All posts by NY Times Bestselling author Lawrence McDonald

Larry McDonald; founder of THE BEAR TRAPS REPORT investment letter, is a political policy risk consultant to hedge funds, family offices, asset managers and high net worth investors. As former Managing Director, Head US Macro Strategy at Societe Generale, he's a frequent guest contributor on Bloomberg TV, CNBC, Fox Business, and the BBC. Larry is a NY Times bestselling author, his book "Colossal Failure of Common Sense" is now translated into 12 languages. He ran a $500 million proprietary trading book at Lehman Brothers, made over $75 million betting against the subprime mortgage crisis and was consistently one of the most profitable traders in the firm. His "Bear Traps" letter is one of the most highly regarded on Wall St. He's participated in 3 major financial crisis documentaries: Sony Pictures, Academy Award winning documentary the "Inside Job," BBC‘s "The Love of Money" and CBC‘s "House of Cards." He's delivered over 72 keynote speeches in 17 different countries, at Banks, Investment Firms, Conferences, Law Firms, Insurance Companies and Universities.

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.

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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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Lucy and the Football, Wall St. Faked Out Yet Again by the Fed

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Lucy and the Football

Heading into Fed meetings, each time public “Fedspeak” (governors on the speaking tour) raise the hawkish bar (expectations for a more aggressive policy path – rate hikes). In every instance, Wall Street gets drawn in, gold heads into capitulation. Next, the “dovish hike” (below sky-high expectations) triggers the gold rally. Rinse and Repeat.

Gold Miner’s $GDX Returns after Fed Rate Hikes

Mar 2018: +5% (so far)
Dec 2017: +17%
Jun 2017: +17%
Mar 2017: +18%
Dec 2016: +36%
Dec 2015: +136%

Bloomberg data

Hook, Line, and Sinker

Each and every time the Fed has hiked rates, their effort to signal the hike has been well over-cooked.  In an effort to provide transparency they’ve consistently oversold rate hikes.  Wall St. (sell-side economists) take the sales pitch hook, line, and sinker.  It’s “Lucy and the Football” over, and over and over again.  Heading into the Fed meetings, very consistently, the hawkish song (threats of pulling away accommodation)  from the Fed has punished gold, only to see a beautiful relief rally each time.

Managing and Measuring the Street’s Expectations is the Key

The Federal Reserve has been gold’s best friend. Heading into (rate hike) Fed meetings, each time the public “Fedspeak” (governors on the speaking tour) raises the hawkish bar (expectations for a more aggressive policy path – rate hikes). In every instance, the Wall Street gets drawn in, gold heads into capitulation. Next, the “dovish hike” (Fed delivering well below sky-high expectations) triggers the gold rally. Each round of expectations out of balance has led to higher gold (and gold miner’s) price action in the weeks after rate hikes.

Since last week’s Fed Meeting, the probability of a June rate hike has plunged, from 90% to near 73% – while gold has surged from $1307 to $1350. When you’re trading gold, you’re actually trading eurodollars, the Fed rate hike expectations curve.

Gold Silver Cross, Speaks to a Global Economic Recession

The divergence between the two means prices for gold are 82 times those of silver, which is 27% more than the 10-year average and the highest level in two years, data analyzed by WSJ Market Data Group show.  A higher gold-to-silver ratio is viewed by some investors as a negative economic indicator because money managers tend to favor gold when they think markets might turn rocky and discard silver when they are worried about slower global growth crimping consumption. Industrial uses account for about 55% of demand for silver, according to the Silver Institute, leading some traders to link it more with base metals like copper and others.

China Warning

The precious metals ratio last stayed above 80 in early 2016, when worries about a Chinese economic slowdown roiled markets, and in 2008 during the financial crisis. The ratio’s recent rise comes as speculators have turned bearish on silver and inventories in warehouses have risen, a sign there could be too much supply.

COT Data, Bullish

Our friend Jordan Roy Byrne notes net speculative positioning in Silver (against Open Interest) hit 1.7% this week, the lowest on record. To us, this is more than BULLISH.  Friday’s commitment of traders (COT) report showed speculators shifted aggressively net short, something NOT seen every day, and commercials are almost in balance, which is also unusual and bullish in our view.

