150520 2015 May StrayReflections

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May 2015

Jawad S. Mian, CFA, CMTManaging EditorStray Reflections

Stray ReflectionsA Complimentary Special Report from Mauldin Economics

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Jawad S. Mian May 2015

Stray Reflections

No Shortcuts to the TopOn Saturday, April 25, just before midday, a powerful 7.8-magnitude earthquake struck Nepal, wreaking havoc in the nation that is the birthplace of Buddha. There has been immense human and cultural loss. The death toll from the earthquake has passed 6,000, with about 14,000 injured and many thousands in remote areas still unaccounted for. UNICEF estimates nearly one million children in Nepal have been severely affected by the devastation. Meanwhile, scores of religious sites and internationally recognized monuments that had been preserved for centuries have been irrevocably destroyed.

Source: US Geological Survey via National Geographic

Nepal is located in the Himalayas and home to eight of the world’s 10 tallest mountains. The earthquake, whose epicenter was 135 miles west of Mount Everest, triggered multiple avalanches. The treacherous plumes of ice and snow slammed into the Everest base camp, where expeditions were stationed to prepare to ascend the world’s highest peak. The 2015 climbing season was just beginning and it now looks to have been shuttered. At least 21 people were killed, making it the deadliest day on the mountain in history.

American mountaineer Mike Hamill, who was caught on the Everest base camp amid the chaos, kept a running journal of his experiences on his smartphone. From the National Geographic, here is what he wrote:

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1 p.m., April 25: An hour after earthquake and avalanche

The glacier beneath our feet shook violently, swaying, popping, and we heard a torment of rock and ice barrel down the flanks of the largest mountains on earth…

This place is supposed to be safe. Most consider entering the Khumbu Icefall, above Base Camp, as climbing into the danger zone. Although avalanches running off surrounding peaks become white noise because of their frequency; in the middle of the expansive U shaped Khumbu Valley, we feel safe, buffered by lateral moraines and ice ridges a half a mile wide.

When I felt the ground sway and shake, the first thing I thought of was the safety of our climbers at Camps 1 and 2 above. I narrowly missed being pummeled by an ice avalanche there in 2005, and know the risks of the Western Cwm (the narrow glacier valley above the Khumbu Icefall). It’s hard to believe that our preconceptions about safety and risk can be so completely false.

Ain’t No Mountain High EnoughAmerica’s preeminent high-altitude mountaineer, Ed Viesturs, knows all about risk. He is the only American (and 12th person overall) to have successfully climbed all of the world’s 14 mountains over 8,000 meters, and only the sixth person to do so without the aid of an oxygen tank (which he feels can be burdensome). Over a 23-year span, Viesturs went on 29 Himalayan expeditions and summited mountain peaks of over 8,000 meters on 21 occasions. He stood atop Everest seven times, with his first successful ascent of the mountain in 1990 and his last in 2009.

Viesturs took an interest in the Himalayas in high school after reading French climber Maurice Herzog’s grisly account of the first climb of Annapurna (the 10th-highest mountain in the world situated in north-central Nepal). He then began his mountaineering career on the slopes of Mount Rainier, which he has summited more than 200 times. What makes his track record so remarkable is his generally conservative nature with respect to risk in the mountains. He never lost a team member on a climb, and no one was ever seriously injured, which is an astounding feat. On all his expeditions, some combination of training, skills, instinct, and a dash of luck worked in the right way.

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Viesturs describes the art of mountaineering:

I have, if not a deeply religious bent, at least a spiritual one. In this respect, I’ve learned an immense amount from Sherpa culture and its Buddhist faith. The Sherpas have taught me to tread lightly and gently while climbing these magnificent peaks. To climb with humility and respect. And that mountains are not conquered: they simply do or do not allow us to climb them.

On my expeditions, I’ve always noticed that as early as the first days at base camp, the Sherpas can tell which Westerners are there for the right reasons. Climbers who simply love being in beautiful places and relish the joy of climbing for its own sake win their approbation; those who just want to get it over with and go home boasting of reaching the top, don’t.

The Sherpas inhabit the Khumbu Valley and the ones who really build the route up the mountain, using miles of ropes, tents, and other supplies. Without them, nobody would be able to climb Everest. They are experts in the local terrain and serve as experienced guides for mountaineering expeditions.

In 1987, on his first Everest attempt, Viesturs backed off just 300 feet below the summit because the conditions were not right. It was this steadfast commitment to safety that allowed him to climb mountains with such great success. As he says, “Getting to the top is optional. Getting down is mandatory.”

Viesturs believes most accidents and deaths on the high peaks are due to human error, with ambition and desire overpowering common sense. What some people call “summit fever,” he calls “groupthink,” which is when a majority of the group, desperate to reach the top, disregards dangerous weather, route conditions, or other important factors. The least experienced climber tags along thinking if everyone else is going, then it should be just fine.

According to Viesturs, “It’s almost a lemming-type effect. People get swept up in it, it’s that psychological feeling of safety.” No one gives any thought to the acceptable level of risk.

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Stayin’ AliveFrom his best-selling memoir published in 2006, No Shortcuts to the Top, Viesturs gives us this:

About safety, I have a real pet peeve. Countless times—as I’m being introduced to give a slide show, for instance—someone will refer to me as a “risk taker.” I always correct him or her: “I’m not a risk taker. I’m a risk manager. You’re constantly thinking, if this happens, then what do I do?”

Our instincts have evolved over millions of years, instincts that kept our remote ancestors alive. Humans with poor survival instincts got weeded out long ago, through natural selection. The fight-or-flight instinct is a perfect example, passed down to us in our very genes. I’ve learned that I need to listen to my instincts. The signals we receive from them are not imaginary.

Viesturs will tell you he learned this the hard way.

In a 1992 expedition to K2—the second-highest mountain in the world located in Pakistan’s fearsome Karakoram Range—he committed a nearly fatal error when he failed to acknowledge those signals and kept pushing on toward the summit. Yet, even at the time, he knew he was making a mistake.

