Defaults Will Breach The Historical High Next Year – The Fed Is The “Wild Card” by Stephen B. Blumenthal, Capital Management Group

Investor Behavior – “You can bury your head in 10q’s and 8k’s and memorize a thousand facts about a company. You can become an expert on a given stock sector and establish relationships with all of the executives who run the show. You can build your own DCF models and outguess the other guessers on earnings estimates and forward guidance. But until you accept that market mood and behavior is as big a factor as the fundamentals, you won’t ever be completely honest with yourself. The E is only half of the PE. No matter how good you are at understanding and predicting the E, you’ve still only got half the story. The P is determined entirely by psychology.”
(The Reformed Broker)

I was in Chicago this week attending the Morningstar ETF conference.  Jason Hsu from Research Affiliates was a keynote speaker and I loved his presentation on investor behavior.  On the topic of who is supplying your excess return, he said, “People make bad decisions all the time… everywhere”.

At the end of his presentation, Jason was asked if bad investor behavior can be corrected.  “It is impossible to overcome”, he answered.  “Bad behavior will persist and this is the advantage to those with a discipline to take advantage of others bad behavior.” Amen brother.

The bargains in the U.S. will show up when the equity market is 30% to 40% lower.  My two cents is to stay hedged, stay alert and prepared to act. Just like 2008, it won’t feel like a bargain.  Oh but can we see the opportunity.

I always find it helpful when I view a summary of the various markets and asset class performance.  Hope you find the next two charts helpful (a score card summary of the recent market performance).

Defaults Fed

Next is a quick look at various asset class performance after Fed announcements, September, and year-to-date:

Defaults Fed

September, Post Fed and 2015 year-to-date
Source: Bespoke https://www.bespokepremium.com/think-big/

Ok, grab your favorite beverage and let’s dive in.

Included in this week’s On My Radar:

  • Update On The August 25, 2015 Dow Theory Sell Signal
  • Harvard – “Lower Future Returns” and Yale’s – Alternatives Overweight
  • High Yield – Rising Defaults
  • Trade Signals – Weight of Evidence Bearish, Sentiment Extreme, Sell/Hedge Market Rallies (9-30-2015)

Update On The August 25, 2015 Dow Theory Sell Signal

DEFINITION of ‘Dow Theory’

A theory which says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high, it is accompanied or followed by a similar advance in the other. The theory also says that when both averages dip below previous important lows, it’s regarded as an indicator of a downward trend.  Source: Investopedia

On August 25th the Dow Industrials and the Dow Transportation Index simultaneously made closing lows below the mid-October lows of last year and triggering a Dow Theory sell signal.

In the past 18 years, there have only been on inaccurate Dow Theory sell signal.  That was the Flash Crash in May 2010 and it was quickly reversed four weeks later.

For now the August 25 low at 15,666 is holding.  A break below that low would suggest a point to get very defensive though I favor hedged exposure today.  We are in a cyclical bear market period (see Trade Signals below).

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Harvard – “Lower Future Returns” and Yale’s – Alternatives Overweight

The market is expensively priced.  We are in Quintile 5 (most expensive).  Past periods of overvaluation have historically lead to 10-year annualized returns of approximately 3%.  I’m setting my sights on Quintiles 1 and 2 (even Quintile 3 is attractive) with probable forward 10-year annualized returns in the 14% to 16% range.

Better to wait, as Buffett might say, for the hamburger prices to become cheap (Buffett Burgers and the Hallelujah Chorus). I believe we will see that opportunity occur.  Liquidity will disappear, leverage will be forced to unwind, and investors will panic. When? Now? 2016? Later? Who knows, but when it happens it will happen fast.

Defaults Fed

  • From Harvard: The debate about highly-valued assets continues to get louder: private equity valuations are now, on average, at higher levels than in 2007. This environment is likely to result in lower future returns than in the recent past.
  • From Yale: Note that David Swensen has the Yale Endowment positioned into Alternatives (absolute return, leveraged buyouts, venture capital, real estate and natural resources).  Also note the small 4% domestic equity weighting and the larger foreign equity exposure at 14.5%. The university said its fiscal 2016 asset allocation targets are as follows:
  • Absolute return: 21.5%
  • Leveraged buyouts: 16%
  • Foreign Equity: 14.5%
  • Venture Capital: 14%
  • Real estate: 13%
  • Natural resources: 8.5%
  • Bonds and cash: 8.5%
  • Domestic equity: 4%

Source: MarketWatch via 361Capital

High Yield – Rising Defaults

Edward Altman, the New York University professor who developed the Z-Score method for predicting bankruptcies, says “defaults will breach the historical high next year and the Fed is the “wild card” that has the power to determine how quickly the current credit cycle ends.” Bloomberg

“We have blamed the wider Junk Bond spreads on Energy issuers, but last week there was a buyer’s strike.  If this continues, you can say goodbye to easy financing for M&A which will remove one large pillar of support from stock prices”. 361 Capital

  • Altice on Friday sold $4.8 billion of junk bonds to fund its $10 billion purchase of Cablevision Systems Corp., according to S&P Capital IQ LCD. When the deal was shopped earlier this month, Altice expected to sell $6.3 billion of debt, investors said. A 10-year bond was priced to yield 10.875%, compared with yields as low as 9.75% that were suggested by bankers initially, according to S&P Capital IQ.
  • Olin on Friday sold $1.2 billion of bonds to pay for its pending acquisition of Dow Chemical Co.’s chlorine-products unit. Earlier in the month, Olin was expected to sell $1.5 billion of bonds, fund managers and analysts said. The annual interest rate on Olin’s 10-year bonds sold Friday was 10%, up from 7% expected earlier in the month, according to S&P Capital IQ.
  • Companies have announced $3.2 trillion of M&A this year, according to Dealogic, emboldened to merge by cheap debt and the long stock rally that began after the financial crisis.
  • That puts 2015 on pace to rival 2007 as the biggest year ever for takeovers. Issuance of junk bonds backing M&A deals hit a year-to-date record of $77 billion through Friday, according to data from Dealogic.
  • A souring of investors on junk bonds could limit the availability of financing for deals that require a lot of borrowing. Banks have been under pressure from federal regulators to reduce their loans to such companies, and a pinch in the bond market could leave those deals struggling for financing.
    (WSJ)
  • After investors snapped up more than $37.5 billion of bonds issued by junk-rated energy companies in the first six months of 2015, just $5.9 billion has been raised since then, according
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