We are with you our brothers and sisters of España.
(POTD = Picture of the Day) Source: Telegraph
(POTD = Picture of the Day) Source: Telegraph
We warned in our last post before leaving on holiday, “Look for some large sigma event, which is always the case when we are off the desk.” How about a vol spike caused by worries over a nuclear exchange? Nuclear war!
The potential implosion of a presidency?
We think yesterday’s presidential presser has a relatively high probability of being a (or the) structured criticality event that we could look back to as the tipping point that leads to a very volatile autumn.
Structured criticality is a property of complex systems in which small events may trigger larger events due to subtle interdependencies between elements. This often gives rise to a form of stratified chaos where the general behavior of the system can be modeled on one scale while smaller- and larger-scale behaviors remain unpredictable.
Consider a pile of sand. If you drop one grain of sand on top of this pile every second, the pile will continue to grow in the shape of a cone. The general shape, size, and growth of this cone is fairly easy to model as a function of the rate at which new sand grains are added, the size and shape of the grains, and the number of grains in the pile.
The pile retains its shape because occasionally a new grain of sand will trigger an avalanche which causes some number of grains to slide down the side of the cone into new positions.
These avalanches are chaotic. It is nearly impossible to predict if the next grain of sand will cause an avalanche, where that avalanche will occur on the pile, how many grains of sand will be involved in the event, and so on. – Wikipedia
We love applying the conceptual framework of physics and dynamic systems models to economics and the markets, but think the obssession with the math has perverted the analysis and will someday lead to a doozy of a market meltdown when the algos collide and short circuit on a day to be named later.
In the hypothetical worlds of rational markets, where much of economic theory is set, perhaps. But real-world history tells a different story, of mathematical models masquerading as science and a public eager to buy them, mistaking elegant equations for empirical accuracy.
As an extreme example, take the extraordinary success of Evangeline Adams, a turn-of-the-20th-century astrologer whose clients included the president of Prudential Insurance, two presidents of the New York Stock Exchange, the steel magnate Charles M Schwab, and the banker J P Morgan. To understand why titans of finance would consult Adams about the market, it is essential to recall that astrology used to be a technical discipline, requiring reams of astronomical data and mastery of specialised mathematical formulas. ‘An astrologer’ is, in fact, the Oxford English Dictionary’s second definition of ‘mathematician’. For centuries, mapping stars was the job of mathematicians, a job motivated and funded by the widespread belief that star-maps were good guides to earthly affairs. The best astrology required the best astronomy, and the best astronomy was done by mathematicians – exactly the kind of person whose authority might appeal to bankers and financiers. – Aeon
Hat Tip: Jose Cerritelli
Our sense is we are headed for some heated political instability in the United States.
How will it affect the markets?
Depends on trajectory of events, but unless inflation or interest rates spike providing competition for risk assets, don’t expect a bear market to start tomorrow. We have always lived our financial career by Bagehot’s dictum:
“John Bull can stand many things, but he cannot stand
2.0, [-1.5 or 1.25] percent” – Bagehot
We still maintain yield and return chasers will not retreat to their caves, with, the exception of short-term bouts, such as last week, unless policy rates move up another 100-200 basis points and the monetary bases in the G3 shrink by double digit percentage points though quantitative tightening (QT). That is how much liquidity (potential buying firepower) is still in the global system, in our opinion, folks.
What we are looking for?
We still have high conviction the risk markets will experience a swift, short, and steep sell-off in October – 5 to 10 percent – based on:
1) seasonality; 2) the Fed balance sheet should, or could be shrinking ; 3) China’s Party Congress may have concluded, removing the country’s implicit policy put, and thus increasing the risk of a China policy or economic shock; 4) the new U.S. Federal government fiscal year begins October 1 and if the Trump administration has not passed any significant economic legislation, the markets may begin to throw in the towel; 5) there will be more clarity on ECB tapering; 6) even more elevated asset prices as the risk markets grind higher through the rest of summer as we suspect, setting up for a potential blow-off by the end of September; 7) nervousness over the debt ceiling; and, finally, 8) by then, the markets should be sufficiently overbought, overvalued and very vulnerable to event risk. – GMM
Add to that possible key White House resignations.
