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Chipotle Mexican Grill shares are down over 3% after hours following reports that it shut a restaurant in Ohio on Monday following reports of customers getting sick after eating there.

Of course, this is not the first time Chipotle has seen its share price impacted when customers are affected by food-related illness and thanks to the website  IWasPoisoned.com, it is easier than ever to track just where Chipotle is poisoning customers.

In this case, Business Insider reports that three reports were made to the website, indicating that at least nine customers fell sick after eating there over the last several days – with symptoms such as vomiting, nausea, severe stomach pain, dehydration, and nausea.

“We take all claims of food safety very seriously and we are currently looking into a few reports of illness at our Powell, Ohio restaurant,” Chipotle spokesowoman Laurie Schalow said.

“We are not aware of any confirmed food borne illness cases, and we are cooperating with the local health department.”

This outbreak comes just days after McDonalds suffered a much larger problem as over 160 customers across 10 states were hit with a parasitic illness.

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Authored by Nicholas Colas via DataTrekResearch,

Can the S&P 500 rally if Technology stocks don’t? Last week’s sloppy action in the group, capped by Friday’s selloff, make that the question of the moment. This isn’t only relevant to US investors, by the way. Chop up various all-world equity indices from MSCI and others and you will find US large cap Tech is the only reason global stocks are positive on the year.

The central problem here is simple math:

• The Tech sector is 26.2% of the S&P 500.

• Five names represent 15.5% of the index: Apple (4.0% weight), Microsoft (3.5%), Google/Alphabet (3.2%), Amazon (3.0%), and Facebook (1.8%).

• The same 5 names are 7.9% of the MSCI World Index, greater than the allocation for all Japanese equities (7.5%).

Any scenario where the S&P 500 continues its 2018 advance in the face of a decline in Tech shares is therefore something like those “Paths to victory” analyses you see during US presidential elections. If a candidate loses big states like California and New York, what other states must they win to prevail? It is difficult, but as we know from 2016 entirely possible.

As a simplifying assumption, let’s say Tech stocks decline 10% between now and year-end – what the financial press calls a “Correction”. This wouldn’t actually be enough to put Tech in the red for the year, but it would mean a mere 1.1% advance in 2018. After nearly a decade of dramatic outperformance, that would be enough for many to write the sector’s obituary.

Here’s how the S&P’s “Path to Victory” works in that scenario:

#1. To compensate for this decline, we would need 1:1 offsetting positive performance (or slightly better) from at least two of the following four sectors:

• Health Care (14.3% weighting in the S&P)

• Financials (14.0%)

• Consumer Discretionary (12.6%)

• Industrials (9.7%)

• In aggregate, these represent 50.6% of the S&P 500.

#2. Importantly, the rest of the S&P’s sectors (Energy, Materials, Real Estate, Telecomm, Staples and Utilities) have only a 23.2% aggregate weighting.Given their differing fundamentals, it seems unlikely they would work uniformly enough to offset a 10% Tech correction. In our election analogy, they are Hawaii and Rhode Island.

#3. Good news: growth investors will most likely flock to Health Care if Technology starts to falter. Some of this may already be underway: the group is +5.8% over the last month, beating Tech’s 4.7% advance. FactSet earnings estimate data also shows Health Care is cheaper than Tech on 12-month forward earnings (15.8x vs. 19.0x) and expected 2019 bottom line growth (9%) isn’t far off Tech’s expected pace (11%).

#4. Bad news: Consumer Discretionary isn’t likely to help. Some 29% of this sector is Amazon (23.9% weight) and Netflix (5.2%). The rest of the group would have to offset declines here, but since media M&A is in high gear (and these companies are +10% of the sector) that is plausible enough.

#5. That makes Financials and Industrials the make-or-break groups in our 10% Tech correction analysis, as long as you buy the notion Health Care will rally due to sector rotation. A few thoughts:

• Financials are working right now (+6.7% over the last month), thanks to a steepening yield curve and decent earnings. They are cheap to 12-month forward earnings (12.7x) and are one of the few sectors still below their 2007 highs. The group also has an outsized weighting in Value indices, likely winners of capital rotation in a Tech meltdown.

• Industrials aren’t especially cheap (16.5x forward earnings), but the group is still +6.5% over the last month and now even up on the year (0.5%). Trade tensions obviously still weigh on the sector, even with recent positive news on that count.

Summing up: there is a “Path to victory” for the S&P 500 if the index loses the Tech sector, and it runs straight through Financials and Industrials. The former needs the yield curve to steepen (something we think likely). The latter could really use some good news on the trade front (possible, if only because the president likely wants some wins to campaign with ahead of midterm elections).

A few caveats to round out the discussion:

• Our mental model here assumes a slow grind lower for Tech, not a violent decline. Given the sector’s heavy weighting, that would likely spur rapid money flows out of US stocks generally. There would be little chance, in other words, for offsetting capital rotations such as we outlined in this note.

