After sporting middling 1.7% returns in the first quarter, admitted market cynics at Carlson Capital delivered notable 9.9% net second quarter returns to investors. The above mean performance came despite talk of “bubbles” and the “momentum phase” of the stock market kicking in. After investing on a drawdown in the immediate aftermath of Brexit, the $8.5 billion hedge fund thinks one beaten down investment category, the banks, could benefit.

Also see top hedge fund letters here

Carlson rates

Carlson: unprecedented central banks interventions have caused many market participants to question the reliability of market signals

Sounding a tone similar to JPMorgan’s Marko Kolanovic, Carlson Capital Portfolio Managers Richard Maraviglia and Matt Barkoff decry central bank monetary manipulation, although they do it in more dulcet tones.

“It appears that years of unprecedented central banks interventions have caused many market participants to question the reliability of market signals,” they wrote in a second quarter letter to investors reviewed by ValueWalk. “It is abrogation of decision-making responsibility on a massive unprecedented scale.”

The Dallas-based Long / Short strategy is quick to diagnose the difference between correlation and causation when considering lost faith in market signals. “Quantitative investing that ignores fundamentals and focuses on the last-price discovery is a symptom, not the cause,” the pair wrote.

In considering central bank influence on markets, it is what is expected to happen next that could be truly historic and a “bell ringer”, as first reported by Rachel Levy of Business Insider.

Carlson volatiltiy

Japan engaging in monetary / fiscal stimulus experiment is “historic”

In the discussion as to whether Japanese stocks have played themselves out as the effectiveness of stimulus is being questioned, Maraviglia and Barkoff sound a similar tone to that of BCA. The combination of fiscal and monetary stimulus, derivatively referred to as “helicopter money,” could be a significant economic benchmark.

“A game-changing event has occurred in the market narrative in recent days, but one we have also been talking about. On the heels of massive monetary policy, Japan and Europe have introduced the idea of fiscal stimulus,” they wrote.

Calling “helicopter money” a “mania” and negative rates a silly concept, the report noted the addition of fiscal stimulus could result in trend disruption. “As it relates to the US, after several years of austerity, the tide has turned,” with the potential for government spending to now be accomplished through monetary policy institutions.

Central banks have been accused of creating market price bubbles, and here the portfolio managers of the Black Diamond Thematic program show their noncorrelated investing stripes.

“Generally, being the cynics that we are, we have always had a problem with something or some type of bubble. Since 2013, when the momentum phase of the stock market kicked in, excess liquidity has found its way into a series of similar but ultimately end-game bubbles,” the investor letter said, pointing to the charge of stimulus been accused of creating indiscriminate stock market price momentum.

“If 2013 and 2014 was characterized by an insatiable appetite for ultra-growth predicated almost exclusively on concept versus reality in industries such as clean power and biotechnology, and 2015 was about mega-cap domination crowding and quantdriven price momentum (FANG),” with the August 2015 being one example.

With this analysis and Risk Parity a then popular strategy? “2016 has been the year when investors just bypassed growth and moved to risk-parity, frankly a shameless abrogation of any equity-fundamental analysis replaced by the bond proxy.”

In a market environment where risk parity is considered “a shameless abrogation” of bonds, Maraviglia and Barkoff think “US treasuries are the wrong price.” A problem with bonds in the wrong place is that impact correlated markets. “The valuation of the stock market is being set by unreliable price indicators such as bonds,” they wrote, pointing to a stimulus-driven price discovery breakdown. The letter called the anomalies “historic in proportion.”

Don’t get defensive as Carlson likes banks

How does one invest during periods of “unreliable price indicators” and historic price anomalies?

Don’t get defensive, Carlson Capital wrote:

We have a much more significant bet against defensive positioning. We were tactical and active around Brexit, but we essentially took the opportunity to increase exposure to our overarching themes. We believe that we have much more, not less, confidence in our macroeconomic thesis. The data supportive to our thesis is broad and increasingly unambiguous. It is less that the view is not being appreciated as it becomes more lucid, and more that the market has shifted in the completely opposite direction. The valuation of the stock market is being set by unreliable price indicators such as bonds. Our perfect outcome is that no further exogenous excuses present themselves to Chairman Yellen and that inflation becomes irrefutable, most likely by reaching a two percent PCE. In such a scenario, we would expect the Fed to have to hike and that the September FOMC becomes a live meeting. Higher inflation expectations or higher rates should cause a stronger dollar and a reversal in commodity stocks whose fundamentals remain tied to a disastrous China. Low volatility stocks have extreme tail risk. We have a barbell short across both styles and sectors.

In short, Carlson’s analysis is the US economy is far stronger than it was in 2006 – just before the 2008 financial crisis. Jobs, inflation and the ISM all look better and have “far stronger momentum than it did in 2006 with a fraction of the leverage when rates were over five percent.”

As the hedge fund notes:

We started this letter by talking about a bell ringing. Stock and style leadership have become incredibly imbalanced based largely on all of the above. The dislocation is now at an extreme on both intuitive, absolute, relative and academic levels. HOLT notes that “the discount rate differential between the median low volatility stock in the U.S. and the rest of the market has reached multi-year lows, resulting in a “low volatility premium” not seen since the economic crisis of 2008 and the sovereign debt crisis of ‘11/’12.” The mo-mentum trend we discussed in January has shifted to low volatility, quality, and sustainable dividends. Many of these stocks would be sells in their own right based on crowding and valuation, but in most cases, they also have poor and weakening fundamentals even before we contemplate the implications of a disorderly re-pricing of the US treasury market. This factor has outperformed the S&P by seventy-five percent since 2009.

Regarding China, Carlson Capital opines in a similar fashion to Michael Pettis?:

Our China views continue to represent the other side and is a portfolio hedge to our strongly-held view on the US economy. China’s bank losses are going to be sensational. If recovery rates on non-performing loans (NPLs) are typical of an international crisis, then it could be $3 trillion. The banks, via the government, have continued to lend in the first half despite insolvency. This is not how banks are supposed to work. They have achieved this by reclassifying bad loans as lower risk or swapping failing local government debt.

Unfortunately, no matter how one classifies a bad loan, the need for increasingly fresh liquidity does not change. Liquidity is getting tight in China in a world swimming in it. China needs liquidity to keep intervening in its currency, recapitaliz- ing the banks and covering capital outflows. There is a funding shortfall after taking into account deposit growth and net interest income. One intermediate solution is to sell US treasuries, which chimes with the message of this letter. The real solution is to QE, and in China, to QE requires devaluing its currency by lowering the value of the renminbi against the US dollar. Interestingly, China has been steadily devaluing against the USD and a basket of currencies, and has clearly used the distraction of Brexit to continue the process.

Maraviglia and Barkoff look ahead and think the Fed will have enough data to warrant a September rate hike and are a bit tepid despite their over-arching economic thesis. If they are correct on their economic analysis, one group, banks, might benefit:

…there is really only one sector that would do breathtakingly well if we are right: financials. The banks just received the clean- est bill of health from CCAR and will be returning cash to investors through buybacks and dividends pro-forma at three percent when the stocks trade at their lowest valuation in their finest shape. This is in light of the S&P trading at its highest valuation and in questionable shape. Timing is everything, and after a strong second quarter performance based on the positioning asymmetry that we discussed in our last two letters, we have paused somewhat. In the last two months, however, the market style evolved against us almost perfectly; commodities and STUD have rallied sharply, the overall market has made new highs and our core long – banks – have dramatically underperformed.