What do you think the markets will do if Gary Cohn resigns?
That’s at least worth a 5 percent haircut off the S&P500, in our opinion, and a spike to 20 in the VIX, triggering another round of structured criticality.
The exodus of executives sparked talk that Gary Cohn, Trump’s top White House economic adviser and a key liaison to the U.S. business community, might resign in protest as well.
Cohn, who is Jewish, was upset by Trump’s remarks, though he is remaining with the administration for now, sources said. – Reuters, August 16, 2017
Cohn may also come to the conclusion that after the August Congressional recess he is wasting his time as he perceives that the Trump administration has lost all credibility on Capitol Hill and none of his policies has any chance of being implemented. If rumors begin to spread in mid-September, markets will begin to wobble, bigly.
If Chief of Staff, John Kelly, goes? Get shorty, big time.
The 1987 Analog
Since we know crash talk is surely coming, we’ve put together a two-year trading analog of the S&P500 from end of December 1985/2015 to December 1987 and August 16, 2017.
First, over the 20-month trading period, the 1987 S&P500 outperformed the current 2017 S&P500 by over 31 percent as of today’s close. Not much of an analog.
Second, the yield on the 2-year increased 287 bps (45 percent) from the beginning of 1987 to the eve of the crash with the 10-year up 252 (33 percent), peaking over 10 percent. The 2-year is up only 13 bps (11 percent) this year with the 10-year down 22 bps (-9 percent).
Third, the 1987 S&P500 peaked on August 25th and banged around until October 5th, where it was only down 2.6 percent from the peak. It then fell 13.6 percent from October 5th to Friday, October 16, the trading eve of the crash. On Black Monday, October 19, 1987, the S&P500 closed down 20.47 percent, almost double the 1929 crash.
Similarly, the 1929 stock market peaked on September 3, 1929 and fell sharply to close down 32 percent on the eve of Black Tuesday, October 29, 1929. That crash sliced 11.7 percent off Dow Jones Industrial in one day. In both cases, 1929 and 1987 the markets sent a loud signal and warning of an imminent crash as, a matter of fact, the markets were crashing before the big crash.
The major difference of the two markets is the Dow didn’t regain the September 3, 1929 peak until November 23, 1954, more than 25 years later. The 1987 S&P500 reclaimed its August 25, 1987 high on July 26, 1989, less than two years. Compliments of easy monetary policy and the circumvention of a great depression.
It’s probably time to buckle up. We expect volatility to begin to pick up; for the markets to start banging around until October; then experience a Tower of Terror sell-off sometime in October.
Though the sell-off may be the day the algos go rogue, there is no doubt, the full firepower of the PPT and the Fed will be put to work. Can they beat this new technology gone wild?
Gotta be quick on the draw as it could be over in the blink of an eye.
Could be wrong. After all, isn’t this astrology, folks?
See you in a week or two. Look for some large sigma event, which is always the case when we are off the desk. I will try to work off the “fat tails’ on holiday.
Have a great holiday, folks!
Key insights about the companies in this map:
- Collectively, US unicorns are worth approximately $360B.
- Combined, these companies have raised just over $73B.
- After California, New York, Massachusetts, and Illinois, the next-highest unicorn populations are found in Utah (with four) and Florida (with three).
- The top five most well-funded US unicorns are: Uber ($15.1B raised), Airbnb ($4.4B), WeWork ($2.76), Infor ($2.63B), and Lyft ($2.46B).
- The oldest unicorn in the US is the greentech company Bloom Energy, which reached a valuation above $1B in 2009.
- The newest unicorn in the US is 3D printing startup Desktop Metal, which became a unicorn in July 2017 after raising a $115M Series D.