MSCI World Equities vs. the Gold Silver Cross
This is a bit of a mindblower.  Over the last twenty plus years highs in the gold-silver cross (extremely weak silver pricing relative to gold) were met with bear markets in global equities.  Which makes a lot of sense, for decades silver has been a global economic bellwether.   In the 2017-18 global equities, paradigm stocks have climbed even as silver has dramatically cheapened.   To us this speaks to deleveraging in China, industrial metals are pricing in some pain, a lookout warning for the global economy (and equities).  Pick up our full report here.

 

Must Read from the WSJ on Silver, well done.

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Oil Impact: President Trump and the Iran Deal, Countdown to Conflict

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“President Trump, by demanding on Friday that European allies agree to rewrite the Iran nuclear deal within 120 days or he will kill it, set himself a diplomatic challenge that would be formidable even for an administration with a deep bench of experienced negotiators.”

The New York Times, January 12, 2018

By now, most market participants know the abrupt “You’re Fired” Rex Tillerson (former U.S. Secretary of State) moment was driven by a conflict with the President over the Iran deal.

Countdown to May 12th

Brent is nearly 4% higher over the last week as Tillerson’s exit has put a bid under crude.  The perception across commodity trading desks is that the U.S. is far more likely to pull out of the agreement as early as May 12, the next deadline for the White House to extend the waiver on the sanctions.

The North Korea Connection to the Iran Deal

Some of our contacts in Washington doubt the Trump – Kim Jong-un meeting (North Korean leader Kim Jong-un) will actually happen.  They believe it’s a stunt by North Korea.  As the theory goes, NK’s Kim Jong-un wants to push talks out to mid-May when the next JCPOA (Joint Comprehensive Plan of Action – US Department of State) deadline is going down.  What a coincidence, that’s around the same time President Trump has threatened he will withdraw from the Iran Deal.  If the White House does pull the U.S. out, North Korea will fully pursue a nuclear program openly and justify it by claiming the U.S. can’t be trusted in international agreements.  The Trump Administration has said they want to meet before May which backs that up this line of thinking.

Large Upside for Crude if the U.S. Kills Iran Deal

Oil bulls have their minds on 2012.   As the U.S. launched touch sanctions with a bullseye focused on Iran’s oil industry.  Exports plunged by over one million barrels a day.  As we look toward the May 12 deadline on the Obama era Iran deal, a repeat of the drama six years ago would DOUBLE the expected supply deficit in the second half of this year.

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Why the Libor Spike Matters to Stocks and Profit Margins

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Four Rate Hikes Mr. Powell?

“We agree with the market’s hawkish assessment of Powell’s comments this week. At this point, we see roughly even odds that the median dot will show 3 hikes (2.125%) or 4 hikes (2.375%) for 2018 in March, and we think the median dot for 2019 is likely to move up from 2.7% to 2.875%.”

The Goldman Victory Lap, Feb 28, 2018

Three Month Libor

2018: 2.00%
2017: 1.05%
2016: 0.62%
2015: 0.28%
2014: 0.21%

Bloomberg data

Refinancing???  As your eyes are trained on the surging numbers above, think about the impact on corporate credit and profit margins.  With the total amount junk-rated “floating rate” corporate loans up near $2.3T to $2.4T, and a smelly pile of ($1.2T) BB or less rated paper, “Houston, we have a problem.”

The Fed is Sitting at the Banquet of their Consequences

The surge in three-month libor matters because the entire ecosystem of U.S. short-term corporate finance is being repriced.  The Street is finally waking up to credit risk tied to rising rates.  In recent months we’ve warned, at the current pace of spending in Washington – a year from now we’re looking at quarterly Treasury auctions in the neighborhood of $23B – $26B for long bonds vs. $13-$15B now.  But above all, we must keep our eye on short-term, adjustable rate corporate finance.

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Without the Easy Money Gravy Train, Central Banks create Victims. Exit Strategy?  Oh Really???

“The first casualty from the shortage of $ Libor funding looks like it may well be $DB Deutsche Bank. Libor-OIS spreads are blowing out, as is Libor spread over Fed Funds. A state bailout awaits at some point…”

Raoul Pal

Powell’s Shot Across the Bow

Powell was hawkish on Tuesday. He may continue in that vein today, but he also has the opportunity to temper his comments. President Trump has used the stock market as a measure of his performance. While the Fed is clearly independent, Powell will not want to be pointed to as the reason for a bear market. PCE is reported before his comments today. PCE, as well as employment (w/avg hourly earnings) next Friday, and CPI the following week will be important inputs in formulating expectations for the Fed path. With markets fully pricing in 3 moves this year, we will need a fourth dot to justify the pricing.

