Week Ending 3/25/2016

The equity market’s winning streak ended this week as the major indexes fell slightly. The overall US market (VTI) dropped 0.78%, the SP500 as measured by the SPY was down 0.62% and international markets (x-USA) were down 1.91%. The aggregate bond index was about even, falling 0.05%.

performance 3 24 2016


As the market has moved higher traders have been increasing their bets on volatility ETFs like TVIX or UVXY. These ETFs move counter to the market. So if the market is going down, these ETFs usually go up. With volatility priced low, and with the recent rally in the markets, traders have been anticipating a pullback, hence, the increased demand for these ETFs. TVIX brought in $160m on Monday and UVIX has added $723m over the last several weeks. But the market has a funny way of doing what everyone doesn’t expect. The big run-up off the February lows has had these traders and investors, including ourselves, thinking some kind of pullback might be in order, but the market simply has refused to cooperate, at least so far. Despite multiple chances to decline, including on Thursday when the Dow was down over 100 points in the morning, the market has not followed through on the downside. The market closed at its high on Thursday and pretty much at break even for the day. Similar to past rallies over the last few years, the market might be setting itself to do the unexpected and continue even higher with little pause.

But traders/investors looking for a hedge by going long the volatility ETFs need to be aware of their idiosyncrasies. These ETFs are betting on the VIX index. The VIX is not a stock or a fund or anything like that, the VIX is a complex mathematical formula to calculate the expected volatility of the SP500 based on the weighted average of out of the money puts and calls due to expire in about 30-days. Since the VIX is not anything tangible, no one can actually purchase the VIX. But there are future contracts available on the VIX and that is how these funds get exposure to the mathematical VIX calculation. These futures contracts are settled in cash at expiration. The volatility ETFs are based on buying and selling these futures contracts. The futures contracts do not track the actual VIX dollar for dollar. They go up and down based on many factors including the time left until the contract expires.

And that is why going long a volatility ETF is such a dangerous game. While a trader could hit a big payday if the market falls, especially if it happens quickly and unexpectedly, there is usually a huge wind pushing against the long trader every single day. This is called the “roll yield.”

Normally the near-term futures contract is priced lower than a longer dated contract with an expiration date further out. The futures market is said to be in “contango” when it is in this state. The ETFs will own the near-term (and cheaper) contract, but have to “roll” into the longer-dated (and more expensive) contract over time. So the funds are essentially selling low and then buying high, this eats away at the value of the future contract with each transaction. This differential is the “roll yield” and that is why buying a volatility ETF is a loser’s game over time. The trader is betting that he can overcome the roll yield by a sharp decline in the market and that he can get in and out of the fund before the roll yield eats away at this return.

The VXX is a volatility ETF started in 2009, it is down 99% since its founding. But the fund rallied 42% from December 31, 2015 to the market low on February 12. That is the appeal of these funds. The timing has to be just right for the big payoff.

There are rare times when the volatility markets are not in “contango” but in a state called “backwardation.” This is the opposite of contango. When a market is in backwardation, the near-term contract will be more expensive than the longer dated contract. When this happens, and it is rare, the volatility fund will have a tail wind at its back. The fund would then be selling high and buying low.

Needless to say, volatility ETFs are a high stakes game and not for the faint of heart.


We have been waiting and it is starting to arrive. The percent of energy loans classified as in danger of default will be greater than 50% at some point this year at several of the major US banks. Banks are trying to limit their exposure be selling off the loans at a discount, not renewing the loans and cutting back on credit lines. According to the law firm of Haynes and Boone, LLP, 51 producers with $17.4b in debt have already filed for bankruptcy. The most exposure might be to the regional banks like Comerica and BOK Financial, not the majors, as the majors have already begun the process of writing off the loans and have smaller overall exposure.