- The three most active investors in US-based unicorns, by total number of deals to these companies, are the VC firms Sequoia Capital, Andreessen Horowitz, and Tiger Global Management. – CBINSIGHTS
Hat Tip: Craig Blessing
On the eve of nonfarm payrolls here is a nice data dump that gives a good roadmap of what and how many jobs have been created since 2010. We’ll layout just the data with some bullet points and let you make your own conclusions.
- Over 16 million nonfarm jobs have been created since the beginning of 2010, averaging 184K per month.
- Total nonfarm payrolls will have to average 193K per month for the rest of 2017 to equal the 2.24 million jobs created in 2016.
- 25 percent of the jobs created since in 2010 were in the Professional & Business sector, which ranks 5 on a scale of 13 in terms of average hourly earnings.
- Almost half of the jobs – 47 percent – created over the past 7 1/2 years were at the lower end of the pay scale – Education & Healthcare (9); Leisure & Hospitality (13); and Retail Trade (12).
- The Government, Information, and Utilities sectors lost jobs over the period.
- The weighted average wage rank of all jobs created since 2010 is a 9 out 13 in terms of average hourly earnings.
- Education & Healthcare top nonfarm payrolls at almost 16 percent of total employment.
- The Ultilities and Information sector ranked the highest in average hourly earnings in June 2017 with Retail Trade and Leisure and Hospitality at the bottom. See here for more detailed breakdown of wages by sector.
- Information and Financial Activities experienced the strongest real wage growth over the period with the Transport and Warehouse and Manufacturing sector the weakest, with zero real wage growth.
Just saw this chart on Zero Hedge yesterday, which takes me back to the days of graduate school and an unfinished Ph.D. dissertation.
One part of the “Dusenberry Effect” basically states that consumers do not give up their consumption patterns very easy even if their incomes decline. They, in effect, “ratchet” down their living standard very slowly by first having a second wage earner enter the workforce as we saw in the 1970’s when women began to enter the workforce en masse and then by taking on debt to finance their previous standard of living.
…[a] significant part of Duesenberry’s relative income hypothesis is that it suggests that when income of individuals or households falls, their consumption expenditure does not fall much. This is often called a ratchet effect. This is because, according to Duesenberry, the people try to maintain their consumption at the highest level attained earlier. This is partly due to the demonstration effect explained above. People do not want to show to their neighbours that they no longer afford to maintain their high standard of living.
Further, this is also partly due to the fact that they become accustomed to their previous higher level of consumption and it is quite hard and difficult to reduce their consumption expenditure when their income has fallen. They maintain their earlier consumption level by reducing their savings. Therefore, the fall in their income, as during the period of recession or depression, does not result in decrease in consumption expenditure very much as one would conclude from family budget studies. – YourArticleLibrary
We suspect the cumulative policy decisions of bailing out debt holders and punishing savers over the past 30 years has changed attitudes on debt accumulaton. We know several people that didn’t pay their mortgages for more than three years and were not foreclosed on. That is just un-freaking-fair, folks!
The Rise of Tea Party
The duplicity of the policy makers and the banks gave rise too much anger thoughout the country from those who basically, “did the right thing”, paying their bills and mortgages on time. And was one reason for Rick Santelli’s rant in February 2009, which many atrribute to the birth of the Tea Party.
Upshot? No wonder the country is so divided.
Stephen Gandel of Bloomberg out with a good piece this morning on:
…shares of companies that have reported both better-than-expected profits and sales for the second quarter have barely budged this earnings season. It’s the least fist-bumping investors have done for great quarters in 17 years. – Bloomberg
Is the the beginning of a catch up trade?
Stocks rose during the recent earnings recesssion through P/E multiple expansion and this just may be the market allowing fundamentals to catch up with prices. Nah, that’s too rational.
Too much catching up to do as noted by Howard Marks comments below.
