Wall of worry well in tact

It's been quite some time since my last post. I've been quite busy now that I have a "real job" and so blogging is low on the priority list, but I have a lot on my mind that I want to let out. Being in the position that I'm in, I have a lot of interactions with advisers, wholesalers and portfolio mangers which gives me a good sense of market sentiment. I can tell you that I hear a common refrain also echoed in the financial media which is this: "market valuations are high, the risk reward is not favorable" and so everyone has their guard up worrying about the next catalyst that's going to take the market down such as election uncertainty or a rate hike. I know from experience that well advertised worries seldom come to fruition or if they do, like Brexit, they tend to be short lived.

I know Donald Trump has talked a lot about walls but one wall that doesn't get mentioned much is the wall of worry that this market has been climbing. Coming into the year I wasn't too optimistic about the markets because we had a situation where rates were expected to rise along with a trend of declining earnings (due to energy companies). That negative posture was a correct one to have...for a few months. What has happened since the spring is that energy prices hit a bottom and rates have not gone up and that has caused the market to recover from the 1st quarter damage and then some. Everyone, myself included didn't expect the market to rebound as swiftly as it did from those lows in March. Most were expecting a lower low at some point. Well, as the motto of this blog has proved over and over again "the main purpose of the market is to make fools of as many men (any women lol)  as possible" and so here we are not too far off  the all time high which was made in the summer with very little fan fare. Mutual fund and ETF flows have been negative for most of the year even as the market recovered and made those new highs.  I can tell you this from my experience and that of history - major bull market peaks don't end like this. They don't end when people are worried, they don't end when monetary conditions are easy (even if we get some hikes). They end when there is complacency and few see it coming. When oil peaked out a couple years ago how many people called for a decline to $30? Nobody. Not once single fucking person. The prevailing sentiment was that oil was ultimately heading to $200 at some point. When oil started rolling over, most pundits said it wouldn't go below $70... then when it was in free fall we ended up to the point where there were lots of  calls for $20 (which of course never happened either and it marked the bottom).

At those lows in March, I can tell you that sentiment towards commodities was black enough to be considered "maximum pessimism" caliber and as so we are probably in the early stages of a multi-year commodities bull market. As such, I have been accumulating positions in commodity-linked names such as t.hwo. t.cke. t.nsu  and v.orc.b which are fundamentally cheap, have strong balance sheets and lots of upside potential.

I will conclude by saying that I can respect the notion that valuations are high by historical standards when it comes to the overall market (not crazy high but high) but then again, what are the alternatives? Bonds? Cash? GICs? Their yields are piss poor even if rates do start going up. Also, it would be reasonable to assume that if energy prices are on the up and up, overall market earnings will improve next year and what if the global economy actually starts grows at a normal pace which nobody is expecting? The market appeared expensive in the early 90's as it emerged from the recession of 1990 but it "grew" into it's high earnings multiple as the economy went from second to third and fourth gear. Some of you will poo poo this idea but you've probably been poo pooing this entire bull market as well.

Keep an open mind, pick your spots. I'm not suggesting you go all in after the market has had a big run but unless I see a shift in sentiment towards complacency, I'm still giving the bulls the benefit of the doubt if and when we get another pullback. 

Will there be a helicopter drop one day?

It's been a rough ride this year so far no doubt. I already highlighted my concerns in prior posts and the market has been sliding due to them. Back in September I mentioned that it didn't feel like quite like a bear market at that time but I admitted that I personally wasn't afraid enough and that was a red flag suggesting we were not out of the woods yet. I said

 I know that in the depths of 2011 I had more doubts about the market although I gave the benefit of the doubt for a bullish resolution. You know you're near the end of a correction when even the bulls like me start having second thoughts! 

Well, I can say now that I have genuine doubts much like near the depths of 2011, in fact more so. I'm not alone in my doubts. Doom and gloom is thick. Talk of recession is on everyone's lips. Most people are comfortable calling this a bear market - and quite frankly, it is. A bull market is characterized by a grinding uptrend punctuated by sharp but short pullbacks while a bear market is a down-trending  highly volatile, environment punctuated by both severe declines and vicious snap back short covering rallies. We have definitely seen this type of bear market action and so it has to be respected. However, with everyone so quick to embrace it, fearing the worst, from a contrarian perspective this leaves the door open to the possibility that at the very least, an intermediate term counter trend rally is not too far off, much like the rally from March 2008-May 2008 and from March 2001-May 2008. Those rallies ultimately failed but they were doozies. For me to be more confident that we're at the cusp of a mulit-month rally I would like to see a spike in the VIX and outflows. Both have been increasing but only grudgingly so which could indicate not enough fear. Although from anecdotal evidence, I've seen quite a lot of fear such as contacts I have who deal directly with retail investors

There are legitimate worries out there no doubt and it seems like this time it's a culmination of many factors. There's the hard landing in China, European Bank stress, US high yield debt stress and the general deceleration of the global economy. For a good chunk of these problems, the collapse in the energy sector and the strength of the US dollar aided by fed tightening are the culprits. Government authorities have the ability to reverse these negatives to some degree if they have the political will to do so. If somehow OPEC and Russia can come to an agreement to cut oil production the price of oil can rocket to $50 in a heartbeat. If the Fed decides to back off hiking rates for the rest of the year there would be relief in the currency markets (the fed might signal that in their next meeting mid March) . Now, perhaps the damage is already done and any rally would ultimately fail, but if the above happens it would be one hell of a rally and one that could erase all the losses year to date. Memories of 2008 are still fresh and government authorities around the world have learned their lesson to pay more attention to the message of the markets and be proactive.