Bad Loans Hit the Oil Patch WSJ Mar 25 2016


Over the last couple of months, we saw some signs that the manufacturing sector, while still not in growth mode, was at least beginning to stabilize. That thesis took a hit backwards when the new durable goods report came out. New orders for products designed to last three years or more fell by a seasonally adjusted 2.8% in February. That report moved the Atlanta Fed’s GDPNow forecast of 1st quarter growth down to 1.4% from 1.9% the previous week. The GDPNow number was north of 2% a few weeks back, but has fallen over the last few weeks, but it is still positive indicating slow growth.

The Chicago Fed National Activity Index (CFNAI) report for February was mainly negative after a strong January report. All of the major categories were lower. The Employment contribution fell to its lowest reading since September. On a positive note, January was revised higher. The three month moving average is showing growth of about 2.6%.

Existing home sales came in at a seasonally adjusted rate of 5.08m versus 5.47m in January. But new home sales increased by 2% in February to 512k annual rate. There appears to be a big mismatch between where the demand is and what the supply is. In other words, there is demand for lower priced starter homes but there is not supply in that price category. According to Trulia, there were only 238k starter homes on the market versus 423,000 in 2012.

The Richmond Fed Manufacturing Index came in very strong, up 26 points to +22, that is the highest level since April 2010. The Composite and Shipments month over month jump was the largest ever, and the New Orders increase was the second highest ever. These increases, together with the increases last week in the Empire Manufacturing report and the Philly Fed report show some strong regional strength around the country.

However, that strength did not carry over to the Kansas City region. The Kansas City Fed Composite Index moved in the right direction, rising six points, but was negative overall, scoring a -6 for March. This was the 13th straight month of a contracting manufacturing activity in that region.

The ATA For-Hire Truck Tonnage Index was up 7.2% for February and was up 8.6% year over year, indicating faster economic growth in Q1.


Initial claims for unemployment remains low, coming in at 265,000 for the most recent reading. The four-week average is 259,750, which is close to the lowest level since 1973. The labor market remains tight.


Overall, the economic reports had a negative tilt this week, however, we still do not see a recession in the near-term. The market declined just slightly. The market has shown a lot of resilience of late and that might be a “tell” for a stronger market down the line.




Week Ending 3/18/2016


The market continued its remarkable comeback and put in gains for the 5th week in a row, and is now up for the year. The overall US stock market as measured by the VTI was up 1.38% (dividend adjusted), the SP500 as measured by the SPY was up 1.32% (dividend adjusted), international markets (x-US) as measured by the VXUS was up by 0.63% and the aggregate bond index as measured by the AGG was up by 0.69%.

DJI Chart 3 18 2016

The SPY is just under 2 standard deviations above its 50-day moving average, normally indicating an overbought condition. But this market has continued to rise over the last few weeks despite opportunities to turn south.

The market was helped by the Federal Reserve, which prior to Wednesday was still holding the line on four interest rate increases this year. But the Fed got in tune with the market projections, and said rates would rise at a more measured pace, probably two more times this year.


Economic reports were for the most part positive this week. The New York Empire Manufacturing Report went into positive territory for the first time since July. The Philadelphia Fed Manufacturing Survey also showed positive numbers, the first time since August. Both imports and exports at the west coast ports of Los Angeles, Long Beach and Oakland showed increases. There was some negative data on a report measuring jobs openings. Numbers were revised down for December to 5,281,000 from 5,607,000. But the unemployment report continued to be low, coming in at 268,000 in initial claims. That is up slightly from last week but still a very good number. We have now been at less than 300k on the unemployment claims report for 54 weeks and that is the longest streak since 1973.


Problems are emerging with subprime auto loans. Delinquencies greater than 60-days on loans packaged into bonds over the last five years are now at the highest level in two decades, 5.16%. Moreover, the rate is of delinquency is higher on the new loans than the older loans, indicating that standards for loans have recently been made easier. Subprime auto loans have helped power the auto industry’s recent record sales, and any pullback in the availability of these loans would impact the auto manufacturers.


The Chinese currency, the yuan, had its biggest one-day advance against the dollar, rising 0.52%. Although analysts do not seem to believe the currency’s strength is a sustainable trend. As a side note, Trump and other candidates have been arguing that China is manipulating their currency lower, the exact opposite of what is really happening.

