Month: July 2018

A comprehensive final report made public by investigators on Monday has stirred fresh controversy as Malaysian authorities say they “cannot determine with any certainty” why Malaysian Airlines flight MH370 disappeared on March 8, 2014.

However one key irregular finding in the 495-page report is that the Boeing 777’s controls were most likely deliberately manipulated to take the plane off course, perhaps putting to rest theories of remote hijacking, which investigators behind the report also considered, noting only that “unlawful third party interference” could have possibly come into play related to the pilots’ decision to turn back.  

Kok Soo Chon, head of the MH370 safety investigation team, told reporters, “We cannot exclude that there was an unlawful interference by a third party,” in reference to the decision to divert the aircraft from the intended destination. 

Data compiled by civilian and military radars analyzed in the report shows that the plane turned back in a complete U-turn after leaving Kuala Lumpur for Beijing, which investigator’s say must have been done by manual control, and further that Kuala Lumpur Air Traffic Control (KLATC) “did not comply with established procedures.”

Among multiple lapses noted, the KLATC failed to communicate to Vietnamese air traffic controllers that they were handing over communications with the aircraft to Ho Chi Minh, and further ignored the plane’s progress after transfer. 

The disappearance of flight MH370 remains among the world’s greatest aviation mysteries, and Monday’s announcement has reportedly left family members “disappointed” according to multiple media statements. The airline was carrying 239 people, mostly Chinese passengers, before vanishing without a radar trace or any observable signal. 

The jet turned thousands of miles off course from its scheduled route before it’s believed to have crashed somewhere in the vast southern Indian Ocean. 

Perhaps the foremost mystery and element of speculation remains the final communication from the plane. Captain Zaharie Ahmad Shah signed off with “Good night, Malaysian three seven zero” upon the plane’s exiting Malaysian airspace and soon before it turned off course. 

Chief investigator Chon said of the pilots’ background and mental health, which the report spends considerable pages examining, “We are not of the opinion it could have been an event committed by the pilots.” The report also summarized an extensive investigation into the health and potential criminal history of each of the passengers, but turned up nothing unusual. 

Yet speaking at the press conference Chon still added that the findings weren’t comprehensive enough to rule anything out, as the systems in the plane were manually turned off, and as the team was able to confirm the manual u-turn. 

The team reportedly looked deeply into every theory that’s surfaced over the years, and even cited speculation on social media, including the bizarre conspiracy theories like Russian intelligence interference and alien abduction: “We had over 60 allegations…we removed them one-by-one and saw what remained behind,” Kok said.

A number of massive, costly operations have been conducted in the Indian Ocean to locate the wreckage — the most recent concluded in late May after three months which involved the US firm Ocean Infinity scanning an area of 112,000 sq km and netted nothing significant. China, Australia, and Malaysia had previously conducted a $200 million fruitless search last year which covered 120,000 sq km.

The main evidence showing the aircraft at some point plunged into the Indian Ocean includes the 3 confirmed wing fragments that have washed up along the Indian Ocean coast. In all, 27 pieces of debris fragments have been collected but only 3 could be scientifically matched to MH370. 

Chinese Foreign Ministry spokesman Geng Shuang suggested a continued, open investigation: “We hope that all sides can continue to remain in close contact and coordination, to properly carry out relevant follow-up work,” he told a press briefing. 

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Authored by Lance Roberts and Michael Lebowitz via RealInvestmentAdvice.com,

• Part I – “Buy & Hold” Can Be Hazardous To Your Wealth
• Part II – Why Crashes Matter & The Saving Problem
• Part III – Valuations & Forward Returns
• Part IV – The Math Of Loss
• Part V – Choosing The Right Portfolio Benchmark
• Part VI – Should You Invest Like Warren Buffett?
• Part VII – The Problem Of Psychology
• Part VIII – The Only Benchmark That Matters

The Problem With Passive

Passive strategies, which are widely popular with individual investors, are often based on Nobel Prize winning portfolio theories about efficient markets and embraced by the banks and brokers that profit from selling the strategies. They are often marketed as “all-weather” strategies to help you meet your financial goals.

