between them.

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Prime Minister nominee Conte served on the Board of Directors of the Italian Space Agency as a legal consultant to the Rome Chamber of Commerce, and as a supervisory board member to a number of insurance companies going through bankruptcy.

Two Year Bond Yields, Screaming Higher in Italy – 2012-2018
Italy two year bonds, moving from -0.32% in early May to +0.48% this week.  We witnessed the largest yield spread differential between Italy and Spain in over 5 years.  Systemic risk is on the rise.

Further details of the coalition agreement cover:

“Parallel currency”: The new government plans to launch mini-BoTs, controversial securities similar to a parallel currency, as part of the administration’s plan to ramp up expenditure. These short-term securities would be used to pay overdue tax rebates and state suppliers.

Flat tax and universal income: The Lega made its flat tax policy for companies and individuals a part of the contract, with two tax brackets at 15% and 20%. The M5S inserted its basic income plan into the program, proposing a EUR 780 monthly compensation paid to those with no revenue.

EU policy: A number of measures introduced calling for the renegotiation of EU treaties and the EU’s economic regulation on several issues, including the single currency. Both parties pledged to tackle smuggling networks and illegal migration, calling for a new debate in Brussels on European migration. Furthermore, the program calls the immediate withdrawal of sanctions against the Russian Federation.

Pension reform: The program envisions the gradual scaling back of the “Fornero” pension reform.

Sovereigntist economy policy: The program aims to implement a legal minimum wage (not yet specified), ramp up savings protection, increase the responsibility of banking authorities, prevent the sale of Alitalia, and re-negotiate the Turin-Lyon high-speed railway project.

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Late Cycle Divergence: Commodities and Equities

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Since mid-December commodities are 10% higher with equities about 1% lower.  We believe markets have entered a late cycle secular shift into a new regime.

Returns in 2018

Cocoa: +49.6%
Lumber: +27.3%
Wheat: +16.4%
Oil: +14.3%
Nickel: +12.1%
Corn: +11.5%

Soybeans: +10.8%
Aluminum: +6.2%
Nasdaq 100: +4.0%
Gold: +2.1%
Russell 2000: +1.3%
S&P 500: -0.10%
Dow Transports: -0.6%
Dow Jones IA: -1.6%
Copper: -7.2%

Bloomberg terminal data

Hot Commodities laying Pressure on Bonds

Monday the Fed’s preferred inflation gauge (PCE) is expected to hit the central bank’s 2 percent target for the first time in a very long time.  Matching or exceeding that forecast would affirm traders’ conviction that inflation is headed higher, pushing up long-term yields.

Commodities Laying a Beating on Stocks in 2018
“One of the side effects from the 2009-17 period of “global monetary radicalism” is found in the extreme financialization of the developed world’s economy. In the U.S., CFOs (corporate financial officers) have been incentivized to become financial engineers. In recent years, capital investment has been two standard deviations below previous economic recoveries. “Secular stagnation,” low growth rates, paltry interest rates, and worsening demographics, all favored an outperformance of “capital” over “labor.” In these periods, financial assets – like real estate, stocks, and bonds – outperform hard/soft assets like commodities. For U.S. companies, capital investment and other “real” economy-related risk-taking, offered very poor rates of return as the economy operated below its already low level of potential. To keep shareholders pacified, financial engineering through raising low-cost debt to fund share buybacks, ruled the land in recent years. Today, for the first time in nearly a decade, we have a sharp surge in fiscal spending, while the U.S. is operating above trend, and demand for labor (wages, capex) is picking up. Bottom line: we see a cyclical shift into a new regime. As central banks shrink their balance sheets, hard/soft asset (commodities) will outperform relative to overly expensive “financial assets.” This is a freight train coming at us – the only question remains – who’s getting on? We expect this under-loved asset class (commodities) to show leadership in the new regime. In our view, the global QE (asset purchases, quantitative easing, 2009-17) period marked the near term top of “financialization” and its gradual withdrawal into a late cycle landscape will lead to a “rebalancing” between cheaper commodity-related assets and overly expensive financial assets. The tipping point of this secular shift is the central bank taper and tightening process.”