Other currencies have also been gaining against the dollar, the WSJ Dollar Index, which tracks the dollar against 16 currencies, hit its lowest level since June on Thursday (see the chart above). A lower or stable dollar should be a positive for earnings for the SP500, as it makes their products more competitive overseas. A rising dollar was one of the obstacles to rising earnings last year.


The 3.5 year decline in commodities might be coming to an end. The CRB Commodity Index is up 13% over the last 35 days. Commodities tend to run in trends that last a good length of time so if this is not a head fake we might be at the start of a bull run.


Duke University’s Fuqua School of Business did a survey of CFOs to determine the impact of a rise in the minimum wage to $15. Such a dramatic rise would be negative on employment. 41% said they would lay off current workers and 66% said it would slow the pace of future hiring. 66% also said benefits would be cut and 49% said prices would have to be raised. The point is that such a huge increase over a short time period will impact the way business is done, probably speeding up the pace of automation and lowering employment.


Speaking of unintended consequences, the rise of Trump and his style closely matches recent Latin American authoritarian figures like Hugo Chavez and Rafael Correa. In the leading Venezuelan daily, the “El Universal”, Roberto Giusti compared Chavez and Trump, “consummate showmen with a shrewd ability to manage emotions of a large audience and, using a mixture of half-truths, pin the blame for people’s ills on enemies, real or imagined.”

In Latin America, the populists blame big business and corrupt politicians for working with the United States. Trump has spun that strategy around and blames our problems on immigrants and the “very smart” Chinese and Mexicans that have outfoxed our “stupid” leaders. Bernie Sanders strategy is a softer version of Trump but puts the blame on big business and the rich. Neither candidate has realistic solutions.

Incredibly, in 1998, Chavez actually got the majority of the middle class vote. Look at Venezuela now. There barely is a middle class left and the country’s economic system has been destroyed.


The market has come a long way in a short time. Economic news in the US continues to be on the favorable side, and the fear of a recession which really hammered the market earlier in the year has somewhat faded. The rising price of oil as helped that. At this point, the market is probably somewhat overbought. So some kind of pullback would not be unexpected.

Week Ending 3/11/2016

The market continued its move higher as the overall stock market (VTI) advanced by 0.89%, the SP500 (SPY) was up 1.16% and the international markets x-USA (VXUS) had a 1.54% gain. For the year, the SPY is now off only 0.54%. The aggregate bond index (AGG) was roughly flat for the week, +0.037%.


The European Central Bank (ECB) announced it would lower the rate it charges banks by 10 basis points and would provide banks with long term cash. The cash would be free of charge but if it was loaned out there would be a 40 basis point cost. Monthly bond purchases would increase to $89b and would include buying non-financial European corporations with investment grade ratings. The market’s initial reaction was negative but then turned positive on that announcement.


The International Energy Association said it saw signs of a price bottom helping increase the price of crude oil to $38.50. Four weeks in a row of stable to higher oil prices have coincided with a four week stock market win streak.


The market has put in a strong performance over the last four weeks, but from a technical perspective, while the daily trend is up, the weekly trend is still down. The market needs to put in a higher low on the next downturn for that trend to flip. Nevertheless, this market has had ample opportunities to turn down in the last couple of weeks and has managed to push higher each time.


It was a light week for economic news, but we received another positive jobs report. Initial claims for unemployment dropped to 259k, marking the lowest reading of the year and the third lowest reading of this entire economic cycle.

With the generally good recent economic news including the strong employment reports as well as the recover of the equity markets, the chance for a couple of Fed interest rate increases is back on the table. The Fed meets this week. And while we don’t expect an increase this week, the probability for a move in the next few months is markedly higher now.

The latest GDPNow forecast from the Atlanta Fed came in at 2.2% on March 9th. Same level as the week before. So US estimated GDP growth for Q1 continues to appear to be positive.