Our Associate Arthur Bass, Wedbush

HYG Flash Crash
iShares iBoxx $ High Yield Corporate Bond ETF

It’s very clear, there’s substantial single name (specific companies / large drawdowns) pressure within the high yield index HY CDX, the same applies to the HYG.  Financial conditions are tightening at the fastest pace since 2015, those who are swimming naked (most highly levered) are being taken out to the woodshed.

Short-term, Adjustable rate Corporate Finance

In recent years, CFO’s across America stuffed themselves on an easy money gravy train of Federal Reserve (enabled) sponsored cash.  It was an “all you can eat” buffet and one by one they sat down for supper.

“Ultimately, many years from now, we’ll all be seated at the banquet of our consequences.”

Robert Louis Stevenson

Pumped Up Profits Margins Come with a Price

With pressure to keep profits high, many corporate heads of finance made one of the same mistakes Lehman made, the classic “maturity mismatch.”  Borrowing in the short term, at floating rates is the cheapest form of financing there is – it pumps up profit margins.  But when you borrow short-term and lend/spend long, there’s a price to pay if interest rates spike.  Quite frankly, the refinancing cycle is less attractive than a weekend at Guantanamo Bay.  If the FOMC stays on course, a very expensive and financially destructive consequence awaits many CFOs around the corner.

Floating Junk

Total Floating Rate Junk Loans: $2.3-$2.4T*
*BB or less rates Portion: $1.2T
*B or less portion: $500B

Bloomberg, Barclays data

Interest Coverage Ratio Evaporation

In recent years, many investors have talked up the interest coverage ratio across corporate balance sheets as a form of group therapy.  “Oh, it’s ok.  Even though leverage is at record levels, interest coverage (companies’ ability to meet interest payments) is very healthy.”  If you heard this once, you heard it one thousand times.  Now, think about the power of $2.3T of floating rate – speculative grade – paper at cheap financing terms 2010-17.  By borrowing short term at adjustable rates, U.S. CFOs juiced profit margins to record levels in 2016, but at what consequence?  What happens when short-term interest rates surge?  Memories of subprime adjustable-rate mortgages and their impact on U.S. consumption?

Three Month Libor

As the spike in three-month libor marches higher – with an impact on adjustable rates in mind – Mr. Powell may re-think those four rate  hikes (for 2018) by the time the March 21st Fed meeting arrives.  At the current pace, a large portion of U.S. junk-rated companies will have a very challenging refinancing mountain to climb.

Interest Coverage Decay

If you’re looking at total debt over EBITDA, lower quality U.S. corporate debt issuers’ are levered 4.4 to 4.6x.  Yes, that’s up at 2007 nosebleed levels, look out.  Relax, it’s nap time on the Yoga pad, “interest coverage is fine.”  In recent years, ridiculously low rates placed interest coverage rations at a healthy 4.3x.  But wait.  What happens to that smelly $1T pile of  BB in rated floating rate loans when libor spikes?  In our view, interest coverage plunges below 3x on lower quality paper.  If Powell’s FOMC goes through with (Street’s expectations) hikes 3-4x rate hikes this year, we’re looking at a substantial surge in the default cycle.  The Fed likes to pretend they have an exit strategy, but if you do the math, they’ve buried themselves in a “moral hazard” abyss.

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This time, Stocks are Swimming Naked without Bonds

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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for this crowd to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

Think of the dentist in Cleveland, Ohio with $1M in stocks and $1M in bonds in a portfolio. For the first time in twenty years, he / she is looking at their brokerage statement and seeing NO wealth destruction OFFSET from bonds.  Let us explain.

Bonds Protect Stocks, No More
In the 70s and 80s this was very common – over 21 instances where stocks and bonds sold off together two weeks + (clearly inflation-driven). In the 90s only a few (3) instances,  From 2000-2018 there had been nearly zero 2-3 periods where stocks and bonds moved lower together – UNTIL NOW.  As you can see above.  In the 2010, 2011, 2014, 2015 and 2016 equity market drawdowns – bonds rallied in a substantial fashion.  In every “risk off” regime, it has been  stocks DOWN – bonds UP for as far as the eye can see.  This month, for the first time in nearly two decades, the negative correlation between stocks and bonds turned positive.  This is a MAJOR game changer for the wealth management industry.