The Bear Traps Report, February 10, 2018


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Value Flashing a Loud Warning

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Late Cycle Recession Warning in Staples Capitulation

In the last week, we received an  XLY (consumer discretionary)  vs. XLP (consumer staples) warning in our “21 Lehman Systemic Risk Indicators” model (see below).  The recent move is not only unsustainable but also speaks to the increasing probability of recession in the next 12 months.

Over the last two years, value (consumer staples) -4% has underperformed growth (consumer discretionary) +29% by nearly 35%. – over the last year, -10% to +14%.  After last week’s colossal acceleration, the BEATING is now more than two standard deviations outside the thirty-year mean.

XLY vs. XLP Ratio and the S&P 500
Bottom line, the parabolic (see the white line above) outperformance of the consumer discretionary names (ratio of XLY to XLP) has been incredible and is “classic” late cycle activity.  The value depression end is in sight in our view.  Value will crush growth over the next 12-18 months.  A solid leading equity market indicator above, watch for a shift in consumer staples.  The sector typically starts to outperform (after a period of blow off top underperformance) 12-18 months ahead of substantial equity market drawdowns and recessions.

% of Stocks Above the 200 Day Moving Average

S&P Consumer Discretionary: 61%
Brazil: 61%
S&P 500: 54%
DJIA: 53%
Nasdaq: 47%
S&P Materials: 47%
Germany DAX: 37%
S&P Consumer Staples: 31% 

Bloomberg data

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The Four “Irrefutable Truths”

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In many cases, sell-side research (from the major banks) reminds us of the plump chef standing at the head of an “all you can eat buffet.”  Rarely would he whisper health tips into your ear or provide guidance toward restraint.  “Eat up Johnny, all is good.”

In all our years on Wall St., one major takeaway is the danger found in “broad theme consensus.”  Decade after decade we’ve seen this play out in so many different forms.  The more unanimous the sales pitch, when you hear it on every street corner, it’s the best leading indicator to RUN, not walk the other way.

The 2012-14 Sales Pitch: Four “Irrefutable Truths”
Look back to the summer of 2014.  Retail investors were lectured, over and over again on the “four irrefutable truths.”  MLP companies are 1) toll road businesses, with 2) fixed fees, 3) secure long-term contracts, and 4) the commodity price (oil and gas) doesn’t matter.  Of course, ultimately investors learned these truths were more than refutable.  Over the next 18 months, the average stock in the MLP sector would lose nearly 70% of its value (see below).

MLP (Master Limited Partnerships) in the Energy Patch

MLPs are pass-through entities, which distribute almost all pre-tax income to unitholders, who then are responsible for paying the taxes on it according to their individual situations. As such, they benefit from a very advantageous (almost 0%) tax treatment, while regular “C” corporations pay a 21% statutory tax rate (35% prior to tax reform). Since 2005 MLPs have been able, in the FERC’s words, “to recover an income tax allowance in their cost of service” — effectively boosting the amount of pre-tax income to be passed through. This “double recovery” of income tax costs that MLPs enjoyed is now disallowed.

Beaten Up Value, Left for Dead

“The investment industry has long misunderstood the business models and the analysis has been reflective of that misunderstanding.  Until 2015, MLPs paid an increasing percentage of CFFO back to investors, peaking as an industry at >90%.  However, since CAPEX and debt servicing also needed to be paid, debt leverage quietly increased until Debt/EBITDA approached 6x (from normalized 3.5-4x Debt/EBITDA for years) for the industry by the end of 2015.  Finally, when oil production peaked and started to fall in 2015, the credit agencies required pipeline companies to reduce leverage, and dividends were cut substantially.  The dividend cuts scared retail investors, and even today many believe that the business models are under threat.  The sector has fallen dramatically and has deeply underperformed the broader markets. Instead, many pipeline companies are actually doing well, at least operationally.  What has been difficult over the last 2 years is that the marginal dollar of cash flow is being sent to the debtholder and not the equity holder.  For an investment vehicle that is intended to deliver income to investors, incremental dollars not being returned to equity holders is a problem.  However, as in most leverage recovery situations, the recovery is a 2-3 year process and is now going on 3+ years.  So companies like Kinder Morgan (KMI) cut its dividend by 80% in Dec 2015, and has for the first time since then, guided to increase its dividend by 50% in 2018, and 25% for a few years further into the future.  And by the way, KMI’s EBITDA is higher in 2017 than it was in 2015, but the stock was at $40 in the first half of 2015 and is now below $19. We generally look at these companies comparing the RoIC vs the WACC.  The relationship between ROIC/WACC tells us what multiple of Invested Capital we should be willing to pay for the business.  So if a co has ROIC=WACC then it adds no additional value to the capital it has invested and the company should be valued at only its invested capital, no more no less.  If a co’s ROIC is 2x the WACC then the company should trade at 2x the invested capital, and so on.  What is interesting about the group today is that most companies are trading right around their invested capital, and sometimes at discounts.  Historically they’ve delivered 1.25-1.75x their WACC, and that is what makes the opportunity so interesting.”