To be blunt – there is no such thing as an all-weather passive strategy, no matter the IQ of the person who created it. As we have repeated throughout this series, buy and hold/passive strategies are only as good as your luck. If valuations are cheap when you start passively investing, then you have a decent shot at meeting your financial goals. If, on the other hand, valuations are extreme and rich, you are likely to endure a multi-year period of low to even negative returns which would leave you halfway to retirement without much progress towards that goal.

That is not a hypothetical statement. It is simply a function of math.

Howard Marks, via Oaktree Capital Management, and arguably one of the most insightful thinkers on Wall Street penned a piece discussing the risk to investors.

“Today’s financial market conditions are easily summed up:  There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures.  The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best.”

Unfortunately, that was also a repeat of a passage he wrote in February 2007. In other words, while things may seemingly be different this time around, they are most assuredly the same.

This brings us to the “Rule of 20.” The rule is simply inflation plus valuation should be “no more than 20.” Interestingly, while the rule is pushing the 3rd highest level in history, only behind 1929 and 2000, such levels suggest the market is more than “fully priced.” Regardless of what definition you choose to use, the math suggests forward 10-year returns will be substantially lower than the last.

In a market where momentum is driving an ever smaller group of participants, fundamentals become displaced by emotional biases. As David Einhorn once stated:

“The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen.”

Such is the nature of market cycles.

Missing The Target

The trouble with passive investing is best exemplified by the greatly flawed concept of Target Date Funds (TDF). TDF’s are mutual funds that determine asset allocation and particular investments based solely on a target date. These funds are very popular offerings in 401k and other retirement plans as well as in 529 College Savings Plans.

When TDFs are newly formed with plenty of time until the target date, they allocate assets heavily towards the equity markets. As time progresses they gradually reallocate towards government bonds and other highly-rated fixed income products.

The following pie charts below show how Vanguard’s TDF allocations shift based on the amount of time remaining until the target date.

The logic backing these funds and others like it are based on two assumptions:

1. You can afford to take more risk when your investment horizon is long and you should reduce risk when it is short.

2. Stocks always provide a higher expected return and more potential risk than bonds.

Let’s address each assumption.

With regard to the premise of #1 about age and the propensity to take risks, we agree that an investor looking to withdraw money from their portfolio in the next year or two should be more conservative than one with a longer time horizon. The problem with that statement resides in our thoughts for #2 – there is no such thing as a steady state of expected risk and returns. The truth of the matter is that expected returns for stocks and bonds vary widely over time.

When an asset’s valuation is low, ergo asset prices are cheap, the potential downside is cushioned while the upside is greater than average. Conversely, high valuations leave one with limited upside and more risk. This concept is akin to the popular real-estate advice about buying the cheapest house on the block and avoiding the most expensive. Investment risk is not a sophisticated calculation, it is simply the probability of losing money.

To demonstrate, the chart below plots average annualized five-year returns (expected returns), annualized maximum drawdowns (risk potential) and the odds of witnessing a 20% or greater drawdown for various intervals of valuations.

The graph shows, in no uncertain terms, that risks are lower and the potential returns are higher when CAPE is low and vice versa when valuations are high. Based on this historical evidence, we question how an investor can determine asset allocation based on a target date and the assumption that the expected risk and return do not fluctuate.

Currently, CAPE is at 32 which, based on historical data, implies flat to negative expected returns and almost guarantees there will be at least a 20% drawdown over the next five years. Granted, there is not a robust sample size because valuations have rarely been this high. However, given this poor risk/return tradeoff, why should a 2040 TDF invest heavily in stocks? Might bonds, commodities, other assets or even cash, have a higher expected return with less risk? Alternatively, during periods when stock valuations are well below normal and the risks are less onerous, why shouldn’t even the most conservative of investors have an increased allocation to stocks?

