by Jeffrey Miller, Partner, Eight Bridges Capital Management

December 15th, 2016

Uh uh. I know what you’re thinking. “Did he fire six shots or only five?” Well to tell you the truth in all this excitement I kinda lost track myself. But being this is a .44 Magnum, the most powerful handgun in the world and would blow your head clean off, you’ve gotta ask yourself one question: “Do I feel lucky?” Well, do ya, punk?
Harry Callahan, Dirty Harry, 1971

The Trump Trade has been in full effect since election day, with very few pauses.  Anything domestic and regulated or geared to the economy has been on fire, while the stocks that either had their own growth (FANG) or were “safe” havens have fared poorly. In the U.S., Banks (BKX) are up 23.5% since election day, and Industrials (XLI) are up 12.5%.  Regional banks are up even more than their large cap brethren, with the biggest determinant of performance being whether or not the company was a member of a regional bank ETF.  Those in an ETF are significantly outperforming those that are not.  This has been a massive allocation trade, based, as I wrote in my last note, on expectations for higher interest rates, regulatory reprieves and tax relief.

The KBW Regional Bank Index (KRX) hit a new all-time high on December 9th before pulling back a bit.  Since bottoming out from a six-week free-fall on February 11, 2016, both the BKX and KRX are up about 65%.  That is quite a move. In fact, according to KBW, it is the second-best trough-to-peak move on record for them both.  Only the 164% BKX rally from March 9th, 2009 through October 14th, 2009 beat this year (that was a fun time).  For the KRX, its best year-to-date trough-to-peak return came in 2008 surprisingly, when it advanced 88% from July 17th to September 23rd (inauspicious timing, that).  So after what is pretty close to a historic move in banks, you have to ask yourself:  Do I feel lucky?

Well, before we talk luck, maybe we should look at the terms of the bet first.  In an earlier note, May the Odds Be Ever in Your Favor, I wrote “The bond market is, probabilistically speaking, an underdog to perform well over the next 2-3 years.”  Since then, the 10-year US treasury bond yield has risen over 83 basis points from 1.75% to 2.58% as of the close today.  An investor in the 10-year bond has lost nearly 9% of their principal in the 5 months since rates bottomed in July.  Investors in a 60/40 stock/bond portfolio are not doing nearly as well as the headlines on CNBC would suggest.

At the same time, U.S. banks have risen on expectations that the Fed is going to keep raising. But remember, they said the same thing last December, before global tummy troubles made them change their mind.  If you recall, the Fed is very afraid of “uncertainty” and is quite enamored of its own power to cause it.  The market has already priced in at least 4 more Fed hikes, along with a healthy dose of tax and regulatory relief.  How much is priced in the banks here?  Well, if your average bank pays a 35% Federal Tax rate, and that goes to 25%, earnings go up 15.4%.  These rate hikes add another say 3% to 8% depending on the bank.  So, after a 23% move, most of this is already the stocks.  What are the odds that we get more than the 4 hikes that are already baked in?  That’s what you are betting on happening from here if you stay long the group.  I don’t think I feel that lucky.  This past week I closed out my long KRE and XLF call positions and am now market-neutral in financials.

So what about the rest of the market?  What can take the overall market higher from here?  Again let’s examine the terms of the bet.  The broader market is moving up on expectations that Trump is going to be able to get a massive infrastructure package through Congress and get tax reform done. Except Mitch McConnell said last week that any package would be “revenue neutral” – which means it’s not a stimulus package, it’s a reallocation package.  Recall, your traditional Republican Senator is not a big Trump fan, so just because he won, doesn’t mean he’s going to get what he wants.  I think the odds of some more gridlock in Congress over taxes and spending are coming.  Everyone wants tax reform, but if you’re cutting taxes and want to increase spending by say a trillion dollars AND the head of the Senate wants it all to be revenue neutral? Good luck with that.

Let’s Play a Little Poker.  The Terms of the Bet, i.e., Your Hole Cards:

U.S. Stocks:  Valuations are near all-time highs.  Only higher on a number of measures in a few times in the past 100 years, including 1929, 2000, and 2007.  See Steve Blumenthal’s excellent piece for the details.  Odds: Not good.  Timing?  Hard to game. 9 of hearts.

U.S. Bonds:  Valuations are also near all-time highs, although they have dropped nearly 9% for the 10-year and about 19% for the 30-year treasury already.  Cheap yet?  I don’t think so. This move can continue.  Rising rates at some point may impact stocks that aren’t banks.  10 of hearts.

You have suited connectors. Not the best hand, but not terrible.  I’d play it.

5 cards to come on the flop, turn and the river.

The Flop:
China:  Just today China halted trading in “key bond futures” according to the Wall Street Journal.  Its 10-year bond is now at 3.4%, a 16-month high.  After halting trading, do you think yields are poised to go higher or lower?  Me too.  This is after the Chinese government has been doing everything it can to stem the trillion Yuan and counting exodus from its currency.  So far it has cracked down on moving money to Macau, cross-border deals, and companies with operations in China moving their profits out of the country.  That’s right, if you operate in China and make a profit there, it’s become nearly impossible to move the money out.  So, what are profits in China worth if you can’t ever bring them home?  If you said $0, you and I agree.  This is a bad card.  5 of clubs.

