Sui Generis Investment Partners newsletter for the month of March 2017, titled, “No Damn Cat, No Damn Cradle.”
Friends & Investors,
It’s an exciting time to be doing what we do and the team managing Sui Generis Investment Partners couldn’t be more excited about what the balance of this year should bring. February was a solid month for the Fund and our third positive month in a row, posting a net 1.2% return to our investors while still running the portfolio very conservatively. Opportunities abound as investors are still enraptured by the idea that President Donald Trump could implement “huge” tax cuts, cut regulation and boost spending on enormous infrastructure programs…big time. The notion that “animal spirits” have taken stocks materially higher speaks to the level of psychology involved in analyzing the market at large while also revealing a shockingly complacent attitude towards putting capital at risk. Those who read our note regularly may remember our commentary in December which discussed volatility plumbing all-time lows, valuations reaching for all-time highs, borrowed money pouring into stocks and what we view as complacency amongst both institutional and retail investors. Nothing has changed. But we have to talk about something don’t we? So we’re going to do a bit of a dive into how much substance there is to this rally and whether or not there are troubling or encouraging signs when we look inside.
Prior to an interview with Bloomberg last week, the show’s producers prepared the host by sending us their pre-taping questions that aren’t at all dissimilar from questions we get nearly every day. What they likely thought was the most mundane of the questions fascinated us the most, “what do you think of stocks and their valuations?” Seems fairly straightforward right? Our issue, once we truly started to think about crafting a thoughtful answer, was that it didn’t appear to us as though valuation matters at the moment, so it was difficult for us to have an opinion that didn’t make us sound dismissive. Nobody seems to care; even Warren Buffett, the man who told us all to be fearful when others are being greedy doesn’t believe stocks are excessively valued. Our response to Bloomberg included references to the cyclically adjusted price earnings ratio (CAPE) of the S&P 500 which as we type sits at 29.23, the third highest reading ever (3rd only to dates marked just before the crashes of 1929 and 2000). We pointed to the continued rise in margin debt to new all-time highs, the continued fall in equity short positions to all-time lows and the enormous influx of retail money into equities at a year-to-date rate 6x last years all as a sign of a market that is long in the tooth. We could have gone on, but that didn’t change our answer that in a market like this valuation and the traditional metrics to value equities simply do not matter.
Obviously, we don’t want all this to sound like sour grapes and we are honest enough to again point out that we were caught offside by the reaction to Donald Trump’s election victory and suffered in November as a result. But November is a long way in the rearview mirror and at some point this market is going to have to stand on a little more than tweets and we have adjusted accordingly. Every contrarian bone in our body (and there are many) tells us to get short this market, but in so doing we would be breaking one of our fundamental rules, we never short “mo”. Standing in front of a momentum driven market that lacks fundamental justification is a very dangerous endeavor to undertake, though one can get lucky with the timing. We are waiting for some clarity on what we think the next move will be. This is to say, we covered several of our shorts to tighten our focus, run the portfolio market neutral (net positioning very close to zero) and let this storm blow by while focusing our positioning on sectors that should allow us to perform well regardless of the market’s direction. This sharpened focus has turned our attention to two things; trying to figure out what it is the bulls see that we don’t…and oil.
Over the last two weeks we have built up a long position in oil & gas producers for the first time since the launch of our fund. We believe the recent extreme weakness and violent moves to the downside seen in energy stocks is the result of impatient speculative long positions (at a record a few weeks ago) throwing in the towel at precisely the wrong time, because the trade was far too crowded far too early. The expectation that OPEC’s agreement to reduce output would have an immediate impact on crude inventories never made sense, so we waited until the specs started selling en masse to get long. We think that time is now. While the market has been transfixed on the supply data from both the US and OPEC, we might suggest that readers start to look closely at demand figures coming in significantly stronger than most forecasts (including our own) had predicted. Global oil demand in Q1 is pacing at 97.2 million barrels per day, 1.5 million barrels per day above Q1 of 2016. “Product” inventories saw a rare (for the season) global drawdown of roughly 1.05 million barrels per day in February and we haven’t even begun the refinery ramp up into summer driving. The strong demand juxtaposed against a 1.8 million barrel per day decline in supply from OPEC (if they are to be believed) should create upward pressure on crude pricing in the coming months. This isn’t a particularly long term trade, but it should work for at least the next few months.
Finally, to touch on what it is the bulls see in the rest of the market. We know the valuation argument isn’t there and there is no contrarian argument to be made for buying stocks, broadly speaking. As evidenced yesterday, short term interest rates continue to rise as US monetary policy continues to tighten so the cheap money (TINA – there is no alternative) argument is slowly going away as well. This fact conceivably gives a long-lost profit center back to the banking sector whereby banks can make decent money on their deposit base in a higher rate environment. We understand this argument and recognize that because financials are such an enormous percentage of stock markets, this trade is influential. However, the yield curve continues to flatten implying more moderate growth into the future. Yesterday the US Federal Reserve raised the overnight rate by 25 bps and the yield on the ten-year US treasury bond immediately tanked from 2.59% to 2.49%. This is not bullish action for financials and we worry that the yield curve will continue to flatten and eventually invert (lower long term rates than short term, which almost always means a recession is coming).
The animal spirits argument seems to be the big one yet lacks any real substance. Investors are continuing to selectively appreciate the promises of the US administration that they like while simultaneously ignoring the troublesome ones. The replacement to Obamacare has stumbled out of the gate, a timeline for tax cuts continues to be pushed out and the $1 trillion spend on infrastructure is lacking a sponsor who can pay for it. The potential for policy disappointment seems incredibly high to us, yet investors are happy to keep searching for substance in these promises because they want to keep the equity party going. If we hadn’t just seen this play out in energy stocks, we would worry about what an over-extended market might look like when it’s disappointed. Now we know. In looking for something substantive to justify what they’re looking at (a strong market), we can’t help but think of our favorite exchange from our favorite Vonnegut book:
“No wonder kids grow up crazy. A cat’s cradle is nothing but a bunch of X’s between somebody’s hands, and little kids look and look and look at all those X’s . . .”
“No damn cat, and no damn cradle.”
The Sui Generis Team