I quote from a 2010 interview in Slate magazine titled “Into Thin Error” in which Viesturs recounted the episode, which is seared into his memory:

About halfway into the day, the clouds below us slowly engulfed us, and it started to snow pretty heavily. I always contemplate going down even as I’m going up, and I was thinking, “You know what? Six, seven, eight, nine hours from now, when we’re going down, there’s going to be a tremendous amount of new snow, and the avalanche conditions could be huge.”

I talked to my partners and they were like, “What do you mean? This is fine.” So I was kind of alone in my quandary. I knew I was making a mistake; I knew I should just simply go down… I kept saying, “Well, let me go on for another 15 minutes and then I’ll decide.” And then after 15 minutes I’d say, “Let me go on another 15 minutes and then I’ll decide.” And I just couldn’t make a decision, and I put it off so long that I got to the top.

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Even though we succeeded, I don’t ever want to do that again. We just got really, really lucky. There were moments I was convinced we weren’t going to make it down, when I said [to myself], “Ed, you’ve made the last and most stupid mistake of your life.” When we got to camp, I was just so angry with myself….

… It doesn’t matter how long you’ve been there, how much money you’ve spent, how much energy you’ve expended. If the situation isn’t good, go down. The mountain’s always going to be there. You can always go back.

What I learned from that episode has stayed with me for good. It can be summed up in a few words: Your instincts are telling you something. Trust them and listen to them....

If it feels wrong, it is wrong.

Today, he regards it as the biggest mistake of his climbing career. For Viesturs, a mistake is a mistake, even if you get away with it.

This brings me, finally, to my favorite passage in his 2006 book:

When I am climbing, I listen to the mountain. All the information is there, which helps me decide what to do. Arrogance and hubris need to be put aside, and humility and thoughtfulness are essential. I truly believe that is how I survived so many expeditions into a dangerous arena.

Over my investing career, if there is anything I have learned, it is this eternal truth. There is nothing more valuable in life.

From Mountain Man to Macro ManJust as there are risks in climbing, there are risks in investing, but there are also ways to manage the risks. If you eliminate the errors in judgment and manage the mistakes, you can make it relatively safe.

With Stray Reflections, I incorporate risk management into the investment process using 1) macro analysis to avoid economic turbulence by managing the portfolio’s risk exposure, 2) security-level analysis to maintain a value bias to the holdings within the portfolio, and 3) technical analysis for price trend discipline and to stay open-minded and flexible when challenged by the market.

If you’re trading macro, the biggest risk you need to manage is your self.

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Each day, I listen to the market intently. All the information is right there, which helps me decide what to do. I strive to reduce the influence of emotions and ego on my trading. There is no resting. Just when you think you have it all figured out, you don’t. There is always another cock-up.

How many times have you put off a painful investment decision, even when you knew you were making a mistake, only to see your capital lose a third of its value?

Yup. Been there.

It doesn’t matter how long you’ve been thinking about a trade, how much time and money you’ve spent, or how much research you’ve done. If the situation isn’t looking good, get out. The market’s always going to be there. You can always get back in.

Don’t be a hero.

Investment ObservationsEd Viesturs backed off Mount Everest, 300 feet below the summit. Should investors today also heed caution and withdraw from the stock market, even as it scales new celestial heights? Are investors’ preconceptions about safety and risk completely false? Have we given sufficient thought to our acceptable level of risk? Or are we just lemmings, swept up in the psychological feeling of safety? Are we making a mistake? What are our instincts telling us?

I pay close attention to the embedded beliefs in financial markets and assess risks and opportunities in this context.

It is the changing views and behaviors of market participants that alter asset pricing, which is driven by both new information and shifting interpretations of existing information.

Right now, it appears market participants have lost faith in the long-term global growth outlook. Investors favor easy-to-understand narratives. Thus, one of the most popular tales has been that unprecedented stimulus from central banks is levitating stock prices globally without any “real” economic improvement. The belief is that this will all end badly.

Bill Gross also chimed in with his latest investment outlook:

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A “sense of an ending” has been frequently mentioned in recent months when applied to asset markets and the great Bull Run that began in 1981. Then, long-term Treasury rates were at 14.50% and the Dow at 900. A “20 bagger” followed for stocks as Peter Lynch once described such moves, as well as a similar return for 30-year Treasuries after the extraordinary yields are factored into the equation: financial wealth was created as never before. Fully invested investors wound up with 20 times as much money as when they began. But as Julian Barnes expressed it with individual lives, so too does his metaphor seem to apply to financial markets: “Accumulation, responsibility, unrest… and then great unrest.”

Many prominent investment managers have been sounding similar alarms… successful, neither perma-bearish nor perma-bullish managers have spoken to a “sense of an ending” as well. Stanley Druckenmiller, George Soros, Ray Dalio, Jeremy Grantham, among others, warn investors that our 35-year investment supercycle may be exhausted. They don’t necessarily counsel heading for the hills, or liquidating assets for cash, but they do speak to low future returns and the increasingly fat tail possibilities of a “bang” at some future date.

Savor this Bull market moment, they seem to be saying in unison. It will not come again for any of us; unrest lies ahead and low asset returns. Perhaps great unrest, if there is a bubble popping.

Source: Hedgeye

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A Brave New WorldGross sees an Everest asset price peak that allows for little additional climbing. Although I’m sympathetic to his view, I find undue pessimism about the macro outlook.