Twenty Year Lows

Investors cut bond market allocation to a 20-year low amid fears of a ‘crash’ – The recent market correction and spike on bond yields scared professional investors, according to the February Bank of America Merrill Lynch Fund Managers Survey. Investors sliced bond allocations to their lowest level since 1998, with a net 69 percent underweight fixed income.  – CNBC

  • US Treasury Federal Budget, Yearly Tax Receipts vs. National Debt

2017: $1.787T vs. $20.244T*
2007: $1.163T vs. $9.002T

US Treasury Data

*US debt to surge by $1T every year until 2022 under Trump budget.

Early Innings

When you think about the $1.5T of capital that’s flown into passive bond ETFs and risk parity strategies, this crowd has a colossal disinflation bet on. In a regime change, a period where stocks and bonds move lower together, the flight of assets out of passive bond risk parity will be ferocious. Then add the credit quality deterioration globally (AAA rated corporates / sovereign credits off 30-40% in terms of the amount of high-quality paper last 10 years). Then look at debt to GDP in G20 countries, up from 70% (ten years ago) to near 100% (maybe 110%) today.  Next, look at the emerging market (EM) dollar-denominated debt issued 2007-2017, in the trillions.  There’s a new EM player at the table trying to sell/refinance a large debt load.   Next, look at the budget explosion out of Washington.  The 2018 US budget deficit has ballooned from $700B (year-ago forecasts) to nearly $1.2T. All this speaks to a regime change.  We believe we’re in the first or second inning, there’s a lot more to come.  Stay tuned.

The 2529 Bounce

Fierce bulls are never taken down by one sword, this one has some fight left.  So far we’ve seen two bounces (7.8% and 4.9%) off of 2529 in S&P 500 futures.

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.  As the ten-year Treasury bond surged in yield (2.02% to 2.85%), bonds have lost nearly $2T in value since September.

2008 Equity Drawdown

In the 2008 equity drawdown, bonds rallied from 4.22% to 2.05%, providing nearly $4T of positive cushion to offset the equity wealth destruction.

2015 Equity Drawdown

In the 2015 equity drawdown, bonds rallied from 2.44% to 1.35%, providing nearly $2.1T of positive cushion to offset the equity wealth destruction.

2011 Equity Drawdown

In the 2011 equity drawdown, bonds rallied from 3.42% to 1.74%, providing nearly $2.5T of positive cushion to offset the equity wealth destruction.

2010 Equity Drawdown

In the 2010 equity drawdown, bonds rallied from 3.92% to 2.82%, providing nearly $2T of positive cushion to offset the equity wealth destruction.

2018 Equity Drawdown

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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Regime Change

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for this crowd to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

Inflow of into Passive MF and ETFs

January

2018: $105B
2017: $68B
2016: $18B
2015: $22B

Bloomberg data

Many of these investors don’t realize, passive investing in bond ETFs is a colossal disinflation bet.   As the tide turns, this mad mob will rush for the exits, commodities will become the big winners relative to bonds and equities.

Hot Wages

U.S. payrolls surged by 200k in January, ahead of Street expectations for 190k. Gains were largely in the private-sector hiring (+196k). The unemployment rate remained unchanged at 4.1%.

Wage growth caught all the attention in this report, and it didn’t disappoint. Average hourly earnings rose a relatively strong 0.3% in January and accelerated to 2.9% year-over-year. That marks the fastest pace of wage gains since 2009.

ISM Prices Paid are on Fire

This week we saw hot ISM prices paid (U.S. factories expanded more than forecast in January and near the fastest pace in more than 13 years). While ISM’s measure of prices paid increased to the highest level since May 2011 (keep in mind, U.S. 10 year bond yields were up near 3.50% in the Spring of 2011).  What’s driving all the bearish bond sentiment?  One major reason is found in the “growth to bold yield” disconnect.   For most of the last fifteen years, the U.S. 10 year bond yield was “tied to the hip” of manufacturing ISM prices paid.  In our view – as you can see above – the current level of ISM prices paid should be associated with U.S. Treasury bond yields 60-70bps (+0.60% to +0.70%) higher than current levels.  In recent years as inflation expectations plunged, the disconnect between ISM and 10s (Treasury bonds) widened.  Over the last month, as inflation expectations surged, these two long lost friends are spending far more time together. 

