Client Confidential – September 25, 2017

Client Confidential – September 25, 2017

Client Weekly Update: September 25, 2017

Dear investors,

Targeted short exposure was unchanged last week at 31%.

The small advance in the S&P500 masked significant moves within sectors.  The broader market rally ran unabated, with the (previously lagging) small cap Russell gaining another 1.3%.  Financial stocks also continued to rally.  The banks (BKX) jumped another 3.4%, boosting two-week gains to 7.6%.  But as the laggards rallied strongly, some of the highflyers underperformed.  The Nasdaq100 declined 0.9%, with favorites Apple and Tesla under pressure.

The Toys “R” Us bankruptcy – a once dominant player that succumbed to excessive leveraged buyout debt – provided a reminder of the potential landmines lurking in corporate credit.  Corporate spreads generally widened last week.

I was mildly encouraged by the market reaction to last week’s Fed meeting.  Ten-year yields rose to one-month highs, while market probabilities for a rate hike before year-end increased to 60%.  Yellen’s comments on rates – “We continue to expect that the ongoing strength of the economy will warrant gradual increases” – and the inflation “mystery” signal at least a modest retreat from recent ultra-dovishness.  Moreover, Yellen’s tone was consistent with recent subtle shifts from other global central bankers.

There appears to be an emerging central bank consensus view that global financial conditions need to be somewhat tightened – that time has come for a cautious path toward “normalization.”  The case arguing “peak monetary stimulus” is strong, yet markets still trade based on expectations for loose financial conditions as far as the eye can see.  The markets’ inability to begin discounting a tighter monetary backdrop increases the probability for a difficult future adjustment.

In general, markets have been conditioned over recent years to disregard risk – market, economic, political and geopolitical risks.  To be concerned with risk has repeatedly hurt performance – especially relative to the major equities indices.  This has forced most active investment managers to mimic passive strategies – risk indifference and all.  This dynamic has boosted the likelihood of a significant market reaction at some point when risk can no longer be ignored.

According to Goldman Sachs research, U.S. equities are approaching the longest period in history without a 5% correction.  This is indicative of what has become deep-seated complacency.  Markets are content to disregard a tightening of global monetary policy that could still be several months away.  Similarly, the securities markets can assume the best when it comes to prospective U.S. tax reform.  North Korea, on the other hand, is a potential catalyst that could hit the markets at any point.  How long can markets ignore what has the potential to evolve into a very serious crisis?

Market internals are showing increased instability.  When the favorite longs underperform while the popular shorts outperform (on the upside), it usually indicates that the hedge funds are uncomfortable with their positioning and moving to take down risk (incipient de-risking/de-leveraging both on the long and short sides).  This has in the past been integral to the market topping process and a precursor of a more general market “risk off” backdrop.  But it also creates challenging market uncertainty, volatility and general instability.

I’m ready to add exposure – and I’m ready to reduce exposure.  We’ll look to reduce exposure if we’re losing money.  To increase exposure, I would need to see indications of risk aversion.  I would prefer to see weakness in equities corroborated by widening corporate debt spreads.  Rising global yields would support the thesis of a tightening global liquidity backdrop.  A general “risk off” – selling in global equities, fixed-income and commodities – along with currency market instability – would provide important support for my bear thesis.




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