Structural elements such as aging demographics, extremely high debt ratios, and technological displacement of labor are often cited to explain a stunted global growth model for the future. Many economists insist that the world faces years, if not decades, of “secular stagnation.” However, as Anatole Kaletsky points out, the “new normal” for the world economy since 2008 hasn’t been very different from the pre-crisis period. According to the IMF, during 1988-2007 (the 20 years before the crisis), the average annual growth of the world economy was 3.6%. The latest IMF forecast for 2015 is 3.5%, and 3.8% in 2016. According to Kaletsky, although this continuity seems hard to square with the slowdown in economic activity in all major economies since 2008, the reason that the world economy, as a whole, has not slowed is due to the shifting balance of economic activity from slower-growth advanced economies to faster-growing developing economies. In the advanced economies, the IMF expects 2.4% growth this year, compared with a 2.8% average during the two decades before the crisis. In the emerging economies, growth is projected at 4.3% this year, below the 4.9% average of the pre-crisis decades. However, the emerging economies now account for 51% of global economic activity, compared with 36% in 1994. So, even as they slow down, they contribute more than ever to global growth. The bottom line: there is no evidence of secular stagnation in global statistics.

Source: GaveKal Research

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What’s more, since 2008, the world has never looked as good as it does today.

Previously, the global economic recovery remained choppy and uneven, with different countries adjusting to the post-2008 world at different speeds. US growth was sluggish since 2009 with the household sector deleveraging; Europe was reeling from a sovereign debt crisis in 2010-2011, falling in and out of multiple recessions; Japan was mired in a deflationary spiral which brought Shinzo Abe to power in 2012; and China was always perceived to be at risk for a hard landing with the commodity rout gathering pace in 2013-2014.

Now, the global macro stage is beautifully set.

The US household debt-to-income ratio is back to its 2002 level, and the decline in interest rates has brought down the cost of servicing this debt to affordable levels. Credit growth has revived, and business confidence has healed, which should now bring about a resumption in capital spending.

With the unemployment rate at 5.4%, labor markets are strong enough to boost wage inflation. According to the Employment Cost Index, initial unemployment claims fell to 262,000 last month, the lowest since April 2000, and salaries rose 2.7%, the highest since 2008. Job and income gains have encouraged housing demand to return.

The weak performance in the first quarter is not representative of the true state of the US economy. Strong momentum in the labor market, ongoing recovery in the housing market, and the sharp decline in energy prices should combine to generate robust consumer-led growth. The US recovery should re-accelerate in the coming quarters, aided by a marked reduction in fiscal drag. There is no risk of a recession, in my view.

According to Lombard Street Research, the US has restored the underlying health of its economy, and Washington is close to stabilizing the public debt-to-GDP ratio.

Diana Choyleva, Lombard’s Chief Economist, writes:

Given the maturity profile of government debt, the effective interest rate is likely to fall in the next two years, even if the Fed funds rate rises. The IMF forecasts it to be 1.4% in 2014 and 1.6% in 2015. The effective interest rate was 3.6% in 2013. The government is set to stabilize public debt to GDP at 106%, given nominal GDP growth of 4%-5% in 2014. Nominal GDP growth will then do the job of cutting the debt-to-GDP ratio fast.

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Europe crawled out of recession in 2014, and the region’s economic turnaround is in its early stages. The combination of a weaker euro, increased bank lending to the private sector, less fiscal austerity, and lower oil prices should provide a positive growth surprise over the next two years. Although core inflation remains close to zero, the deflation scare appears to be over for now. Consumer prices ended a four-month streak of declines in April.

The liquidity spigots are wide open, and lending costs have sharply fallen, which resulted in 4.6% annualized growth in M3 money supply in the first quarter, the fastest pace since 2009. Loan growth also turned positive for the first time since 2012. As the banking sector represents more than 80% of the total credit intermediation in the euro area, the importance of renewed acceleration in credit creation to lift Europe out of its stagnation cannot be overstated. European banks have overseen a large-scale recapitalization, taking their common equity capital ratio from 6% in 2011 to 11% at present, which is extremely positive.

The European crisis is forcing tough fiscal adjustments and structural reforms, benefitting the common currency in the long run. Markets are less worried about public debt, and judging by the performance of European bank stocks, the risk of a euro-area breakup has all but disappeared.

Although many pundits have dismissed Abenomics as a failure, I strongly believe Japan has entered a virtuous cycle of positive change and rising asset prices. Abe has taken aggressive and definitive action against the “shrunken mindset” that has plagued Japan for decades. We are witnessing a secular shift in mood, which has revitalized corporate animal spirits.

Corporate profits are at an all-time high, and bankruptcies are at a 24-year low. The jobless rate of 3.4% is at its lowest level since 1996, while the job offers to applicants ratio is at its highest level since 1992.

Over 80% of prospective graduates began the New Year with unofficial job offers in hand. Such tightness in the labor market has been the reason wages are increasing at the fastest pace in 15 years.

Looking at interest rates, currency values, and energy costs, Japan will continue to receive a significant reflationary boost this year. The yen has now fallen to the most competitive level in 40 years, and inflation expectations have risen, pushing real rates into negative territory. Last November, Abe also postponed the planned 2015 consumption tax increase, which further bolsters the cyclical outlook.

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Abenomics is delivering tangible results. Financial markets observer Peter Tasker makes the case that Japan has experienced a substantial improvement in its solvency, with the total addition to Japan’s “shareholders’ equity” exceeding 100% of GDP since the program of monetary reflation began in 2012.

Tasker explains his bold claim:

The strengthening of Japan’s national balance sheet has been dramatic, thanks to the stock of net overseas financial assets, equivalent to some 60% of GDP, which make it the world’s largest creditor. Add together the change in the yen value of this treasure chest to the rise in stock market values, and the rise in real estate values, and you have a massive stealth de-leveraging—not by reducing debt, but by boosting national “equity.”

An improvement in relations and defusing of tensions between Japan and China— evidenced by the massive surge in Chinese visitors to Japan lured by the cheap yen and Abe’s attempts at fixing “past relations” with China—is also decidedly bullish.

Source: South China Morning Post

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I find it astonishing how many people still talk about Japan deflating or China crashing. The market is telling you something completely different.

The roaring bull market in Chinese stocks on record volume and breadth implies that the Chinese economy is not as bad as the pervasive gloom suggests and might indeed surprise positively in the year ahead. A stock market rise of such scale is certain to have powerful effects on the real economy. This will likely lend support to Asian and emerging economies more generally as well.