To point out the flaws of TDF’s the article is largely based on stock valuations and their expected risk and return. We do not want to convey the thought that investing is binary (i.e. one can only own stocks or bonds) as there are many ways to gains exposure to a variety of asset classes. Active management takes this into consideration before allocating assets. Active managers may largely avoid stocks and bonds at times, for the comfort of cash or another asset that offers rewarding returns with limited risk.

Simply, the goal of an active portfolio manager is to invest based on probabilities.

Math always wins.

You Aren’t Passive

At some point, a reversion process will take hold. It is then investor “psychology” will collide with “leverage” and the problems associated with market liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the “herding” into “passive indexing strategies” begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause large spreads between the current bid and ask pricing for passive funds. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Don’t believe me? It happened in 2008 as the “Lehman Moment” left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious, and without remorse.

Currently, with investor complacency and equity allocations near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough.

If you are paying an investment advisor to index your portfolio with a “buy and hold” strategy, then “yes” you should absolutely opt for buying a portfolio of low-cost ETF’s and improve your performance by the delta of the fees. But you are paying for what you will get, both now, and in the future.

However, the real goal of investing is not to “beat an index” on the way up, but rather to protect capital on the “way down.” Regardless of “hope” otherwise, every market has two cycles. It is during the second half of the cycle that capital destruction leads to poor investment decision making, emotionally based financial mistakes, and the destruction of financial goals.

No matter how committed you believe you are to a “buy and hold” investment strategy – there is a point during every decline where “passive indexers” become “panicked sellers.”

The only question is how big of a loss will you take before you get there?

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Commission-takers and asset-gatherers desperate to reassure their clients that a 15-20% collapse in their favorite stocks in 3 days is “just a fleshwound”…

 

China stocks closed lower overnight, with CHINEXT (China Tech-heavy index) leading the slide…

CHINEXT is back near its lowest since Jan 2015…

European stocks were lower, led by DAX once again…

All major US equity indices red for the day with Nasdaq worst…

 

For the month of July, all major indices remain green but Small Caps and Nasdaq are laggards…

 

Digging down below the index headlines, things are very mixed all of a sudden.

FANG stocks are down around 9% (cap-weighted) in the last three days, that is the worst rate of decline since February 2016…

Since NFLX broke the damn a week ago, things have gone a little bit turbo…

 

TWTR has collapsed…

 

TSLA is tumbling…

 

But as Tech tumbles, banks are bid…

 

Value stocks soared relative to growth in the last few days – erasing all of June and July’s performance…

As Morgan Stanley noted – The bottom line for us is that we think the selling has just begun and this correction will be biggest since the one we experienced in February. However, it could very well have a greater negative impact on the average portfolio if it’s centered on Tech, Consumer Discretionary and small caps, as we expect.  

 

Global Bonds are on the verge of breaking out… or reversing…

 

As everyone reacts to The BoJ last week (and prepare for tonight)…

 

Treasury yields rose on the day (though 2Y ended unch…)

 

Steepening the yield curve to 4-day steeps…

 

However, 10Y remains below the 3.00% Maginot Line…

 

The Dollar fell back to strong support levels…

 

Offshore Yuan was relatively stable for once with overnight weakness bid back as US markets slumped…

 

Cryptos are down from Friday’s close but had a chaotic day today…

 

Crude managed gains on the day as the dollar weakened but PMs and copper were practically unch…

 

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At the same time as Morgan Stanley’s institutional traders were warning that the current tech sell is “different this time”, warning that “you can’t have a >$100bn loss in a well held name and not have collateral damage” and calculating that “the performance of HF longs based on 13F holdings shows the last few weeks have been a ~2 standard deviation loss event”, Morgan Stanley’s equity strategist had some even harsher words: “the selling has just begun and this correction will be biggest since the one we experienced in February.“

The reason for that is the same one Nomura discussed on Friday: “the most important trade of the past decade is now reversing” namely the reversal of the growth/value which has also commingled with the “momentum trade”, abd which means that the growth/tech “market leadership” that defined the market for the past decade is now gone at least for the time being.

