Yesterday we wrapped up the first half of 2016. Today we want to step back and take a look at how markets fared in the face of a lot of threats, if not chaos.
Even after Brexit, an early year correction surrounding the oil price bust, and an indecisive Fed, U.S stocks are UP for the year!
The old adage that stocks climb a wall of worry during a bull market continues to hold true.
The S&P 500 ended the first half of 2016 up 2.7%, while the blue chip Dow Jones Industrials Average rose 2.9%. The tech-growth heavy Nasdaq was the worst performer ending the first half of 2016 down 3.3%.
This tells us a couple of things: first the world is not falling apart (contrary to what most people think). In fact, U.S stocks are putting up nearly a 6% annualized return for the year (just shy of the S&P 500’s historical average — better than the long term average on an inflation adjusted basis).
Most interesting, value stocks are significantly outperforming growth stocks – for the first time in a long time. The Russell 1000 value index is up 6.1% for the first half of 2016 vs a 1.3% loss for the Russell 1000 growth index. So value stocks are outperforming growth stocks by more than 7 percentage points this year or around 14% on an annualized basis. Never have we seen more blue chip stocks trading at incredible, beaten down values – 7% of the S&P 500 is trading below book value.
Remember, in the past few months, we’ve talked about the similarities in stocks to 2010. Through the first half of this year, we’ve had the macro clouds of China and an oil price bust that shook market and economic confidence. Back in 2010, it was Greece and a massive oil spill in the Gulf of Mexico. When the macro clouds lifted in 2010, the Russell 2000 went on a tear from down 7% to finish up 27% for the year. This time around, the Russell has already bounced back from down 17% to up 2%.
With economic expectations in the gutter, global rates at record lows, and central banks continuing to ease and buffer potential shocks to the system, the opportunities for positive economic surprises have never been greater. We think positive economic surprises in the next half can be the catalyst for a surprisingly big second half for stocks.
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Yesterday we looked at some key markets, some that have recovered nicely following the Brexit news, and others that are still down on either safe-haven demand or speculation of economic drags due to the Brexit. One particular spot that hasn’t fared well in the past week is Japan.
Japan is three years into a bold plan to beat two decades of deflation and restore its economy to prominence. The data shows that their efforts haven’t translated so well just yet. Inflation is still dead, and economic growth — about the same.
Two key tools in the Bank of Japan’s QE program, which is designed to drive inflation and economic activity, is a weaker yen and a higher stock market. Since they telegraphed their intentions of big, bold QE in late 2012, Japanese stocks have risen by as much as 140%. And the yen has declined by as much as 38% against the dollar. But over the past 12 months, about half of those “policy gains” have been given back. And post-Brexit the attrition has only worsened.
Still, after three years and big moves in the yen and stocks, the inflation objective remains a distant target. What does it mean? The Bank of Japan has to do more. A lot more.
We think they can, and will, ultimately destroy the value of the yen — mass devaluation.
Unlike the U.S., which is constrained by “flight to safety” global capital flows and a world reserve currency, Japan has the ingredients to make QE work, to promote demand, and to promote growth. Japan has the largest government debt problem in the world. They have an undervalued currency. They have a stagnating economy with big demographic challenges. They have are in a deflationary vortex.
They have the perfect attributes for a mass scale currency printing campaign. Not only can it work for their domestic economies, but it serves as the liquidity engine and stability preserver for the global economy.
In normal times, the rest of the world wouldn’t stand for a country outright devaluing their way to prosperity. But in a world where every country is in economic malaise, everyone can benefit – everyone needs it to work. It can be the solution for returning the global economy to sustainable growth. We wouldn’t be surprised to see USDJPY return to the levels of the mid-80s (versus the dollar)in the not too distant future. That would be 250+. Currently, 103 yen buys a dollar.
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Yesterday we talked about the ECB’s projection on how the Brexit will impact on euro area GDP. And we looked at charts of Spanish and Italian sovereign debt. Both suggested that the market reaction, to the downside risk from Brexit, might be over-exaggerated.
Some markets have already fully recovered the Brexit-induced declines. But some key safe-haven assets continue to show healthy capital flows.
Let’s look at some charts.
Source: Reuters, Billionaire’s Portfolio
The chart above is a look at UK stocks. These are blue chip companies listed on the London Stock Exchange. You can see the 9% has been completely erased in just three trading days.