Even commodities have firmed up in the last month, particularly industrial metals, which may indicate that the Chinese economy is stabilizing, at the very least. Real interest rates in China are among the highest in the world, so there is significant scope to ease its monetary policy stance.

This year promises to be the first year since the 2008 crisis where the odds are moving decisively in favor of a fortuitous synchronized global growth upcycle. Economic prospects are slowly brightening and macro risks diminishing, rather than intensifying. From a cyclical vantage point, I believe both new information and a changing interpretation of existing information will be beneficial for stocks, to the detriment of government bonds in general.

The global stock-to-bond ratio is going much higher.

The Bear TrapWho would think that after six years into an equity bull market, being bullish would still feel contrarian? It’s because of this strange feeling that I expect this investment cycle to last much longer than what historical episodes suggest.

After two terrifying bear markets in a span of 15 years, I can appreciate the abnormally large “wall of worry” that still persists. Scarred investors feel that new risks are lurking around the corner. The traumatic experience has been seared into their memory. However, to quote investor Leon Cooperman, “Bear markets do not materialize as a result of immaculate conception.”

Don’t let memory get in the way of such a jolly market. Instead of waiting for a grand comeuppance, investors should adapt to the new reality. We can be critical of the policy choices that have been made over the years, but it is what it is. We must live with it. The real risk for investors is to get stuck in this “groupthink” that sees everything as a giant Ponzi scheme, which will ultimately collapse.

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The world will only end once.

Investors must put aside their ideological beliefs and become radically agnostic in their analysis. There is no room for dogmatism in markets. In this game, money is how you keep score. There are no points for deriding Yellen, Draghi, or Kuroda.

According to Dylan Grice, debiasing ourselves must involve an honest assessment of what we want: do we want to be right about everything, or do we want to know what’s true?

For me, macro investing is about finding the hidden Truth. I want to know what I can translate into an actionable trade idea.

That the current bull market is being driven purely by QE is an old wives’ tale. While monetary stimulus has clearly played a leading role, I think the QE narrative is inherently lazy and overstated, especially as it omits a discussion of some of the more fundamental shifts that have taken place since the crisis.

As per Ken Griffin, speaking at the recent Milken Institute Conference, “Corporate America moves at lightning speed today in reaction to new information.” Despite the severity of the 2008 recession, US corporate profits rose back to record levels just three years after the recession ended. There has been a considerable sea change in corporate psychology.

Source: Yardeni Research

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Much ink has been spilled regarding the share buyback boom and how it has diverted cash away from creating jobs and investment. The claim that QE has given US companies more of an incentive to invest in their own shares than in plant and equipment is not entirely true, in my view. Barclays estimates that the portion of cash flow allocated to capital expenditures is 40%, down from more than 50% in 2002 but at the same level as 2006 when the US economy was humming along nicely… and QE had not even been conceived.

Buybacks are hardly the reason capex spending has been so weak, although it is still around 5%. A more credible explanation is the fact that this has been one of the weakest economic recoveries on record.

However, if the recovery is sustained, as I expect, then looking at the slowing trends in productivity, I imagine critics of share buybacks won’t have to wait too long for a capital spending revival. There are already initial signs of improvement.

There is no shortage of cash available to spend on capital projects for long-term expansion. As per Bloomberg, five years of profit growth have left S&P 500 companies with $3.6 trillion in cash and marketable securities, plus they have raised a record $1.3 trillion through bond sales last year. With far more money than they can allocate to profitable investment opportunities, CEOs have been returning nearly 30% of their cash to investors in the form of buybacks and dividends. I don’t see why this elicits so much scorn. This year, the total is expected to exceed $1 trillion for the first time ever, with over half of that coming from buybacks. Share buybacks may have fueled the rally in some stocks, but just like QE, it’s being given too much credit for boosting the broader stock market.

In analyzing the macro landscape, I examine four major drivers: growth, valuation, liquidity, and technicals. Although buybacks, QE, and overall central bank activity are a key determinant of the liquidity environment, they offer an incomplete macro picture unless special attention is given to the other factors as well.

American PhoenixMake no mistake—the US secular bear market that began in 2000 is over.

The March 2009 low represents the beginning of a new secular bull market in US stocks. The longer-term structure for the market will remain bullish even if the S&P 500 trades down to 1,600 levels. Total returns are unlikely to match the stellar returns during the past 30 years, however, and the path forward will be fraught with some major cyclical swings.

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For now, the “pain trade” will be the S&P 500 moving higher by another 200 points. Even as stocks have moved to all-time highs, investor caution is still reflected by the underperformance of cyclical stocks versus defensive stocks since 2010. This behavior stands in sharp contrast to previous equity bull markets when cyclicals outperformed.

From an Elliott Wave perspective, the rally in US stocks from their mid-2011 low is impulsive and seen as wave 3 of a larger 5-wave bullish sequence, which is not yet complete. A wave 4 corrective phase will occur from much higher levels, which I anticipate to be more severe and longer lasting than what we have generally been accustomed to lately.

Source: J.P. Morgan

From a more practical standpoint, I wouldn’t be surprised to see stocks become even more richly priced in the current cycle. Although valuations for the US stock market have risen sharply in recent years, global equity valuations are not unduly high by historical standards.

If I’m right about the global growth upcycle, then valuations have room to climb much further. I see no reason why US stocks can’t trade at 20 times earnings over the next several years.

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Frankly, given the slow and fragmented nature of this recovery, it is still too early in the investment cycle to worry about valuations. Historically, valuation is a poor timing tool, and valuation considerations only matter once the economic expansion looks exhausted, which is certainly not the case right now.

Considering the current low-yield environment, the US equity risk premium remains fairly generous. If we assume the fair value for the real 10-year yield to be 1% (it is currently only 0.25%), then the S&P 500 earnings yield today would need to be 5% to generate the same average equity risk premium of 4% that prevailed over the 1960 to 2007 period. As it happens, the current earnings yield for the S&P 500 is closer to 6%, which suggests US stocks still have meaningful upside.