- The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
- The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16. This multiple was exceeded only in 1929 and 2000 – both clearly bubbles.
- While the “p” in p/e ratios is high today, the “e” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity. Thus today’s reported valuations, while high, may actually be understated relative to underlying profits.
- The “Buffett Yardstick” – total U.S. stock market capitalization as a percentage of GDP – is immune to company-level accounting issues (although it isn’t perfect either). It hit a new all-time high last month of around 145, as opposed to a 1970-95 norm of about 60 and a 1995-2017 median of about 100.
- Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established.
– Howard Marks
The market seems to running out of room to the upside as valuations are extremely extended and growth seems to running up against supply constraints, especally labor in the U.S.. Need some quick producitivity gains to nudge non-inflationary economic growth higher and for equity markets to continue their impressive run.
Fits the last factor of the event risk check list of eight reasons why we expect an October sell off, though, we are not expecting a bear market.
More money quotes from the Bloomberg piece:
- To be sure, Wall Street earnings beats are always a bit manufactured. Analysts often lower their estimates toward the end of the quarter, or soon after it, only for companies to hurdle over that lower bar. On average, over the past five years, 68 percent of the companies in the S&P 500 have reported better-than expected earnings. This year the number is slightly higher at 73 percent. Despite the kabukiness of it all, investors have generally seen those positive earnings surprises as good news.
- Through Tuesday morning, 314 of the companies in the S&P 500 have reported their earnings for the three months ended June 30. Of those, 174 had profits and sales that were better than analysts’ expectations. Yet shares of those companies were flat compared with the rest of the market in the 24 hours after they reported, according to research from strategists at Bank of America Merrill Lynch. Five days later, the same stocks performed slightly worse than the rest of the market.
- Since 2000, shares of companies reporting better-than-expected earnings have generally risen about 1.6 percentage points more than the market on the day after they announce earnings. The last time that stocks on average failed to jump on good earnings was the second quarter of 2000, 17 years ago.
- It’s not clear exactly why the cheers for good earnings have been muffled. Savita Subramanian, Bank of America Merrill Lynch’s top U.S. equity strategist, says it’s potentially a bad sign. Investors are overly optimistic, anticipating good news. That can be a sign of a market top. The S&P 500, for example, had not yet peaked in July 2000, even though tech stocks had already started to drop, when companies started reporting their profits for the second quarter that year. The market’s massive slide began the next month. The Dow Jones industrial average closed at a record on Tuesday. – Bloomberg
Consider the big banks. Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. reported better-than-expected earnings per share by 11 percent, 6 percent and 8 percent, respectively. Yet their shares fell on the day they announced their earnings. JPMorgan’s shares are still down slightly. One exception appears to be Apple Inc., whose shares jumped after better-than-expected earnings on Tuesday evening. – Bloomberg
Not a compelling case to make a directional bet, but a great piece to add to your information set. We expect to grind higher through mid-September, which sets up for a decent October correction. This said, realizing market timing has been pretty much a mug’s game.
Not as relevant as it used to be, but something to keep on your radar. Transports approaching 200-day moving average at 9,117.59 (corrected on Aug. 19) and diverging from Industrials.
Dow Theory, baby!
The [Dow} theory was created by Charles Dow in the early 20th century (after whom the two indexes above are named after) and it examines the relationship between the transports and industrial averages. Simply put, it states that major trends must be confirmed by both the transports and industrials indexes. Confirmation of a trend higher sends a “buy” signal in the market; one of a trend lower sends a “sell” signal in the market. – CNBC
Interesting revenue makeup from Apple’s earnings release.
Overall revenue up 7 percent y/y; iPhone revenue up 3 percent y/y; and the only negative is a 10 percent y/y decline in China – sixth straight quarter down in the country. Tim Cooke a little more upbeat on China, however.
The iPhone made up 55 percent of the company’s revenue for the quarter with services now gernerating 16 percent.
Market likes it. Stock up over 5 percent in after hours.