There is a popular notion that government authorities have already used up all their bullets to stimulate the economy. The latest attempt has been negative interest rates which so far has fallen flat on it's face. I think it's pretty sick to see savers get punished. What's this world coming to? There's another option that nobody is talking about which I think could ultimately be used. It's the "helicopter money drop" idea proposed by Ben Bernanke in 2002. What if governments announced they are going to give every adult citizen a monthly paycheck of $500/month and they financed this by simply printing money? You might say this is ludicrous, it will lead to high inflation, it's a moral hazard, ect  but whatever you say it would be a huge fiscal stimulus and unlike QE, it puts money directly into people's pockets, it reduces debt burdens.  You don't think this could happen? Well, I bet 5 years ago nobody thought negative interest rates could even happen either. Now, I'm no economist and I'm not going to debate the consequences of such a policy but I do know that in paper based currency economy there is no limit as to how money can be printed which gives governments the ability to give it's a citizens a  "mulligan" if they wanted to. Theoretically,the government can pay off all our mortgages with the stroke of a pen.Will it get to that point where we literally get free money? Don't think it can't happen....don't underestimate the ability of the government to intervene in the economy.

2016 will be for traders

In prior years since I've started this blog most of the time I would look upon the new year and have a decent sense of what lied in store because there were at least a few major indicators that suggested the bull market since 2009 had room to go. I was generally bullish long term and always suggested to give the bulls the benefit of the doubt during corrections. I advocated buy and hold as a result. This time around I can't say that because we are in a situation where corporate profits as a whole are rolling over and monetary conditions are tightening which are not the ingredients for an advancing bull market that is 6 years old. At the very least this suggest the bull market will be on hiatus characterized by choppy action for months with a reasonable possibility of a full blown bear market.  The bulls would argue that profits have only rolled over marginally (so far) with energy and the strong US dollar as the culprits and although interest rates are now on the rise, we're a long way from monetary policy being restrictive.They can also argue that with energy being so oversold it's poised for a bounce back which would be positive for overall corporate earnings in 2016. These are a good points, however, the burden of proof is now on the bulls and until we actually see evidence of earnings turning the corner for the better, investors will be skittish. Also, with the fed in tightening mode there is always going to be the fear that they will over do it and cause the economy to tip into recession not to mention the belief many have that this entire bull run was predicated on the fed's easy monetary policy which is now being unwound. As a result of the above, the market will have a very hard time making headway and the best we can hope for would be a range bound market. 1994 and 2004 were the last times the fed tightened monetary policy for the first time coming out of recession and although there was ultimately a bullish resolution,  the markets were range bound for months as investors took a wait and see approach to see what kind of economic damage if any, the tightening would do. Once the market got the sense that the fed was just about done with little or no damage to the economy, the markets took off. Will this happen again this time around? We will see....I think it's certainly doable but then there's the bear case which is not weak by any means.

There is an eerie parallel of the energy crash to that of the tech and housing crashes of 2000 and 2007 respectively which lead to recessions and major bear markets for stocks in general. Both those aforementioned sectors were important drivers of the cycles that preceded them, responsible for significant earnings and job creation. When they crashed they created stresses in corporate bond markets and resulted in job losses which at first were dismissed as isolated events that wouldn't spill over to other sectors. Energy state Texas was by far the greatest contributor to job creation in the US since 2009.  In fact about 40% of all job creation in the US since 2009 was due to Texas!

To believe that this prosperity in Texas was not due to the oil boom would be very naive. I've heard the  argument that Texas is no longer as energy dependent as they once were as their economy is more diversified but I'm quite sure the energy sector in Texas leads their economy and  drives other important sectors such as housing and retail - it certainty can't be the other way around.  Now that the oil sector is in the tank we are at serious risk of seeing the reverse of this Texas wealth effect kick in.
There is a silver lining to the oil crash in that it's an economic windfall to consumers which is different compared to the tech and housing crashes whereby there's no such windfall. I'm not sure that's going to be enough to offset the negatives but at least there is a positive effect.

The bottom line though is that flat/down earnings when there's monetary tightening is simply not a good recipe for bullish action when you have the market trading at arguably high valuations. I think the best the bulls can hope for at this point is a range bound market but as I've mentioned many times on this, I never felt we reached the euphoria stage of this bull market and people are always so quick to turn negative at the first hint of trouble and so the contrarian in me is not writing off this bull market yet, however, for the first time in a long time, I'm giving the bear case a lot of respect. Be careful.