Although margin debt is at all-time highs, I don’t view it as a sign of concern. It is not the absolute level of margin debt but the 12-month rate of change that matters for the stock market. In the past, the signal to sell stocks was when margin debt was expanding rapidly on a 12-month rate of change basis—it was rising at 72% in February 2000 and 63% in May 2007. (See chart below.)

In our current experience, the measure peaked at close to 40% in 2013 and dipped just below 0% early this year. It has reversed higher since, which has marked great stock market buying opportunities previously in 1995, 1998, 2005, and 2012. Looking at the current 5% reading, I would argue the speculative phase is some ways off.

Source: Dalma Capital, Bloomberg

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The equity bull market will only be endangered when markets start to price in interest rates reaching restrictive levels. For that, the spread between the US 10-year bond yield and corresponding level of economic activity should be watched closely. Normally, an economic recession or an equity bear market has occurred when the bond yield exceeded the level of nominal economic growth rate for an extended period of time. With US nominal GDP growth expected to be above 4% in 2015 and the 10-year yield at 2.2%, this does not appear to be a concern at the moment.

The Fed has a powerful incentive to prevent rates from rising to levels that would make the debt burden pernicious. While the Fed will begin hiking rates this year, policy normalization will occur at a measured pace—and only against a backdrop of improving global growth and a strengthening US economy. This is a very bullish signal, even if the “noise” leads to some market turbulence initially.

Source: BCA Research

The annual growth rate of the Fed’s balance sheet has fallen from nearly 40% in early 2014 to less than 5% last month and is expected to fall below zero in the second half of this year. The investment environment is progressively shifting from an excessive reliance on liquidity to growth. Anyhow, average stock market returns for the past nine tightening cycles have been largely in line with those for the past nine easing cycles.

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A Conscious RecouplingGlobal stock markets have decided to “consciously recouple” in 2015.

The rally in European stock markets from the October 2014 low has simply been breath-taking. The ongoing stealth bull markets in Japan and China have also now been followed by significant breakouts in underperforming Asian markets, such as Hong Kong, South Korea, and Taiwan. I do not recommend a defensive posture at this stage, given major cyclical tailwinds and a global liquidity picture that is still expansionary.

Global equities will continue to advance, as global growth conditions firm and earnings gradually strengthen. Based on valuations and relative monetary policy settings, I expect non-US stocks to lead the way. US stocks are currently at 60-year price-relative highs versus their European counterparts, while Asian stocks have underperformed US stocks by over 400% since 1995. International stock markets are just beginning to catch up to the US benchmark, which has an almost 100% outperformance lead from the March 2009 low.

There is a global capital rotation underway, and I’m most bullish on Europe and Japan.

The bullish case for Europe is straightforward: return on equity is well below its historical mean and forward earnings are bottoming, leaving considerable room for earnings upside as economic activity picks up.

In Japan’s case, investors remain fixated on the ghosts of its deflationary past and are unable to embrace the possibility of a major secular change. In my view, the real possibility of corporate structural reform in Japan is one of the most underappreciated investment stories. Abenomics is leading companies to become much more concerned about their excessive cash balances and overall shareholder returns.

According to Barron’s, Japan Inc.’s cash pile hit a record 217 trillion yen ($1.81 trillion) at the end of last year: an amount that is equivalent to 40% of Japan’s GDP and nearly the same percentage of the country’s total equity market cap of about 500 trillion yen. Last year alone, Japanese companies increased dividends by 19% while share buybacks rose by 55%. There has been a tripling of announced share buybacks over the last five years to 4.5 trillion yen in 2014, up from 1.5 trillion yen in 2009. Abe’s moral suasion has pushed management teams to finally act in the interest of shareholders with meaningful corporate governance reforms.

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Profit margins are at record levels, and return on equity is on the rise, now at 8.3%, up from 5.7% two years ago. With corporate profits at an all-time high, the surge in Japan’s broad indices so far has been driven by increased earnings, rather than by multiple expansions. Two years into the launch of Abenomics, valuations remain as attractive as they did on day one.

The secular bull market in Japanese stock began in 2012. As deflationary pressures abate and credit growth picks up, the rally is broadening and financials are beginning to outperform. I don’t believe Japan’s equity re-rating is complete.

Get Out of Bonds, Risk-FreeFor exceptional returns in 2015, it is not enough to just be bullish on non-US stocks; you must also short US bonds. Bond yields in much of the developed world have fallen to unjustifiably depressed levels. There is a major revaluation risk to owning government bonds at this stage of the investment cycle. With macro risks waning and inflation expectations slowly rising, I suspect global bond returns have probably crested. We have been short US Treasuries since January.

According to David Rosenberg, for the 10-year Treasury note to generate a 14% return, it would have to fall to 50 basis points. Even with the US Economic Surprise Index declining to its lowest point since the 2008 recession, however, bond yields were unable to sustain a sharp move lower in the first quarter. That leads me to believe yields are likely to move higher once the data improves.

Source: Bloomberg

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The inflation environment has been changing substantially. Not only is core inflation stabilizing in the major economies, headline inflation is poised to rise in the months ahead.

The US 10-year break-even rate (a market-based gauge of inflation expectations) bottomed in January at 1.5%. By mid-March, it had reached 1.65% and is now trying to push through 2%. In early January, the German 10-year break-even fell below 0.6% and had doubled to 1.2% by mid-March. It has now settled at 1.3%. Japan’s 10-year break-even rate was near 0.7% in mid-January, rose above 1% in March, and is now at 1.1%.

As the world emerges from the perceived threat of deflation, bond yields should rise toward equilibrium levels. I urge investors to gravitate out of richly priced bonds and into stocks. The bond bull market is over.

I expect that the US 10-year yield will rise to approximately 3.5% over the next 12 to 18 months as global growth accelerates (particularly in Europe and Japan), inflation expectations will continue to recover worldwide, and the Fed will hike rates for the first time in 11 years.