The reason for that is simple: after the stock prices of tech stocks got carried away in the first half, their Q2 earnings, even though for the most part significant beats to expectations, left the market asking for more, leading to such historic blow-ups as Facebook and Twitter, in the process crippling the momentum trade and forcing numerous unwinds.

This, to Morgan Stanley, suggests that the risks to the stock rally are building, and with growth rates peaking and extended positioning, the 3-day slide that started Thursday will only get worse, to wit:

Friday finally showed signs of market exhaustion. With Amazon’s strong quarter out of the way and a very strong 2Q GDP number, investors were finally faced with the question of “what do I look forward to now?”

As a reminder, Morgan Stanley was the one bank which on July 8 “went out on a limb” downgrading tech stocks to Sell and as Wilson comically adds, “truth be told, we haven’t had much interest from clients wanting to follow us down this path.” Nevertheless, he adds somewhat gleefully, “since our upgrade of Utilities on June 18th, defensive sectors have meaningfully outperformed.”

Below is the chart that Wilson would like to call his “victory lap.”

Wilson continues:

While our call did not foretell of any major earnings misses, it did suggest there was a lot more risk in Tech and growth stocks generally than what was perceived. Therefore, even good earnings could lead to disappointing price action while any miss would be severely punished. From our vantage point, the weaker earnings beat from several Tech leaders and outright misses from Netflix and Facebook were simply additional support for our call.

Here Morgan Stanley also invokes the “dumb herd” concept touched on earlier by Citi, with Wilson writing that he admits “the market sent some misleading signals over the last few weeks by limiting the damage to the broad indices when Netflix and Facebook missed.”

We believe this simply led to an even greater false sense of security in the market. The icing on the cake was perhaps the positive statements following the talks between Juncker and Trump which pushed the major indices past key resistance levels late in Wednesday’s session. The price action in that last half hour of trading Wednesday showed some evidence of potential “panic buying” and hedges getting stopped out.

Wilson, moonlighting as a comedian, then adds that Morgan Stanley itself “was having a difficult time ourselves as the S&P passed our upside target of 2830.” However, everything changed just 2 days later, and by Friday, the market finally exhausted. 

With Amazon’s strong quarter out of the way, and a very strong 2Q GDP number on the tape, investors were finally faced with the proverbial question of “what do I have to look forward to now?” The selling started slowly, built steadily, and left the biggest winners of the year down the most.

The bottom line for Wilson and Morgan Stanley is that “the selling has just begun and this correction will be biggest since the one we experienced in February.” But the far worse news is that a liquidation in tech/growth “could very well have a greater negative impact on the average portfolio if it’s centered on Tech, Consumer Discretionary and small caps, as we expect.“

He’s right: as a reminder, the vast majority of the stocks most widely held by the hedge fund community are tech names.

There is a silver lining: while tech’s decade-long leadership may be ending, it may provide some relief for long-suffering value investors, who have been crushed as growth has consistently outperformed value for years on end.

However, a reversal is starting as we wrote in “Entire Equity Universe In Turmoil”: Hedge Funds Crushed As Value/Growth Unwinds” and just on Monday, value stocks already outperformed growth stocks by 1.8%.

It could just be the beginning of a long overdue mean reversion as the market’s biggest hedge fund hotel ever burns down.

If a mean-reversion is indeed on deck, the profits for value investors – at least those who are still alive – could be phenomenal, and would come at the expense of growth investors who could face a quick and brutal catastrophe, now that the world is shifting from a monetary-led stimulus, to a fiscal one, as JPM’s Marko Kolanovic suggested earlier.

There is one additional consideration: as Bloomberg notes, correlations between all investment factors are once again on the rise, citing a Bernstein report, which is increasing systematic risk for active investors, and these “linkages may only continue to tighten as the earnings season concludes, as investors pay more attention to global threats.”

This threatens another group of investors: as Bloomberg explains, not only have same-way factor moves crippled quantitative funds – which rely on the diversification benefit of multiple factors – “but rising correlations also make it difficult for fundamental managers to scrub out unwanted factor risk” according to Fraser Jenkins, who recommends reducing active risk.