Companies are in an earnings recession. According to Factset, 99% of companies have now reported earnings. 69% beat their earnings estimate and 47% beat their sales estimate. The market sells at a forward p/e of 16.1, which is above the 5-year average of 14.4 and the 10 year average of 14.2. Looking forward to Q1, analysts have now cut estimated earnings by 8.8%. The 5-year average for the entire quarter is -4%. The estimated year over year earnings decline for Q1 is now -8.3%. At the start of the quarter, the estimated growth was +0.3%. Energy, materials and industrials are leading the decline. The estimated sales decline is -0.8%. Analysts are looking for positive earnings and revenue growth beginning in Q3. On an annualized basis, analysts are looking for earnings to increase 2.7% and revenues to increase 1.6% for 2016.


While economic news in the US has been improving, there has been a decline overseas. The odds of a global recession are now slightly higher than a few weeks ago. The OECD Composite Leading Indicator for OECD countries plus six key nonmember economies fell by 0.1 point in January to 99.1, the lowest level since September of 2009.  When broken down by individual countries, only 47% of the composite leading indicators are now above their long term averages. According to Ned Davis Research, when less than one-half of the countries are above their long term averages the global economy has usually been in recession. However, a global recession does not necessarily mean a US recession and for now, the US appears to be continuing in slow growth mode. As we wrote on 2/12/16, when the global economy is in recession but the US isn’t, the loss in international equity indexes has been about 17%, compared to 45% when the US and the global economy is in recession.



Overall, the equity markets have been strong over the last month. The US economy shows continued slow growth and led by strong employment reports, does not appear to be headed for an imminent recession in the next several months. Overseas, the global economy is slowing and the recession threat is now higher.

Week Ending 3/4/2016


It was a very strong week in the equity markets as the overall US stock market (VTI) increased 2.99%, the SP500 (SPY) was up 2.74%, international markets (VXUS) flew higher by 6.03% and the aggregate bond index fell 0.33%.
On a daily basis, the trend is no longer down. The market has put in higher highs and higher lows. Bears still argue this is simply a bull run inside of bear market. They may be right, time will tell. It is not unusual for strong rallies inside of a bear market. But our belief is that for a bear market to take hold, the US economy would have to spin into recession. And the last few weeks, while mixed, the thrust of the economic data has been indicating that the US will avoid recession for now. This is confirmed by the latest GDPNow estimate of Q1 real GDP growth, which moved up to 2.2% from 1.9% last week.


Non-farm payroll had another strong report, rising 242,000 in February. The prior two months were revised higher by 30,000. The unemployment rate remained steady at 4.9%. The average work week fell by 0.2 hours and average hourly earnings dropped by 0.1%.

Initial claims for unemployment rose by 6,000 to 278,000. The four-week average dropped by 1,750 to 270,250.

Overall the employment reports are positive and show strength in the US economy.


Productivity of nonfarm workers fell at a 2.2% seasonally adjusted rate in Q4 of 2015. It was the weakest report since Q4 of 2014. This was not a good number. Only four times since 1994 have there been weaker quarters. Lower productivity coupled with higher wages increases unit labor costs, and at some point, higher unit labor costs will encourage businesses to find ways to reduce those costs. In other words, cut employment or slow its growth.


Factory orders were up 1.6% in January, a seven month high. The ISM Manufacturing report came in at 49.5. A reading of 50 is considered break-even, so 49.5 would indicate a small decline in activity, but that number is better than recent reports and was better than the consensus estimate of 48.5. It is the second straight month with a higher reading (month over month). Recent reports like this might be indicating that the manufacturing sector has stabilized.


The ISM gauge of nonmanufacturing businesses fell to 53.4 in February from 53.5 in January. That is the lowest level in two years but still a healthy amount above the break-even level of 50. The reading indicates the US economy continues to expand.


Moody’s Investor Service monthly tall of the least creditworthy companies (ie junk ratings with a negative outlook) rose to 274. The all-time high was 291 in April of 2009.