Curiously, according to Erik Swarts, yields are following the inverse pattern from the secular (1979-1985) pivot of 10-year yields, which would place them on a glide path higher over the coming months.

Source: Market Anthropology

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Just as the Sherpas taught Viesturs to tread lightly and gently while climbing magnificent peaks, we too chase Everest-type returns with humility and respect. We know that markets are not conquered: they simply do or do not allow us to make money.

The SeekerSiddhartha is an allegorical novel by Hermann Hesse written in 1922. It deals with the story of a restless Indian boy named Siddhartha, who leaves the comfort of his home and embarks upon a spiritual journey in search of peace and wisdom.

On his quest, he first spends time with the Samanas, who encourage him to live a life of deprivation. He practices fasting, meditation, and self-denial, but all his efforts are in vain. He feels no closer to enlightenment. He tells his friend Govinda, who also accompanies him on the journey, of his doubts.

I find only a short numbing of the senses in my exercises and meditations and that I am just as far removed from wisdom, from salvation, as a child in the mother’s womb.

His unrelenting search for a universal understanding of life takes him to Gautama, the Buddha himself. He has heard that Gautama was a man of bliss, and that Brahmans and princes bow down before him and become his students. He decides to walk over to the town of Savathi to meet the exalted one.

He looked at Gautama’s head, his shoulders, his feet, his quietly dangling hand, and it seemed to him as if every joint of every finger of this hand was of these teachings, spoke of, breathed of, exhaled the fragrant of, glistened of truth. This man, this Buddha was truthful down to the gesture of his last finger. This man was holy.

Never before, Siddhartha had venerated a person so much, never before he had loved a person as much as this one.

But Siddhartha feels little curiosity for the Buddha’s teachings; he does not believe that they will teach him anything new. He feels strongly that true wisdom can only come from within. So, while Govinda chooses to stay and seek refuge with the monks, Siddhartha moves on.

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He ventures into the city where he meets Kamala, a courtesan, who sends him in the direction of material pursuits. Even as a rich man, however, Siddhartha realizes that the luxurious lifestyle he has chosen is merely an illusion, empty of spiritual fulfillment.

He had been captured by the world, by lust, covetousness, sloth, and finally also by that vice which he had used to despise and mock the most as the most foolish one of all vices: greed. Property, possessions, and riches also had finally captured him; they had become a shackle and a burden.

With a gloomy mind, Siddhartha leaves everything behind and decides to live the rest of his life by the presence of a river where he earlier met Vasudeva, an enlightened ferryman.

He becomes an observer of nature, and the river teaches him many lessons with Vasudeva as his guide. He learns from it continually. Above all, he learns how to listen. The quieter he becomes, the more he is able to hear. Siddhartha also realizes that he has learned something new from everyone he has met on his path. There is Truth all around. From that moment, Siddhartha ceases to fight against his destiny and thinks only of the Oneness of all life.

There shone in his face the serenity of knowledge, of one who is no longer confronted with conflict of desires, who has found salvation, who is in harmony with the stream of events, with the stream of life, full of sympathy and compassion, surrendering himself to the stream, belonging to the unity of all things.

He is an inspired man.

Years later, Govinda, still restless in his heart, comes to the river after hearing talk of an old ferryman who is regarded as wise. He asks Siddhartha to ferry him over, not recognizing him at first as the friend of his youth. As the two old friends begin their trip across the river, Govinda asks Siddhartha to share some of the things he learned on his journey.

What could I say to you that would be of value, except that perhaps you seek too much, that as a result of your seeking you cannot find…. When someone is seeking, it happens quite easily that he only sees the thing that he is seeking; that he is unable to find anything, unable to absorb anything, because he is only thinking of the thing he is seeking, because he has a goal, because he is obsessed with his goal.

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Seeking means: to have a goal; but finding means: to be free, to be receptive, to have no goal. You, O worthy one, are perhaps indeed a seeker, for in striving towards your goal, you do not see many things that are under your nose.

Don’t we all spend our lives searching for something?

We write our goals, design our paths, and then chase after it with everything we have. We pursue our objectives aggressively and directly—ignoring all other possibilities—and try our best not to deviate from the plan.

In place of hurrying on the path with our hands stretched out, reaching for the goal—which always seems farther out in the distance, fleeing from our grasp even as we get closer—perhaps we should walk through life with our arms wide open and our palms tilted toward the sky.

In this manner, we would be open to receiving everything that comes our way and live in the present, as opposed to pursuing some uncertain future. Rather than feeling tired of life and the long road ahead, we would be free of worry and slowly discover the joy of surprising ourselves instead.

Maybe we learn something new on every step along the way. When Siddhartha glanced at the river, he realized something: “This water ran and ran, incessantly it ran, and was nevertheless always there, was always at all times the same, and yet, new in every moment!”

I’ve grown up to believe there are no coincidences in life. We are always in the right place, and everything happens at exactly the right time. Instead of obsessing about our goals or destination, maybe we should remain in the present moment and just let the universe move about.

Like the river, life has its own flow; we cannot impose our own structure upon it. We can’t control it—all we can do is listen to its current. Sometimes, when the outside noise dulls down, the quietness within reveals a lot, but only if you listen, intently.

In the end we all belong to God, and to Him we shall return.

Jawad S. Mian

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PositionsWe currently have 44 open trades across 15 investment themes.

https://www.mauldineconomics.com/order/plan/15211801

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Positions - Closed


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Stray Reflections

Stray Reflections Track Record SummaryStray Reflections is a global macro advisory publication with a focus on major investment themes and actionable trade ideas. Our primary objective is to achieve long-term capital appreciation by identifying a diversified portfolio of trades that each add incremental alpha for our clients.

The inefficiencies at the heart of macro investing are permanent, as they relate to the inherent uncertainty of the future. The vast majority of the data required is publicly available. The differentiating factor is the ability to analyze and thematically organize the information into coherent theories.

The starting point of our investment process is complete independence of analysis and thought. We do not set out to be consensus or to be contrarian, but instead to be independent. Our guiding principle is to help investors understand and navigate through all the complexities of an unstable, deflation-prone world.