What about commodities? This is Goldman’s commodity index. It’s completed recovered declines, in large part to the reversal in oil and the continued surge in natural gas. Remember we talked about natural gas earlier in the month as it looks like it’s on a path to $4. It nearly hit $3 today.
Source: Reuters, Billionaire’s Portfolio
So we have some traditional “risk-on” assets sharply recovering losses.
But, the “risk-off” trade continues to hold in the traditional safe-haven assets. Bonds are being bought aggressively. You can see the U.S. 10-year yield is nearing levels of the peak of the European Debt Crisis, when Spain and Italy were on the precipice of blow-up.
Source: Reuters, Billionaire’s Portfolio
Interestingly, the 30-year yield is sliding too. This flattens the yield curve, which suggests bets on recession. But this extreme level is historically has been a bottom throughout the crisis period (2008-present).
Source: Reuters, Billionaire’s Portfolio
The dollar continues to hold post-Brexit gains — another sign of safe-haven flows.
Source: Reuters, Billionaire’s Portfolio
And next, the safe-haven flows continue to hold up in gold. But it’s not the runaway market gold bugs would hope for in a time of global stress.
Source: Reuters, Billionaire’s Portfolio
One could argue that the safe haven flows could be coming from core Europe, as Germany is most at risk in the Brexit for the ultimate bad outcome scenario (as we discussed yesterday, where the Brexit could create a spill over into European Monetary Union countries looking for the exit door). But as we reviewed yesterday, the sovereign debt markets in the vulnerable spots in Europe (Italy and Spain) aren’t giving that “bad outcome” signal.
Source: Reuters, Billionaire’s Portfolio
What about Japan? Japanese stocks have bounced sharply, but were among the worst hit given the sharp rise in the yen (a traditional safe-haven).
Source: Reuters, Billionaire’s Portfolio
And finally, U.S. stocks have come back aggressively, but haven’t fully recovered the decline.
Source: Reuters, Billionaire’s Portfolio
What do we make of it? If we consider that the biggest risk associated with Brexit is a destruction of global confidence, rising/recovering stocks go a long way toward defending against that risk. Since the central banks are in the business of defending stability and confidence in this environment, and they are clearly on patrol, they may have a little something to do with stock market recoveries (if not directly, than indirectly).
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We’ve talked about the Brexit effect the past couple of days. And we’ll continue on that theme today, as people continue to digest the results and come to grips with potential outcomes.
The knee-jerk reaction in markets has suggested that there is considerable fear of another global financial crisis. But as we’ve said, things today are very different than they were in 2008. The failure of Lehman triggered a global credit freeze. That brought global banks to their knees and, therefore, even massive Fortune 500 companies couldn’t access capital needed to operate.
Again, this time is different (typically dangerous words to say, but true). The financial system remains well functioning. Most importantly, central banks are pro-actively maintaining stability and confidence by offering liquidity to banks and have made it well known that they stand ready to act where ever else needed (i.e. intervention).
So now we’re seeing some projections of the economic implications of the Brexit coming in. The ECB thinks it will shave “as much as” ½ percentage point in GDP growth in Europe.
Here’s a look at euro area GDP…
Source: Tradingeconomics.com
You can see the damage to the economy in the global financial crisis. While Europe is still emerging from stagnation, lopping off ½ percentage point is far from a “Lehman moment.” Plus, if the euro weakens, as it should, on the outlook, that economic hit will be softened dramatically. When we think about the broad Brexit implications, Europe is probably the first place everyone should be looking, and the ECB’s projection doesn’t look so bad at all. With that, the market volatility we’re seeing seems to be over-exaggerating the Brexit effect.
Still, the biggest risk associated with the Brexit is that it becomes contagious. As we said on Friday, the potential Grexit (of last year) and the Brexit are most different for one simple reason. The British vote doesn’t involve a country leaving the common currency — the euro.
The British, of course, have their own currency, and among all of the EU countries, the British have probably retained the most sovereignty. It’s a fracturing of the euro, the second most widely held currency in the world, that would trigger a global financial and economic crisis. That’s the big danger. If other EU countries that are also part of the common currency (the monetary union – the EMU) took the lead of Britain, then it gets very ugly.