US Equity Long Futures Positioning

2018: $405B
2017: $280B
2016: $185B
2015: $280B
2014: $240B
2013: $220B
2012: $155B
2011: $160B
2010: $150B
2009: $130B
2008: $280B
2007: $210B
2006: $180B

CFTC, GS data

Heading into February, investors have never been this long equities.  We use CFTC (positioning, measuring the crowded trade) data as an important contrarian indicator.  Over the years, as positioning wanes (2006, 2009, 2016), these are the best times to over-weight stocks.  In the bond market, the sensitivity to a rate change (in prices and wages) is greater than ever before.  It is very high, in our view the U.S. is hitting capacity constraints and risks overheating. The Trump tax cuts and spending plans are further juicing the economy at the wrong moment.  At the same time, a weaker dollar adds even more stimulus (with over $60T of GDP outside the U.S. vs. $18T inside, a weak dollar injects emerging market economies with a steroid like high).  In Davos, Axel Weber (former Bundesbank head) said: “today we’re adding stimulus on stimulus, this is after the credit channel mechanism of monetary policy shut down when interest rates collapsed to zero during the post-Lehman slump.” Quantitative easing lifted the economy through a different mechanism, by boosting financial markets – a wealth effect from gains in equities, bonds, and property.  “People have been lulled into complacency, forgetting what will happen when normal conditions return,” Weber said.  We’re now switching back on the credit and interest rate channel. We do NOT believe central bankers can effectively manage the risk path they are on.

Bond Yields and Equity Market Volatility, now in a Regime Change

This week, with nearly a 4% drawdown, the S&P 500 just posted its biggest (weekly) loss in two years.  If you look carefully above, we’re clearly in the middle of an important regime change. In recent years as volatility surged, long bonds (U.S. Treasuries) rallied with lower yields. Today, we’re in the early innings of a secular change in this regard, bond yields are moving HIGHER with the VIX, wow.  We have a special report on bonds and our trading thesis for 2018, pick it up here.   

As the (Bond) Bears Dance in the Night

Short interest and bearish sentiment have reached rare levels in the bond market. In U.S. Treasuries, overall short positioning is back to all-time (high) extremes reached post the 2016 Presidential election. We must remember, after periods of highly unusual positioning – interest rates typically become range bound over the short to medium term. In other words, you have to let the shorts cover. This process will put a bid under the bond market over the near term in our view. Once the large short supply has been cleansed, we can get back to a firm, bearish view on rates. We’re sticking with our 3.50 to 4.00% (in U.S. 10 year Treasuries) range target for 2018.

Lessons Always Found in the Put-Call Ratio

Hindsight is always 20/20, but it’s so interesting to note that three of the LOWEST readings (last five years) in the put-call ratio occurred as the U.S. equity market reached its January 2018 perch.  Likewise, market bottoms are often found when put-call readings are up in the 1.00 to 1.20 neighborhood (we’re not there yet – even after Friday’s market plunge).  Investors often get all “beared up” at the lows and “bulled up” at the highs, there are a lot of lessons in here.  In January, mutual fund long positioning surged in tandem with the rebound in growth to a 6-year high, as some long lost investors came back to stocks.  A look over at aggregate shorts in cash equities and ETFs – led by reductions in Technology shorts – (in January) is telling.  This was the first time tech shorts moved below the elevated range they have been in since the financial crisis.  Similar to late 1999, this outcome is a sure sign that the shorts have been carted off the field in this vicious bull market run.  Right on cue, of course, January inflows into U.S. equities surged, and are on track for the largest monthly inflow on record (we’ll get the final data next week).

U.S. Treasuries and Corporate Bonds Held Overseas

Repatriation

2017: $650B
2007: $40B

*Post tax reform, as capital comes back to the United States, a very large bond buyer might NOT be there in the same way she’s been so over the last 10 years.  We believe this is starting to contribute to the latest rate shock.  The assumption was there was “cash” held overseas, ultimately it was actually “bonds.”  Data from company SEC filings, Bloomberg and CS. 

 

Last Time Bond Yields Surged with Equity Market Volatility?

On May 22, 2013, the Federal Reserve announced that it would begin tapering back their roughly $70 billion a month in bond and mortgage-backed securities program.  A series of positive economic developments in the spring of 2013 led Federal Reserve Chairman Ben Bernanke to testify to Congress on May 22, 2013, that the Fed would likely start slowing— tapering—the pace of its bond purchases later in the year, conditional on continuing good economic news.   Similar to this week’s price action in markets, bond yields surged with equity market volatility as investors exited stocks and bonds together.  

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