Italy:  Quick, what is the third-largest issuer of government debt in the world, at $2.5 trillion Euros?  Since this is the Italy card, you guessed right. In case you let your FT subscription lapse, the situation there is “not good,” and not just because the country voted no on a referendum.  It’s not good because most of its banks are insolvent (if your bad loans are 20% of assets while your equity is about 10%, you have a problem – it’s not rocket science).  How can Italy resolve this problem?  If it was back on the Lira and out of the Euro, it could devalue and recap its banks with government cash. If it stays in the Euro, Draghi and the Dreamers (hey, new name for a band?) in Brussels will have to do some form of extend and pretend again – but that just delays the inevitable, while saddling the Italians with a stagnant economy and massive unemployment.  Remember, before the advent of the Euro, Italy was a manufacturing powerhouse with an economy and stock market that outperformed Germany.  Since the joining the Euro, it has badly lagged.  How hard will it be for the “leave” candidate in Italy to make that point?  Another bad card. 4 of spades.

France:  Not too dissimilar to Italy, but it isn’t as acutely aware of its issues yet and its banks are in somewhat better shape than Italy’s. They have elections on April 23rd, 2017, and the incumbent is already out.  Marine Le Pen has a very good chance of doing well in the election, and if she gets significant power, you could easily see a push here for cutting ties to Brussels as well.  This is a neutral card – say the Jack of diamonds.  Now we have 3 to a straight.  Odds of hitting it are 4.4%.

Keep betting?  At this point I’d fold.  But say it’s a friendly game, and the company is good.  You call knowing you’re probably going to lose.

The Turn:
U.S. Politics:  Looking out say 6 months, what are the odds that nothing weird, strange or dangerous happens here?  Right now in the U.S. there are high hopes for a Congress that can roll back some of the most harmful regulations stifling business, simplify and streamline the tax code, and get business investing in the U.S. again. A lot of that actually happening is already in stocks.  In addition, there are a lot of unhappy voters making all sorts of noise about being obstructionist, as well as questions about the DNC hack and other issues.  But will they meaningfully impact stocks, enough to derail the momentum it has right now?  I don’t think so.  Queen of hearts.

The River:
Geopolitics: Chinese military aggression (South China Sea), Russian military aggression (Baltics) and the likely breakup of the Eurozone. Any of these things would be a negative for stocks. The odds of all of them happening are low, but the odds of at least one of them happening are pretty good, and if any of these happen, stocks will be down 10% fast, if not more.  3 of clubs. We lose.

What cards do we need to hit to make a winning hand?   All of these are needed for stocks to go significantly (10% or more) higher:

The Eurozone abandons its austerity measures and moves to fiscal stimulus, not just monetary accommodation.  With the Germans running the show, odds are low.  But if it hits, Europe could actually show some growth.  Absent that, continued stagnation.

The U.S. passes a $1 trillion or more infrastructure package without offsetting spending cuts or tax increases, while reducing the top corporate tax rate to 25%.

China doesn’t implode under its massive debt burden.

A strengthening dollar doesn’t create another emerging market debt crisis (recall, since most emerging market debt is denominated in US dollars today, a stronger dollar makes it harder for those countries to repay their debts.)

Oh please, I scare easy.
The Killer, Dirty Harry, 1971

If all that makes it seem like I scare easily, I guess I’d argue that I like to be aware of my surroundings.  When stocks were at valuations that were extremely attractive in 2009, I was buying hand over fist.  As they have become fairly-valued and then overvalued recently, I have definitely become more cautious.  Right now I’m market neutral, with small bets via options on a SPX decline.  I am still short international sovereign debt, along with small shorts on the Italian and Chinese stock markets.  I’m leaning long in some tech companies, consumer discretionary stocks, and defense in the U.S., with a number of shorts in other sectors offsetting that.  For more specific ideas, please email me for a free trial of my new StockPicker newsletter, where I will be discussing specific stock and sector picks in more detail.  Just reply to this email for more information. The next one comes out this weekend.
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This week’s Trading Rules:

  • Think through all the potential scenarios and then make an informed, probability-based decision.  Betting big to hit a runner-runner straight is gambling not investing.
  • Doing nothing is often the best bet.

SPY Trading Levels:
Resistance: The market is just off its highs, so there isn’t much resistance.  The top of the Bollinger Bands is at 229 – look for some resistance there. The market is overbought but can still trend higher in the near-term.
Support: 221/222, then a lot at 219.  After that it’s 216, 212.50, then a little at 210.

Positions: Net neutral stocks (both long and short stocks). Short XLU, SPY, and BWX. Long options on SPY, KRE, XLF, HYG.