Mark Laskin, from 2013-2017 he was the CIO of T Boone Pickens’ BP Capital Fund Advisors, where he managed Energy and MLP portfolios.

King of Retail Pain, MLPs
The ultimate goal of the Bear Traps report is to discover bear markets transitioning into the new bright bull.  Last year we were fortunate to get the solar, oil and steel sector migration north right.  This year in the MLPs, we got sucked into a bear trap in January.  In error, we chased this group (see the red circle above) into what we believed was a new bull market.  We could have stopped ourselves out (stop-loss sell) but our cost basis was manageable from a trading perspective.  Today, coming out or the grip of a multi-year grizzly bear market, we believe the MLPs are very close to a major bullish move higher.  Over the last few years (see above) we’ve witnessed an incredible amount of capitulation selling.  Only when the last retail investor (previous heavy ownership) has given up on the sector can it move higher.  The question is, who’s left to sell?

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Measuring Capitulation

Our seven-factor capitulation model quantifies the “fannies rushing to the exits”, and looks back historically in an attempt to measure the selling pain.  Is this a category three hurricane, or a more treacherous Cat 5?

In November’s first major MLP capitulation, we had an 18% gain from our AMLP entry into the new year (see above). Next, we tried to buy on the trend break (red circle above), thinking this was the great jailhouse break out of the bear’s multi-year grip.  Next, we were met with a painful second round of selling last month, and we should have, in all likelihood, lightened our position there. In October, she was trading 9M shares a day, but by the November capitulation, it was 20M a day! They were jumping over the seats, swinging on the chandeliers, trying to get out through the bathroom window, the wild mob wanted OUT of the MLPs. Moving forward to the March capitulation, we had reached 25M shares a day, a true panic yet again!  Who’s left to sell the MLPs?

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Rising Interest Rate Risk

“It is true that in rising rate environments the relative performance of MLPs to the S&P 500 is lower, but relative to other known rates-like sectors (such as utilities and REITs), MLPs tend to outperform. This makes sense as oil prices are the key driver, and oil often goes up in hiking cycles. As oil prices continue to rise we expect MLP performance to turn higher as oil becomes the marginal driver. Over the past decade, MLP correlation to crude prices has remained quite high. Against the rate backdrop it is important to notice that in credit spread terms, MLP yield valuation are getting very attractive again, especially given these oil price levels and their trends. The average spread of Alerian MLP (AMLP) to the Ten year treasury yield since 2000 has been around 350bps, and is currently over 600. The yield valuation is there while AMLP yields over 8%.  Bottom line, MLPs are a BUY (AMLP equity) in our view with an attractive risk – reward.”

Bear Traps Report, March 28, 2018

Impact of FERC (Federal Energy Regulatory Commission)
The Federal Energy Regulatory Committee (FERC) ruled last month that it will revise its 2005 Policy Statement for Recovery of Income Tax Costs and no longer allow master limited partnership (MLP) interstate natural gas and oil pipelines to recover an income tax allowance in the cost of service rates. The news triggered a dramatic capitulation sell-off (see above) in the MLPs out of fears of a considerable hit to their operating profit.