Perhaps the first place to look for that potential spillover, is in the sovereign debt markets of Spain and Italy — the two big EMU constituents that were close to default four years ago. When those countries were on the brink of collapse in 2012, the 10-year government bond yields were trading north of 7% (unsustainable levels).
Source: Reuters, Billionaire’s Portfolio
Source: Reuters, Billionaire’s Portfolio
Today, Spanish and Italian 10-year debt is yielding just 1.3%. In a post-Brexit world, where the real risk is contagion, both of these important market barometers are indicating no contagion danger.
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Over the past two trading days, we’re seeing the “risk-off” flow of global capital that we saw through the early stages of the global financial crisis.
For a long time, Wall Street sold us on the idea of sector and geographic diversification for stocks. That abruptly ended in 2008-2009. It was clear that in a global crisis, the correlations of sectors, geographies and many asset classes went to 1 (i.e. almost everything went down–a few things went up).
Our table below gives some perspective on how the swings in global risk appetite have affected financial markets since the onset of the financial crisis in 2008.
In a sense, the risk trade is an easy one to understand. When the world looks like a scary place, people pull back and look for protection. They pull money out of virtually everything, including banks, and plow money into the U.S. dollar, U.S. Treasurys and gold (the safest parking place for money in the world, on a relative basis).
At the depths of the global financial and economic crisis, there was a clear shift in investor focus, away from “return ON capital” toward one of “return OF capital.” Then, as sentiment improved about the outlook, people started taking on more risk, and that capital flow reversed. But with each economic threat that has bubbled up since, we’ve seen this risk-off dynamic quickly emerge again.
Two trading days following the Brexit vote, the market behavior is clearly back in the risk-off phase. The question is: Are we back into the risk-on/risk-off seesaw in markets that we dealt with for several years coming out of the worst part of the crisis?
As we said, there are huge differences between now and 2008. When Lehman failed, global credit froze. Today financial conditions globally have tightened a bit, but nothing remotely near the post-Lehman fallout. Most importantly, as we’ve said, we had no idea how policy makers might respond and how far they might go. Now we know, they will “do whatever it takes.”
When was the last time we had a huge sentiment shock for global financial markets and for the global economy? It was only a year ago, in Greece. The Greek people voted NO against more austerity and more loss of sovereignty to their European neighbors (namely Germany). That vote too, shocked the world. But all of the draconian outcomes for Greece, which were being threatened, with such a vote, didn’t transpire. Greece and Europe compromised.
Bottom line (and something to keep in mind): A bad outcome for anyone, at this stage in the global economic recovery, is a bad outcome for everyone.
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The world was stirring today over the UK decision to leave the European Union. Here are a few things to keep in mind. As we discussed earlier in the week, the repercussions of the Brexit are very different than those that were feared over the potential “Grexit.” Greece was threatening to leave the euro. It would have had major and immediate financial complications, which could have quickly paralyzed the financial system.
The Brexit is more political than economic (not financial). And any retrenchment in the banking system because of uncertainty can be immediately quelled by central bank intervention. Not only were the central banks out in front of the potential exit outcome, promising to provide liquidity to the banking system, but they were also in last night stabilizing currencies, and likely bond yields as well.
As we said, there are also huge differences between now and 2008. When Lehman failed and global credit froze, we had no idea how policy makers might respond and how far they might go. Now we know, they will “do whatever it takes.”
The market volatility surrounding the Brexit may actually be a positive for the global economy. Seven years into the global economic recovery, global central banks have thrown the kitchen sink at the crisis, and they’ve proven to be able to stabilize the financial system and the global economy, and restore confidence. And that has all indirectly created an economic recovery, albeit a slow and sluggish one. But they haven’t been able to directly stimulate meaningful economic growth (the kind you typically see coming out of recession) because of the nature of the crisis.
Fiscal stimulus has been the missing piece of the puzzle.
Governments have been reluctant to spend, given the scars of the debt crisis. This may give policy makers an excuse to green light fiscal stimulus. After all, growth (or the lack thereof) is the primary driver of the public discontent – not just in the UK, but globally. Growth has a way of solving a lot of problems.
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On Friday we looked at four key market charts that suggested the worst of the Brexit storm may be behind us.
As of Friday afternoon, the bookmakers had the odds of the UK staying in the Eurozone at 64%, versus 36% leaving. And as we looked across the prices of gold, oil and stocks, all were suggesting, at least technically, that the peak of fear, regarding a Brexit, had passed.
