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Q3/Q4 2016 Hedge Fund Letters

Friends and Investors,

Quotes have never really been our thing. We have worked with colleagues in the past who loved to emphasize a point with a quote as we’re sure many of you do as well. And while this has never been our favorite method of getting a point across, we can’t help but be reminded of two investing legends whose careers are often considered the pinnacle of the investment profession and the fact that both uttered (more or less) the same celebrated line. We will use the exact words of Warren Buffett rather than those of Sir John Templeton for familiarities’ sake but again they espoused the same sentiment, “be greedy when others are fearful, and be fearful when others are greedy.” This is a very hard thing to actually do and we aren’t in the business of playing Monday morning quarterback on what others are doing with their money. We are however in the business of exploiting the widespread belief that “this time it’s different”, incidentally what Sir John described as the four most dangerous words in investing.

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Why do we bring this up? It’s an interesting subject given that very infrequently do markets find themselves on the extremes of fear and greed. Further, buying a stock as it’s getting beaten up and selling it when it has rallied beyond what is logical is a very counterintuitive thing to do, it’s hard and even the best investors don’t do it particularly well. So be forewarned, we’re going to point out some things that if you follow the maxim uttered by Mr. Buffett, are inherently bearish. But this isn’t meant to be a Little Big Horn for market bears, we are simply going to point out a few indications of investor enthusiasm for stocks. As stewards of capital we believe it’s our duty to provide some colour on what we’re observing, so back to the fear/greed spectrum.

 

If you’re reading this it’s entirely likely you know stocks, the US dollar, bond yields and commodities have exploded higher since the election of Donald Trump. You may know that President-elect Trump summoned a dozen titans of the tech industry to his office last Wednesday, amusingly making Mr. Trump (and his children who were in attendance for some reason) some of the least wealthy people in the room. Trump led by suggesting they should all like him because stocks have rallied since his election. So the “Trump bump” is very real and unsurprisingly, he is happy to take credit for it.

Our goal now will be to dig into whether or not his election is causing measurable greed and if so, how it’s manifesting itself. Let’s start with the obvious. There are measures around the world for this sort of thing and the most straightforward we could find is the “fear & greed index” run by CNN Money which incorporates seven indicators in its quest to give an accurate reading of investor sentiment. Amongst these are demand for “junk” bonds, stock option activity, market momentum and volatility. Somewhat logically, the latter is the only signal not flashing “greed” or “extreme greed” given that when stocks go straight up there isn’t usually much volatility to speak of; however we digress, the index is flashing extreme greed at the moment.

So now that we know that the world is clamoring to own stocks at the moment the real point of this exercise should be to identify where the opportunities are. Maybe the enthusiasm is completely justified; perhaps there’s a forgotten sector that has unjustly underperformed; or just maybe, if Mr. Buffett and Sir John knew what they were talking about, this might end up looking like a rather obvious opportunity to have sold stocks. To what extent then are investors rushing out to buy stock? Margin debt on the NYSE, which for the uninitiated is the money investors borrow from their brokerage firm for the expressed purpose of buying stocks, is hovering at all time highs of roughly $500 billion. Margin levels are very highly correlated to stock returns and we see what we think is an obvious issue on the horizon of interest rates moving up, making it getting incrementally more expensive to buy stocks with someone else’s money. This week’s rate increase of 0.25% in the US amounts to an additional interest cost of roughly $1.25B on NYSE margin accounts; great for brokers but investors better hope everyone else stays greedy! For good measure, bullish sentiment in the latest survey by Investors Intelligence hit 58.8% this week, which it said was the third reading in the “danger zone” and near the 60% level last seen in mid-2014 when a broad market top was forming.

So we’ve established that investors are feeling greedy and they’re using a lot of other people’s money to satisfy that need for risk. The next step is to figure out where all that money is going on a slightly more granular level than just saying “stocks”, though that wouldn’t be incorrect; Equity valuations in North America are currently trading in the 98th percentile, which is to say they’ve only been more expensive twice, ever. So yes people are going out and loading up on stocks but there are more interesting movements happening in this market, and they typically coincide with the end of a cycle. The now ubiquitous “Trump bump” applies to a few areas more so than others. The Russell 2000, the small capitalization index with the most breadth in the world, is up 14% since the election and trading at its highest forward price/earnings ratio ever outside of the tech bubble. Anything even distantly related to infrastructure spending in the US has led to what we can only describe as a frenzy. Anecdotally, on December 1st, Caterpillar updated their guidance for 2017, suggesting that earnings consensus for the year at $3.25 was “too optimistic”. Naturally the stock traded up nearly 1% on the day to close at $96.24, or nearly 30x the earnings estimates for next year that management believed were too high. We point this out because it’s a rare opportunity to see a company attempt to talk their stock down and fail…it’s that kind of market.

You may recall that we had suggested in the summer that bond yields had bottomed (we were right) and that rising yields would be a headwind for stocks (we were wrong). Rising inflation expectations since the election have led to a selloff and record short positions in US treasuries, causing bond yields (and subsequently the dollar) to spike.  Paradoxically, surging inflation expectations for the US have caused gold to tank as its inverse relationship to the dollar has temporarily overwhelmed its status as the best store of wealth during inflationary times. This aversion to metals isn’t an “across the board” phenomenon as it seems to be targeted at gold and gold alone. Industrial metals have rallied strongly

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