We share excerpts from our research publication below, which highlight some of our important macro calls and investment recommendations since inception in February 2014.

February 2014“The US 10-year bond yield since 1986 shows a clear secular downward channel. We monitor this very closely since it has served as one of the best signals to time low-risk entry and exit points from global markets. The cyclical peaks and troughs in yields have coincided with a major risk-off and risk-on response in stocks, respectively.

“Since the US 10-year bond yield hit a secular low of 1.43% on June 1, 2012 (its lowest level ever), it gained 113% to 3.05% on January 2, 2014. This was the fastest rate of change increase over an 18-month period in the past 30 years. Such a quick and sharp adjustment higher in rates has nearly always preceded a drop in stock prices. It would be prudent to build a protector portfolio concentrated in US Treasuries.”

The US 10-year bond yield declined from above 2.7% in February 2014 to 1.65% in January 2015. It was one of the biggest “surprises” of 2014.

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March 2014“In trading markets this year, our strategy is guided by the words of Horace— Many shall be restored that are now fallen and many shall fall that are now in honor…. To heed Horace’s advice, we started looking for assets that were held in honor that may suddenly fall from grace. Social-media stocks. Biotech.

“Social network stock prices have seen a more than three-fold surge since mid-2012. These baskets of stocks are trading at 12 to 13 times sales, almost equivalent to valuation levels at the peak of the tech bubble…. Hot money flows into the biotech group have driven up valuations to nosebleed levels. A sizeable price decline is probably around the corner, and we have initiated a short position in social-media and biotech stocks.”

Biotech stocks peaked on February 25 and fell 21% in the next two months; social-media stocks peaked on March 7 and fell 25% in the next two months.

April 2014“We think the downside in Chinese equities is much less than what people currently anticipate. In our view, Chinese stocks are probably late in the process of completing a massive de-rating since the equity market is down more than 50% from its 2007 peak and trades two standard deviations below the average measure of Chinese GDP relative to global GDP.

“At its all-time highs, Chinese stocks traded more than two standard deviations above. The current valuation level (6.8-times forward earnings) discounts much of the macro concerns in our view…. We are perhaps among the few who actually see the weakness in Chinese equity markets as providing a special opportunity to establish strategic long-term positions.”

Chinese stocks have been the best-performing asset class over the 12 months since our recommendation, returning 114%.

May 2014“Solar stocks can be classified to have experienced one of the greatest bear markets of the 21st century—from an all-time high in May 2008 to the low in November 2012, an incredible collapse of 95%. We believe rising electricity prices, lower solar costs, and widening adoption and scalability will turn this group into a real winner in the long run.”

Solar stocks are up 27% since that call.

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June 2014“The real China story is taking place online. E-commerce is booming. The number of Chinese online shoppers has surged to 300 million, more than doubling in three years. We are enthusiastic about the long-term prospects for Chinese Internet stocks and believe China’s rush toward consumerism will lead to outsized gains for the best-positioned players.

“We believe Chinese Internet stocks have all the basic ingredients to turn into the next investment mania: leading innovation, high growth expectations, abundant liquidity and global speculation.”

Our preferred Chinese e-commerce pick, JD.com, has risen 38% so far.

July 2014“While investing in Iraq carries plenty of risk, it is a risk worth taking, in our view. If there was ever a time to buy when there’s blood on the streets, it is now—to heed Baron Rothschild’s timeless advice. At a time when equity risk premiums are precariously compressed around the world, we believe a small allocation to an uncorrelated secular investment opportunity that has one of the highest potential growth rates and equity risk premiums should be viewed as prudent portfolio strategy. There aren’t many post-war reconstruction growth stories that are also blessed with world-class natural resource endowments.”

Iraqi stocks have since fallen 20%.

“What makes us nervous [about oil] is speculative positioning in the CFTC oil futures market, which stands at a record extreme and has previously led to sharp price declines.”

Oil prices peaked only days earlier, and July marked the beginning of the oil crash.

August 2014“The attitude of policymakers in Japan has firmly changed, and we expect to see that reflected in the public and corporate Japan before long as well. The aggressive monetary actions and supportive fiscal measures will result in a viable turnaround in the nation’s attitude. We don’t believe Japan’s equity re-rating is complete. We are witnessing a secular shift in mood in Japan, and we feel stocks will stand out to be the clear winners. Japan has one of the most favorable micro tailwinds in the world.”

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Japanese stocks are up 30% since then. Corporate profits are at an all-time high, and return on equity is on the rise, now at 8.3%, up from 5.7% two years ago. In 2014, Japanese companies increased dividends by 19%, while share buybacks rose 55%.

September 2014“Investor enthusiasm for euro-denominated assets has dampened, but we feel this is only temporary. Our analysis leads us to conclude that the risk of a major deflationary bust in Europe, while not exaggerated, is likely to recede and that economic indicators should improve, even if it takes time. We believe another buying opportunity will soon emerge in European equities as risk appetite wanes over the next two to three months.

“Our favorable macro view on Europe rests on understanding that the strong headwind from bank deleveraging will now begin to ease and lead the economy to gradually approach its trend growth rate of 1.5%.”

European stocks bottomed in October but have risen 24% to date. German stocks are up 35%. Europe’s economic turnaround is in its early stages, and growth should exceed 1.5% in 2015.

October 2014“The macro environment is turning against risk-seeking behavior: global growth estimates are being downgraded on an almost weekly basis, world inflation keeps creeping lower, liquidity and momentum are rapidly fading, copper and oil are breaking down, and markets around the world are starting to act wobbly. It is the month of October. Historically, it has been one of the most unkind months to investors.”

US stocks peaked in September and fell sharply in October. The S&P 500 lost 7%, and the Russell 2000 was down 11%.

November 2014“We believe we are entering a ‘new oil normal’ where oil prices stay lower for longer. Our analysis leads us to conclude that the price of oil is unlikely to average $100 again for the remaining decade. We think the next five years will see a trading range develop with prices oscillating between $55 and $85.”