“With growth becoming less synchronized, correlation on the rise and value no longer representing cyclicality, this is all evidence that we are heading towards a phase when growth will start to slow,” Fraser Jenkins wrote.

 

Assuming Morgan Stanley is correct, and the market is facing a sharp, painful drop, the biggest lingering question is just how far president Trump, who has made his displeasure with falling stocks clear on numerous occasions, go before launching another attack on the Fed and demanding an end to tightening, if not lower rates and, eventually, QE?

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As we detailed here first, during the months of April and May, as the Yuan-denominated oil futures were launched, trade war threats escalated, and sanctions were unleashed, Russia liquidated almost 90% of its US Treasury holdings.

The question most had was simple – why?

Speculation ran the gamut from this action being a dress-rehearsal – carefully coordinated with Beijing to field test what would happen if/when China also starts to liquidate its own Treasury holdings; to forced sales to cover liquidity needs on sanctioned Russian entities.

But now we have an “insider’s” view on why Putin was puking his T-Bonds.

Andrei Kostin, chairman of Russia’s second-largest bank VTB, told RIA Novosti that there are three reasons behind Russia’s decision to dump its bonds…

“Look, the latest sanctions, which have already been touched upon by our leading enterprises such as Rusal, Renova, undoubtedly shows us that we need to be more cautious. I think that the Central Bank reacts to this too, because the Central Bank the bank is often criticized for keeping money abroad, I think that it’s partly correct, everyone does it, but, of course, it’s necessary to somehow minimize risks, reduce these risks

… because today the US represents the largest threat… from the point of view of imposing sanctions of any kind is greater than all others.”

“I think that this, too, probably the Central Bank and the Ministry of Finance take into account in its policy,”

The head of VTB also recalled that the bank had prepared proposals aimed at de-dollarization and de-orphanization of the Russian economy.

“I recently met with the president, I told him the proposals of our bank to reduce the dollar in the calculations, in general, in the economy of our country.”

This is a measure that, in my opinion, has two sides: on the one hand, it is good for developing its own market: if we will create our derivatives and we will hedge the risks on the whole instrument within the Russian market, it will be very good, as well as calculations.

“On the other hand, life makes us,” Kostin said.

Additionally, Elvira Nabiullina, head of the Bank of Russia, said in June, responding to a question from Duma deputies about the sale of almost half of the US debt by the regulator in April, explained that the Central Bank is pursuing a policy of diversifying international reserves and taking into account all risks, including financial, economic and geopolitical decisions.

So to sum it all up, Russia liquidated its US Treasury holdings:

• The rise of the mulipolar world – to send a geopolitical message to the world over US sanctions bullying;

• Dedollarisation – to enable the redistribution of reserves in favor of gold; and

• Preparation for a global reset – due to “the feeling of impending trouble in the world economy.”

Do those sound like the kind of events that you should be acting on too? Is it any wonder that Putin is public enemy no.1 given the possibility that these risks may translate into actions by the worlds’ investors?

Remember, it was  just last week that Putin officially warned his “American partners” that:

“…the restrictions they impose involving the dollar… are a major strategic mistake because they’re undermining confidence in the dollar as a reserve currency.”

“We will continue to use the US dollar unless the United States prevents us from doing so.”

And given the volume of noise coming from Washington’s establishment, that could be sooner than many – aside from the Russians themselves – may be thinking.

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President Trump said on Monday that he is willing to meet with Iranian President Hassan Rouhani with “no preconditions,” exactly one week after he blasted out a fiery all-caps threat to the regime over Twitter. 

“I would certainly meet with Iran if they wanted to meet. I don’t know if they’re ready yet,” Trump said, responding to a reporter’s question during a White House press conference alongside Italy’s new Prime Minister Guiseppe Conte. 

.@POTUS on Iran: “I’m ready to meet anytime that they want to and I don’t do that from strength or from weakness. I think it’s an appropriate thing to do… No preconditions. If they want to meet, I’ll meet.” pic.twitter.com/KhRc38jrt3

— FOX Business (@FoxBusiness) July 30, 2018

Watch for the MSM to follow the North Korea playbook on this one – blasting Trump for failing to follow “protocol” as he carves a new path through international relations. 