Gold was rising sharply early last week. Oil began to slide. These are two very important barometers of global risk appetite, and those moves were clearly demonstrating fear and uncertainty in markets.
But on Thursday, gold put in a key reversal signal. So did oil, on Friday. Those reversals continued today. Additionally, a very key bond market in Germany (the German 10 year bund yield), which traded into negative yield territory at one point last week, has been clawing back into positive territory since Friday (trading above 5 basis points today – positive 5 basis points).
Why? Because of this chart…
Above is an update of the bookmaker odds on a Brexit. The chances of a leave have now dropped from 44% to 25%, since Thursday.
That’s why global markets are aggressively taking back the hedging and selling from last week.
The UK vote is this Thursday. We’ve said months ago, that despite the speculation of a UK exit, it was not going to happen, given where the oddsmakers were pricing the risk (at about 70/30 in favor of staying for much of the way), and given the scale of the “fear of the unknown” in the voter’s eyes. Adding to that, we expected that the warnings from big public figures would come in hot and heavy as the date approached. Type in the words “Brexit” and “warning” into Google and you get almost 7 million results.
Already, everyone has weighed in with draconian warnings in an attempt to influence the decision: from the UK Prime Minister, the head of the Bank of England, the head of the IMF, to the ECB, to the Fed and the U.S. President. Now UK employers have been latest, directly writing their employees to warn of the business damage from a ‘leave’ vote.
If the Brexit risk continues to abate, and the referendum comes and goes on Thursday, with a ‘stay’ vote, that should clear the way for broad global stock market rallies and a sharp bounce back in yields, as the focus will quickly turn to a July Fed rate hike.
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After a shaky few days for markets, we head into the weekend with some relative calm today. Next week the UK vote on leaving or staying in the European Union will dominate the market focus.
The pressure in markets had been building in recent days on the pick-up in momentum for the Brexit vote in the UK. A log on the fire for that pressure was the inaction from the four central banks that met this week (Fed, BOJ, SNB and BOE). Yields in German 10-years slid below zero. U.S. yields (10 years) hit four year lows. Stocks were sliding, globally. The upward momentum for gold started to kick in. And then we had the tragic murder of a member of British Parliament (widely considered to be politically driven, as she was a ‘stay’ advocate).
So leveraged positions across markets that were leaning in the direction of the momentum unwound, to an extent, on the news.
Today we want to step back and take a look at some key charts as we head into next week.
First, the odds of a Brexit from the bookmakers…
As we’ve said, along the way, despite the coin flip projections coming out of the many polls in the UK, this estimation has been clearly favoring the ‘stay’ camp by about 70/30. Though in recent days the probability of an exit had risen to 44%. Following the tragic news yesterday, that number is now back to 36%.
Next is a chart of gold. This is the safe haven trade, though it hasn’t much allure in quite some time. Still, gold found some legs in the past 10 days.
But as you can see in the chart above, after a $35 higher yesterday, it reversed sharply to close on the lows. In the process it put in a very nice technical reversal pattern (an outside day – where the day’s range engulfs the prior day’s range, caused by low conviction ‘longs’ reversing course near the highs and hitting the exit doors, exacerbating the slide into the close). That price action would argue for lower gold, and in general, the end of this recent flurry of doubt surrounding the UK vote (and uptick in broad market volatility).
As we know, the sustainability of the crude oil recovery is a huge factor in global financial market stability. After trading above $50, it had six consecutive days of lower lows, but it bounced back aggressively today, also posting a key reversal signal (bullish outside day – again, good for the global stability outlook).
Finally, a look at the chart of the S&P 500 …
Despite all of the negative messaging across the media and uncertainty from the investment community, as we head into the weekend stocks sit just 3% off of the all-time highs.
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Last week we talked a lot about the German bund yield, the most important market in the world right now. Today we want to talk about how to trade it.
The best investors in the world love asymmetric bets (limited downside and virtually, if not literally, unlimited upside). That’s the true recipe to building huge wealth. And there is no better asymmetric bet in the world right now than the German 10-year bund.