Brent was at $84 then. It fell to $45 by January.

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“We don’t see any signs of OPEC restraint at the group’s next meeting on November 27. It can be grasped that the lower the price of oil falls, the greater the need to compensate for lower revenues with higher production, which paradoxically pushes oil prices even lower.”

No cuts were made at the OPEC meeting, as expected, and the oil crash accelerated. Saudi Arabia raised oil production to above 10 million barrels per day (mbpd) in 2015.

“In the past, higher resource prices increased the occasions for military conflicts as nations would scramble to secure necessary supplies. Going forward, however, we firmly believe lower oil prices pose a greater risk of escalating current geopolitical challenges.”

Saudi Arabia launched airstrikes against Yemen in March to bring political regime change. Tensions between Saudi Arabia and Iran have increased further.

December 2014“We are skeptical of the consensus mindset and don’t think that the US dollar can appreciate significantly over the next five years. We view the recent strong run-up in the currency’s value as a cyclical phenomenon—not a secular upturn—and suspect it offers an excellent opportunity for investors to diversify outside of the dollar.”

The dollar peaked in March after an 11% rally in the early months of 2015. It is down 6% from its peak.

“We believe the dollar is now vulnerable to a re-widening of the current account deficit on the back of stronger household consumption. The temporary fillip to the current account from the shale oil boom, weak import demand, and lower interest rates should reverse in the next five years…. America will struggle to attract the same amount of external capital as it has in the past.”

In March, it was reported that the current US account deficit widened sharply in Q4 2014, the largest shortfall since 2012.

In May, it was reported that the demand for US government securities sold at auction declined in Q1 2015. The bid-to-cover ratio was 2.75 in 2015, down from 2.87 in 2014 and the record 3.15 in 2012.

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January 2015“Our analysis leads us to conclude that the cyclical path of least resistance for commodities will turn up later this year. The commodity cycle peaked with the blow-off move in silver in April 2011, and we suspect the cycle has troughed with the crash in the oil market in the back half of 2014, which has continued into the early part of 2015. We feel the crosscurrents buffeting commodities will gradually settle on the side of higher prices.”

Commodities bottomed in March and have since risen 10%. Oil is up 50% from its lows.

February 2015“Once the shock of the speed of the recent drop in oil prices is overcome, we could see a major mindset change in the bond market…. German bunds are in a final fifth wave and have reached the upper end of the 30-year, secular bullish-trend channel.”

US 10-year Treasury yields have rallied from a low of 1.65% in January to 2.25% in May, due to a rerating in both growth and inflation expectations.

German 10-year bund yields fell from 0.3% in February to below 0.1% in April and then rallied sharply to above 0.6% in May.

“Investors should diversify their holdings away from the US. The outperformance of the US stock market has been exceptional, but relative valuations and monetary policy settings favor Europe and Asia.”

YTD Returns: US +2%, Germany 18%, Japan 12%, China 34%.

March 2015“We believe the deflationary psychology has progressed too far. The investment landscape is about to shift for the first time in over four years, and it is important for investors to take note. Since the summer of 2011, we have seen deflationary trends dominate: US dollar rising, commodities falling, global growth slowing, global bond yields declining, and US stocks outperforming the rest of the world. If we are correct in our thinking about the “deflation” trade coming to an end, all these trends should reverse.”

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In mid-March, the dollar peaked, commodities bottomed, and yields made a higher low. International stock markets are outperforming the US benchmark in 2015, which has an almost 100% outperformance lead from the March 2009 low.

“The ECB has commenced QE, and we wouldn’t be surprised if markets copy and paste the post-Fed QE implementation script—higher euro, higher yields.”

The euro made a multi-year low on March 16 at 1.048 and has risen above 1.12 in May. German bund yields bottomed on April 17 and have seen the biggest upward climb in a quarter-century.

April 2015“It may not seem like it now, but we believe monetary authorities have overcome the threat of deflation. They have been successful in changing people’s perceptions and breaking the deflationary mindset, even if this is not yet reflected in the level of global government bond yields. The inflation environment has been changing substantially. It is entirely conceivable that inflation in major economic blocs will stabilize as we approach mid-year and enter a slow, long-term bull market.”

The US 10-year break-even rate bottomed in January at 1.5%. By mid-March it had reached 1.65% and is trying to push through 2% in May. In early January, the German 10-year break-even fell below 0.6% and doubled to 1.2% by mid-March. It has now settled at 1.3%.

“Should the S&P 500 hover above 2,000 and oil prices stay above $50, we think the Fed will be keen to hike rates at the June FOMC meeting.”

Remains to be seen.

“We believe recent weakness in EM [emerging markets] does not herald a repeat of the 1997 Asian crisis. We don’t think a Fed interest rate hike will lead to a disorderly carry trade unwind, an EM debt crisis, and another global recession. Most importantly, we now believe the risk of a one-off Chinese devaluation is also off the table….

“If we are correct in our view that China is in the early stages of a new long-term bull market, then emerging markets as a whole will not be left behind for too long. The economic integration model led by China, with Xi’s vision of a ‘New Silk Road,’ holds the promise to provide a structural tailwind.”

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The People’s Bank of China (PBOC) is making more public overtures to make the renminbi a global reserve currency.

The ongoing bull markets in Japan and China have also been followed by significant breakouts in underperforming Asian markets, such as Hong Kong, South Korea, and Taiwan.

The Stray Reflections PhilosophyAs a global macro advisory publication, Stray Reflections is focused on major investment themes and actionable trade ideas .

The investment environment is changing at a rate that’s representative of global economic imbalances, fund flows, and geopolitical risks. Very few past models are still valid and such a situation has contributed to the extreme uncertainty that currently prevails. With Stray Reflections, my guiding principle is to help investors understand and navigate through all the complexities of an unstable, deflation-prone world.

You can begin receiving Stray Reflections each month by clicking here.



Stray Reflections 35

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