Wake Up Call

Last week turned out to be a wake-up call for market participants across all asset classes and across all geographies. Here are some of the highlights from the week that was:

·         Dow’s worst week in 3 years

·         VIX’s largest weekly gain since September 2011

·         Gold’s best week in 6 months.

·         US Dollar’s worst week in 18 months

·         10-year US yields worst week since June 2012

And finally, for the icing on the proverbial cake, Greek stocks fell 20% last week, making it the largest weekly loss in 27 years! This monstrous move in asset prices was hinged on a few very critical pieces of information.


China kicked the week off by reporting its Big 3 data points from November: retail sales, fixed asset investment and industrial output. The Big 3 and China’s November trade data showed the world’s second largest economy is continuing to slow. In addition, China’s consumer inflation data hit a 5-year low and the producer price index declined for the 33rd straight month.

Clearly, China is not immune to the deflationary forces that are putting a stranglehold on global economic growth. All of this led to further bolster the expectations that the PBOC will enact further easing measures in the coming weeks. There is only one problem with that expectation. The PBOC is hypersensitive opening up the flood gates for hot money rolling into the Chinese equity markets.

So, the fact that investors have front run the PBOC’s easing actions, pushing the Chinese equity market higher, actually reduces the likelihood that the PBOC will cut rates or increase liquidity through other avenues.

The PBOC actually showed this distaste for hot money last week. The PBOC pegged its currency more strongly, which is implicit tighteningand simultaneously tightened collateral requirements for equity margin by no longer allowing AA-rated bonds, or lower, to be used as collateral for buying stocks. The PBOC took this action because it is concerned about the amount of the money that has flowed into its corporate bond and stock markets over the last 6 months and wants to curb the flow of speculative money.

However, it remains to be seen whether the PBOC dislikes speculative money more or less than it dislikes the fact that its economy is slowing and inflation continues to leak lower. Once we understand the answer to that question, we will know how to trade Chinese markets.


Slow Growth

If you didn’t know that the world’s economy was slowing, you do now. And no, this slowing didn’t start just because oil has been getting demolished in the last 3 weeks. In addition to China, Japan reported an updated Q3 GDP number that showed the world’s 3rd largest economy contracted by 1.9%, which is worse than the initial GDP report which showed a 1.6% contraction.

The Eurozone data from last week was also pitiful, inflation is still falling and the latest data on the ECB’s LTRO facility shows that banks borrowed less than half of what was available in the second round of lending. This just shows how far away the ECB is from its goal to expand its balance sheet.

What about the US? The retail sales numbers from November actually looked pretty damn good. Retail sales accelerated for the 3rd straight month and hit the highest annual growth rate in over a year. That said, the US can’t carry the world economy on its own shoulders. It's like the Dad doggy paddling in the deep end of the pool holding little Johnny. He can probably hold his head and little Johnny’s head above water.

But what happens when 3 or 4 of Johnny's friends jump on the Dad’s back? Even if Dad is a strong swimmer, eventually he finds his head is underwater. The US isn’t going to be able to maintain its head above water with China, Japan, the UK and the Eurozone all clinging to its shoulders. And the markets have been signaling this reality all year long. Regular readers of TWR know that I will routinely discuss my US High Growth Index and my US Slow Growth Index.

As the names would imply, one index performs well when US growth is expected to accelerate higher and the other performs well when US growth is slowing down. Except for approximately 6 weeks this year, the Slow Growth Index has handily outperformed the High Growth Index. Here are the year-to-date returns as of this past Friday’s close:

US Slow Growth: 17.5%

US High Growth: 5.1%

US Equities (S&P 500): 10.3%

Assets that anticipate slower growth have outperformed their high growth counterparts by 1240 basis points, and have outperformed the broader market by 720 basis points. How’s that for some alpha! 

The hedge fund manager in me would prefer to be LONG slow growth assets and SHORT high growth assets—that would have produced a 12.4% risk free rate of return. That hedged strategy would have also outpaced the broader US equity market by 240 basis points, if you’re into that kind of thing. The playbook that has been working will continue to work until further notice. Capital is going to continue to find its way to the US, because right now, the US is the tallest of the pigmies.


Same Old, Same Old

The saying “You are the average of the five people you spend the most time with” is meant to convey that you should be very careful with the people you choose to hang around. As it pertains to the markets, your investment performance will be the average of your information sources.

I’ve written on many occasions over the last 2 years about the importance of choosing your information sources very carefully and to have an iterative process for evaluating your current sources as well as prospective sources of information.

I drink my own Kool-Aid and I am constantly evaluating new sources of information as well as my current stable to make sure that the information I’m feeding into my investment process is critical and effective.

Last week I received an email from an analyst at a sell-side research firm inquiring if I would like to talk further about their research services. The analyst had attached a coverage list of about 200 companies complete with the firm’s proprietary ratings and price targets for each company.

As I read through the list two things stood out to me. First, the price target for every single company in the firm’s coverage universe was higher than the current price. Let me repeat that.

This firm is advising its research clients that every single stock that it covers will be trading at a higher price in 12 months.

Second, as I looked at the firm’s rating for each company, I realized that there wasn’t one “sell” rating. Clearly, if every company is going to go up in value over the next 12 months, why would they tell you to sell or reduce your position in this company?

In addition, only 25% of the companies had a “neutral/hold” rating and the remaining 75% of the companies had a “buy/accumulate” rating. What kind of value is this firm providing by telling you to go out and buy/accumulate the majority of companies they cover? 26 of which happen to be investment banking clients. Always read the fine print.

I worked at Merrill Lynch in 2001 when the head of the global internet research team, Henry Blodget, got bounced for giving internet companies high ratings while at the same time emailing his colleagues that the stocks were total crap. And by “got bounced” I mean that he accepted a buyout offer from ML and left the firm. I’d love to see the emails of the analysts that work at the firm prospecting for my business. That might be information worth paying for.

I tell you all of this for three reasons:

First, always understand the perspective, and possibly the compensation structure, of the source providing you information. This will help you filter the information more effectively, adjusting for any inherent biases.

Second, this is a great example of how Wall Street works. Most money is being managed long-only and everything is a buy or accumulate, all the time. You can gain an edge by being a two-way trader, LONG and SHORT, and by being willing to dispassionately attach a SHORT or NEUTRAL bias to markets when warranted.

Finally, despite 2 market crashes, 1 financial crisis and a ton of reform and regulatory changes, nothing has changed in 14 years. This is to our advantage as well because it contributes to the inefficiencies in the markets that allow us to produce above average returns with a fraction of the risk.