Changing Lanes

My daughter recently scored her learner’s permit, and for some reason she hates changing lanes.

Indicate, check the side mirror, glance quickly over your shoulder at your blind spot and then ease into the next lane. This only takes a second, but I appreciate that it can be overwhelming if you’re new to driving.

You might be asking: how can you get anywhere in this world without changing lanes?  

My daughter simply gets in the lane she knows we eventually need to be in, and stays there for the entire trip!

You can imagine my morning commute to Starbucks when she gets in the right-most lane six miles away from the storefront that provides the magic elixir of life. We wait patiently while cars ahead of us make their turns. Meanwhile, the left lane is as clear as the Antipodes Islands.

The other day, during my four-hour commute to Starbucks, it occurred to me that investors have this same fear of changing lanes.

Despite the fact that we can’t pinpoint the exact destination of economies or financial markets, investors hunker down in the right lane anticipating a turn that may or may not ever come. In the process, they leave their portfolios at risk of underperformance and outright losses.

Right now, investors are stuck in gridlock in the right lane believing U.S. growth is slowing, when they should be cruising in the left lane investing in growth assets because U.S. growth is, in fact, accelerating.  


Data Dependent

Last week started with the latest durable goods report for March. Both capital goods and durable goods clocked nice year-over-year gains of +3.0% and 4.8% respectively. Both growth rates are barely below three-year highs.

The week ended with the first estimate of Q1 GDP, which further confirmed the left lane as the place to be. Although to hear the media tell it, you need to be in the right lane anticipating the worst:

CNBC – “US first-quarter growth weakest in three years, as consumer spending falters

Bloomberg – “US Economy Grew 0.7% in First Quarter, Slowest in Three Years

ABC News – “US economy expanded at weakest pace in 3 years”

It never ceases to amaze me how misleading headlines can be, even from “reputable” news sources. What the media failed to mention was that the U.S. economy grew at a 1.9% annual clip during Q1 2017. While this growth rate is a slight slowdown from Q4 2016’s annual growth rate of 2.0%, it’s still well ahead of the 1.3% growth the U.S. economy experienced last summer.  

Keep in mind that the first quarter of this year was always supposed to be the quarter with the lowest annual growth rate, so a slight deceleration was expected.

A breakdown of Q1 corporate earnings further confirms that we are in a better economic environment. Over half of the S&P 500 companies have now reported, and sales growth is averaging +6.2% and earnings growth is up to +12.5%.

There are green shoots everywhere. Why would you want to be bogged down in the right lane with everyone else who thinks the “economy is slowing” turn is just ahead?

It’s not only the data, either. Financial markets are confirming in real time that U.S. growth is improving.


Mr. Market Says What?

Last week, the entire U.S. yield complex, from 2-year to 30-year yields, gained ground. Quick question: would yields rally on fresh Q1 data if it was truly the weakest quarter in three years?

But it’s not the bond market alone confirming growth; stocks are also shouting it loud and clear.

I track two proprietary market indices that help me gauge U.S. growth in real time. One index is comprised of assets that outperform when U.S. growth is accelerating, and the other is a basket of assets that outperform when U.S. growth is slowing.

During Q1 2017, the High Growth index outperformed the Slow Growth index by 290 basis points. Last week, amid data that was the “weakest in three years,” the High Growth index gained 192 basis points while the Slow Growth index declined by 151 basis points. That’s another 343 basis points of outperformance in merely one week!

Not only that, but the Nasdaq cracked 6,000.00 for the first time ever, and the market cap of the MSCI World Equity Index crossed $50 trillion for the first time ever!

Financial markets are running hot, confirming the accelerating U.S. data and telling you unequivocally to get your butt into the left lane.

That said, apparently hedge fund managers prefer to conduct research by watching “Fast Money Losses” on CNBC or reading Bloomberg articles rather than being data dependent.


It’s Not Just Teenagers

Based on the latest futures market data, it appears that it’s not only first-time drivers who have a fear of changing lanes—so do hedge fund managers. These guys have crowded into the right lane by shorting U.S. small caps, because they fear growth is slowing and the post-election market rally is over.

Hedge funds are net short more than 70,000 Russell 2000 index contracts. This is a massively bearish position, and the largest short position since September 2014.

That’s a high level of conviction, but those guys must have felt like Linda Blair last week when the Russell 2000 had its biggest three-day rally in four months and tagged a brand new all-time high. Ouch!

Small caps love a growth-accelerating environment, which is why the Russell 2000 is up 23% since last June, versus a 15% gain for the S&P 500.

Shorting U.S. small caps with the current U.S. Fundamental Gravity is like hitting on your wife’s sister during Thanksgiving dinner at your in-laws’ house. It’s a really bad idea!

Hedgies are finding out the hard way that driving in the right lane in anticipation of slowing U.S. growth can lead not only to underperformance, but also to significant losses.


The Bottom Line

At some point, U.S. growth will slow, but it’s not happening now, and probably won’t for at least two more quarters. Why would you spend the next six miles stuck in gridlock, exposing your portfolio to below-average returns or outright losses, just because you’re scared to change lanes?

Stay data dependent, process driven and risk conscious, and join me in the left lane where we are cruising like it’s the Autobahn. There will be plenty of road signs when it’s time to move into the right-most lane and get defensively positioned. When that time comes, you simply indicate, check the side mirror, glance quickly over your right shoulder and change lanes.