With that in mind, in recent weeks, we’ve revisited Bill Gross’ statement last year, when the 10-year government bond yields in Germany were flirting with zero the first time. He called it the “short of a lifetime” to be short the price of German bunds – looking for yields to bounce back. It happened. And it happened aggressively. Within two months the German 10 year yield rocketed from 6 basis points to over 100 basis points (over 1%). But even Gross himself wasn’t on board to the extent he wanted to be. The bounce was so fast, it left a lot of the visionaries of this trade behind.
But over the past year, it’s all come back.
Is it a second chance? German yields are hovering just a touch above zero — threatening to break into negative yield territory for one of the world’s most important government bond markets.
As we said on Friday, the zero line on the German 10-year government bond yield is huge psychological marker for perceived value and credibility of the ECB’s QE efforts. And that has huge consequences, not just for Europe, but for the global economy.
Given the importance of this level (regarding ECB credibility), it’s no surprise that the zero line isn’t giving way easily. This is precisely why Bill Gross called it the “short of a lifetime.” With that, let’s take a look at the incredible risk/reward this represents, and a simple way that one might trade it.
There is a euro bund future (symbol GBL) that tracks the price of the German 10-year bund. Right now, you can trade 1 contract of the German bund future at a value of 164,770 euros by putting up margin of 3,800 euros (the overnight margin at a leading retail broker). If you went short the bund future, here are some potential scenarios:
If you break the zero line in yield, the euro bund future would trade up to about 165.50 (it currently trade 164.77). If you stopped out on a break of zero in yield, you lose 730 euros (about $820 per contract). If the zero line doesn’t breach, and yields do indeed bounce from here, you make about 1,500 euros for every 10 basis point move higher in the German 10-year bund yield.
For example, on a bounce back to 32 basis points, where we stood on March 15th, the profit on your short position would be about 4,600 euros (or about $5,200). If German bund yields don’t breach zero and bounce back to 1%, where it traded just a year ago, you would make about 15,000 euros ($16,900) per contract on your initial risk of $820 – a 20 to 1 winner. Of course, there are margin costs to consider, given the holding period of the trade, but in a zero rate world, it’s relatively small.
If you’re wrong, and the German 10-year yield breaches zero, you’ll know it soon.
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On Tuesday we talked about the quiet bull market in commodities. Today we want to talk about one specific commodity that has been lagging the sharp rebound in oil, but is starting to make a big-time move. It’s natural gas. And this is an area with some beaten up stocks that have the potential for huge bounce backs.
Natural gas today was up almost 6% to a six month high. The U.S. Energy Information Administration said in its weekly report that natural gas storage rose less than what analysts had forecast. But that was just an extra kick for a market that has been moving aggressively higher in the past NINE days (up 37% in nine days).
Now, we should note, nat gas is a market that has some incredible swings. Over the past three years it has traded as high as $6.50 and as low as $1.64.
For perspective on the wild swings, take a look at this long term chart.
You can see we’re coming off of a very low base. And the moves in this commodity can be dramatic.
Three months ago natural gas was continuing to slide, even as oil was staging a big bounce. But natural gas has now bounced 58% after sniffing around near the all-time lows. Meanwhile, oil has doubled.
Based on the backdrop for oil, broader commodities, the economy we’ve been discussing, and the acknowledging the history of natural gas prices, we could be looking at early stages of a big run in nat gas prices.
Summer is one of the most volatile periods for natural gas with the combination of heat waves, hurricanes and potential weather pattern shifts such as La Nina. During the summer months, a 50% move in the price of natural gas is not uncommon. Another 50% rise by the end of the summer would put it around $4. And four bucks is near the midpoint of the $6.50 – $1.65 range of the past three years.
Billionaires investor David Einhorn has also perked up to the bull scenario in nat gas. In his most recent investor letter his big macro trade this year is long natural gas. Here’s what he had to say: “Natural gas prices are not high enough to justify drilling in all but the very best locations. The industry has responded by dramatically reducing drilling activity. As existing wells deplete, supplies should fall. The high cost of liquefying and transporting natural gas limits competition to North American sources. Current inventories are high following a period of over-drilling and a record warm winter. However, the excess inventory is only a couple percent of annual production, which has already begun to decline. Normal weather combined with lower production could lead to a shortage within a year.”
This all contributes to the bullish action we’re seeing across commodities, led by the bounceback in oil. The surviving companies of the energy price bust have been staging big comebacks, but could have a lot further to go on a run up in nat gas prices.
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