Following a warning from Rouhani earlier in the month that hostile US policies could trigger the “mother of all wars,” after which Trump blasted back via Twitter: 

To Iranian President Rouhani: NEVER, EVER THREATEN THE UNITED STATES AGAIN OR YOU WILL SUFFER CONSEQUENCES THE LIKES OF WHICH FEW THROUGHOUT HISTORY HAVE EVER SUFFERED BEFORE. WE ARE NO LONGER A COUNTRY THAT WILL STAND FOR YOUR DEMENTED WORDS OF VIOLENCE & DEATH. BE CAUTIOUS!

— Donald J. Trump (@realDonaldTrump) July 23, 2018

Trump’s decision to meet with Rouhani would be the first major step towards mending relations after he pulled out of the Obama-era Iran nuclear agreement in which Tehran committed to curtailing its nuclear program in exchange for reduced sanctions. 

Just yesterday we noted that Iran’s currency is in freefall – pegging 102,000 Rials to the US Dollar on the black market, according to currency website Bonbast, and confirmed to AFP by a currency trader. 

Trump suggested a meeting with Rouhani would be the “appropriate thing to do,” and that it would come neither from a position of strength nor weakness, reports Fox News. 

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An American-born Kansas family had their bank account frozen after Bank of America demanded to know their citizenship status, reports the Kansas City Star. 

Josh Collins of Roeland Park, Kansas ignored a letter from the bank asking a variety of personal questions, including whether he was an American citizen or holds dual citizenship with another country. 

Josh was born in Wichita, Kansas, while his wife Jessica Salazar Collins was born and raised in Kansas City, Missouri and is a second generation American citizen whose great-grandfather immigrated from Mexico.

Jessica said she tossed the letter out because she and Josh “thought it was a scam,” since Josh had been banking with BofA for the past 20 years. On July 24, however, Bank of America froze the Collins’ account – preventing them from accessing cash.

When Josh called the bank, they confirmed that his account had been frozen:

“The first question is, ‘Oh, we sent you something in the mail a few weeks ago,’” he recalled to KCTV5. “I said, ‘Yeah, I remember getting something that didn’t look real.’ And they’re like, ‘Oh yeah, we need to know if you’re a citizen.’ You know, I was born and raised in Kansas like Superman. I said, ‘How much more American can you get?’”

The family says they’re lucky they put off a family vacation to Minnesota, as they would have been left high and dry: 

“We would’ve found ourselves up there without money,” said Jessica, who says they’ll be changing banks. “No money for gas. No money to feed our kids. For a hotel. No money!”

BofA said that it’s standard practice to ask about citizenship status when opening a new account or updating customer information.

“Like all financial institutions, we’re required by law to maintain complete and accurate records for all of our customers and may periodically request information, such as country of citizenship and proof of U.S. residency. This type of outreach is nothing new,” Bank of America said in a statement Friday. “This information must be up to date and therefore we periodically reach out to customers, which is what we did in this case.” –Kansas City Star

Except citizenship questions are not federally required according to the California Banker’s Association – the largest state affiliate of the national group. “Not to our knowledge,” said spokeswoman Beth Mills, who added that federal law requires banks must collect and verify just four things about account holders; name, date of birth, address and Social Security number. 

Other federally chartered banks, including Wells Fargo, ask citizenship questions when some new deposit accounts are opened. The U.S. Department of the Treasury increasingly is urging financial institutions to collect as much information on customers as possible, including citizenship status, and to update often in part to ward against the laundering of money that may flow through foreign countries. –Kansas City Star

Bank of America spokeswoman Diane Wagner blamed the Collins family for failing to return the questionnaire. 

“If we don’t hear from a customer in response to our outreach,” she said, “as a last resort, we may restrict the account until we can confirm it is in compliance with regulatory requirements.” Collins wasn’t chosen for any specific reason, according to Wagner. 

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