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FERC Noise

With the recent developments since the FERC rate policy change, the stocks most impacted were those with higher exposure to the cost of servicing pipelines. Given the weakness in EEP and TCP, which are also financing vehicles for C-Corps, we could see difficulties in executing drop downs, a way energy companies monetize the midstream part of their operations. Most of the other MLP names are not as exposed to this recent FERC-related negative impact on the share price, as their drop downs look ok to us. The most impacted pipelines under this ruling are those that have legacy costs of service rates, and those that are earning at their maximum rate. However, the FERC ruling applies only to interstate pipeline assets and not to those that originate and terminate within the same state. Furthermore, the rule is not expected to go into effect until 2020.

In cases where the MLP holds the pipeline asset but a C corporation ultimately owns the MLP, the FERC rule applies. In a reverse case, where the C corporation owns the pipeline within an MLP, the asset would not be subject to the ruling. As a result, we could see strategic reviews and acquisitions within the MLP sector to circumvent the income tax order. Examples of these would be refining companies buying back assets currently held in MLPs (see our M&A section above). The ruling does not apply to, for example, Kinder Morgan (KMI), which acquired its MLP some years back. But in the case of Williams Co. (WMB), it might be collaborating with Williams Partners to create a new corporate structure to hold long-haul assets like its Transco gas pipeline. This is a big opportunity that is certainly worth watching.

The Takeaway

The period of time (between today and the enactment of this tax code restriction), where corporations have the opportunity to buy (and therefore secure) a tax-advantage that they previously saw more value in divesting. They were wrong, and they now have the chance to fix it. Ultimately, only a few MLPs will see a meaningful impact on their earnings from the FERC ruling.  On the other hand, we could see strategic reviews leading to some buybacks of MLPs that were spun off in the past. Refiners have spun out their pipeline assets into MLPs in prior years, but may now want to buy them back to circumvent the new ruling.



The Broken Seesaw

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Imagine walking through the park and across the way there’s a seesaw with an obese child on one end and a thin youngster on the other, that’s no fun.  It simply doesn’t work.

When you think about the $1.5T of capital that’s flown into passive bond ETFs and risk parity strategies in recent years, this crowd has a colossal disinflation bet on.  In other words, so much money has flown into bonds at extremely low-interest rates, if yields surge* there’s no protection on the other side.

*Forget about a surge, just don’t rally.  Interest rates down, bond prices up.  If interest rates are unchanged, bond prices will be as well.

In a regime change, a period where stocks and bonds move lower together, the flight of assets out of passive bond / risk parity strategies will be ferocious.  Click here to get a peek at our winners in this new regime.

VIX Spikes above Twenty vs. US 10 Year Bond Yield

Mar 2018: 2.76%
Feb 2018: 2.81%
Nov 2016: 2.29%
Jun 2016: 1.37%
Feb 2016: 1.68%
Sep 2015: 1.97%
Jan 2015: 1.67%
Oct 2014: 1.90%
Jan 2014: 2.57%
Oct 2013: 2.50%

Bloomberg data

Stocks Down, Bonds Down?

Think of the dentist in Cleveland, Ohio with $1M in stocks and $1M in bonds in a portfolio.  For the first time in 30 years, he / she is looking at their brokerage statement and seeing NO wealth destruction OFFSET from bonds.   We have an eye on credit quality globally (AAA rated corporates / sovereign credits are off 30-40% in terms of the amount of high-quality paper last 10 years).  Next, shift your eyes on the debt to GDP in the G20, up from 70% to near 100% (maybe 110%). Then look at the EM dollar-denominated debt issued 2007-2017, in the trillions, there’s a new player at the table trying to sell / refinance a large debt load. All this speaks to a regime change, we’re in the 1-2 inning we believe, more to come.

Q1 2018, Jack and Jill Ran Down the Hill

Even with the bond rally in March, they still finished Q1 in the red with stocks.

Largest US Equity Market Wealth Destruction

2008: -$10.5T
2015: -$4.5T
2011: -$3.7T
2018: -$3.2T**
2010: -$2.4T

*Last 10 years, Bloomberg US Market Capitalization data.
**only instance in the last 18 years where bonds also lost value. In the 2018 equity drawdown, bond SOLD OFF from 2.05% to 2.85%, ADDING nearly $1.4T of ADDITIONAL wealth destruction.




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