by Jeffrey Miller, Partner, Eight Bridges Capital Management
April 18th, 2017
Galloway: [talking through the batting cage fence] I don’t think you’re fit to handle the defense.

Kaffee: You don’t even know me. Ordinarily it takes someone hours to discover I’m not fit to handle a defense.

A Few Good Men, 1992

 

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We are knee-deep in earnings releases this week, so I will attempt, but probably fail, to be brief in this letter.  The last few Miller’s Market Musings have garnered some comments, mainly along the lines of “that can’t really be true” variety, but, unfortunately, the data doesn’t lie. Since the March 5th letter, the KBW Regional Bank Index (KRX) has fallen a touch over 10%, while the S&P 500 (SPX) fell just under 2%.  But wait, the whole market rallied after the election on the reflation trade (aka, Trump Trade) of lower regulation and lower taxes, which would lead to higher inflation and therefore higher rates, helping the banks the most.  But the banks are telling you the Trump Trade isn’t happening.  Want to know what else is telling you that?  Ten-year treasuries.  The yield on the 10-year had been bouncing between 2.30% and 2.60% since mid-December, before breaking down this week and closing at 2.18% today.  Take a look at the charts of the 10-year and the KRX below and tell me if you want to handle the defense of the reflation trade.  I’ll wait.

US 10-Year Treasury Bond Yield

KBW Regional Bank Index (KRX)

Now, most folks looking at those 2 charts will notice that sizeable gap on the left.  If an investor was cautious, they may start to worry about what will happen now that the 10-year has broken below the level it closed at back on November 14th.  With a lot of money in trend-following systems (see our last Miller’s Market Musings here for more on that topic), this could dramatically accelerate.  If it does, I’d expect the banks to follow suit.  So far, the S&P 500 has held up well in the face of losing the Trump Trade, but if the banks retrace the post-election move, I’d expect the SPX to follow suit, with a first stop at 2300 and the next at 2215, versus a 2342 close today.  That’s a little over 6% down from here.  Not a huge move, but again, with a lot of money in risk parity, vol targeting, and trend following systems, a 6% drop after a long period of quiet moves could accelerate.  You’ve been warned.

 

Col. Jessup: [refering to Santiago] I felt his life might be in danger.

Kaffee: Grave danger?

Col. Jessup: [sarcastically] Is there another kind?

          A Few Good Men, 1992

 

I think markets are in a little bit of danger here.  Banks, which are kinda my specialty, are not cheap, and are dependent on tax reform and regulatory relief to support their current valuations.  Could we get tax reform sooner rather than later?  Maybe. But Treasury Secretary Mnuchin doesn’t seem to think so.  In this Financial Times article, he is quoted as saying that getting a tax bill through Congress and on President Trump’s desk by August was “highly aggressive to not realistic at this point.”  Regulatory relief is easier to make happen, as it doesn’t require Congressional action, but aside from the biggest banks, it doesn’t really do a lot short-term to help earnings.  The regional banks need higher rates and lower taxes, and right now, both are in doubt.  In fact, one important measure, the spread between 3 month t-bills and 5 year bonds, is now the tightest it has been since the election.  Banks make money on this spread.  If the stocks follow this spread back down, we could see a 12-13% fall in the KRX in short order.  The market might be in danger.

Col. Jessup: [from the witness stand] You want answers?

Kaffee: I think I’m entitled to.

Col. Jessep: You want answers?

Kaffee: I want the truth!

Col. Jessup: You can’t handle the truth!

          A Few Good Men, 1992

Here’s the thing: if stocks were trading at reasonable valuations, or even average valuations, and individual investors had rational expectations for forward returns, and funds were being managed in a prudent manner by fiduciaries who were more concerned about capital preservation than they were about index replication, then we could handle the truth about likely future returns from financial assets these days. But none of the above are true today.  Right now, fully 40% of assets in U.S. equities are in passive vehicles, up from 17% in 2005.  Basically, a large portion of the U.S. investing base has bought into one of two basic narratives: 1) it is impossible to beat the market, so why bother trying or 2) markets never go down for long, so why bother studying them and making decisions about holding cash and hedging.  I’ve been reading a lot of articles from folks who manage index strategies crowing about how over the long-term, indexing wins, when really, what they are falling for is a recency bias.  There have been long, painful periods of time when stocks produced painfully negative returns.  If you have a client nearing retirement, or with upcoming spending needs, like college, blissfully ignoring the truth about where we sit today from a valuation and risk standpoint is reckless.  Because the truth is, financial assets aren’t cheap, and you can be fairly certain that if we ever get a sharp, sustained correction again, a lot of that “long-term” money is going to freak at just the wrong time.  That’s when you’ll find real bargains and good risk-reward setups to put cash to work.  Right now just isn’t that time.  Don’t believe me?   Then check out this series of charts on valuation and positioning, and tell me how this ends well.

 

The positioning:

  

Valuations Are Not Attractive Today:

 

 

Right now we are solidly in the “Most Expensive Quintile” bucket of the above chart, with the most recent reading for the Shiller PE (admittedly, not my favorite measure, but its decent for broad views) at 28.94.  The cutoff to be in the 5th quintile in the chart above for most expensive is 19.6x.  The cheapest quintile ranges from 6.8x to 12.8x.  So to get there, we’d have to fall over 55% to be just inside the band.  To get to 6.8x, we’d need to fall over 76%.  That’s just the

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