• Our base case also assumes continued strength in the US economy as well as low sector correlations (something we’ve seen for much of the year, and highlighted in these notes).

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We now may have an idea what was the reason for today’s selloff in Treasurys which pushed the 10Y yield just shy of 3.00%.

According to the NYT, the Trump administration is granting a $100 billion unilateral tax cut mainly helping the wealthy and hopes to bypass Congress in implementing it, “a legally tenuous maneuver that would cut capital gains taxation and fulfill a long-held ambition of many investors and conservatives.”

However, despite the NYT’s alarmist take, Trump’s proposal actually does make some sense: what it calls for is to inflation-adjusted one’s long-term cost basis when calculating capital gains tax. Considering that various welfare programs like Social Security are already indexed for Cost of Living Adjustments, the idea is probably not that outlandish, especially if inflation were to suddenly explode higher.

Here’s how it would work.

Currently, capital gains taxes are determined by subtracting the original price of an asset from the price at which it was sold and taxing the difference, usually at 20 percent. If a high earner spent $100,000 on stock in 1980, then sold it for $1 million today, she would owe taxes on $900,000. But if her original purchase price was adjusted for inflation, it would be about $300,000, reducing her taxable “gain” to $700,000. That would save the investor $40,000.

Treasury Secretary Steven Mnuchin hinted at the idea during last weekend’s G-20 meeting in Buenos Aires, when he told reporters that his department was studying whether it could use its regulatory powers to allow Americans to account for inflation in determining capital gains tax liabilities. The Treasury Department could change the definition of “cost” for calculating capital gains, allowing taxpayers to adjust the initial value of an asset, such as a home or a share of stock, for inflation when it sells.

“If it can’t get done through a legislation process, we will look at what tools at Treasury we have to do it on our own and we’ll consider that,” Mnuchin said, emphasizing that he had not concluded whether the Treasury Department had the authority to act alone. “We are studying that internally, and we are also studying the economic costs and the impact on growth.”

To be sure, any such move would face near-certain court challenges, not to mention cause further turmoil inside the bond market, which is already rather displeased with Trump’s recent busting of the US deficit. It would certainly reinforce a liberal critique of Republican tax policy at a time when Republicans are struggling to sell middle-class voters on the benefits of the tax cuts that President Trump signed into law late last year.

Chuck Schumer was, as usual, ready to hand out criticism:

“At a time when the deficit is out of control, wages are flat and the wealthiest are doing better than ever, to give the top 1 percent another advantage is an outrage and shows the Republicans’ true colors,” said Senator Chuck Schumer of New York, the Democratic leader. “Furthermore, Mr. Mnuchin thinks he can do it on his own, but everyone knows this must be done by legislation.”

Still, no matter whether an inflation adjustment is justified or not, it is indeed the case that high earners would be the biggest beneficiaries of a reduction in capital gains taxes, which however were untouched in the $1.5 trillion tax law that Trump signed last year.

According an independent analyses cited by the NYT, more than 97% of the benefits of indexing capital gains for inflation would go to the top 10 percent of income earners in America, while nearly two-thirds of the benefits would go to the super wealthy — the top 0.1 percent of American income earners.

In other words, the rich are about to get even richer.

Liberal tax economists see little benefit in it beyond another boon to the already rich.

“It would just be a very generous addition to the tax cuts they’ve already handed to the very wealthy,” said Alexandra Thornton, senior director of tax policy at the liberal Center for American Progress, “and it would play into the hands of their tax advisers, who would be well positioned to take advantage of the loopholes that were opened by it.”

And while the proposal is sure to have a contested fate in Congress – and the courts – two questions remains: how would Trump pass such a law, and who would pay for it.

Making the change by fiat would be a bold use of executive power — one that President George Bush’s administration considered and rejected in 1992, after concluding that the Treasury Department did not have the power to make the change on its own. Larry Kudlow, the chairman of the National Economic Council, has long advocated it.

Conservative advocates for the plan say that even if it is challenged in court, it could still goose the economy by unleashing a wave of asset sales. “No matter what the courts do, you’ll get the main economic benefit the day, the month after Treasury does this,” said Ryan Ellis, a tax lobbyist in Washington and former tax policy director at Americans for Tax Reform. So… would this wave of asset sales also lead to the market crash that Trump so desperately dreads?

The decades-long push to change the taxation of investment income has spurred a legal debate over the original meaning of the word “cost” in the Revenue Act of 1918, and over the authority of the Treasury Department to interpret the word in regulations.

“I think we ought to look at not penalizing Americans for inflation,” said Representative Kevin Brady of Texas, the Republican chairman of the Ways and Means Committee, who said he would like to see the Treasury Department make the change through regulation.

* * *

As for who pays, the answer is simple: yield starved investors across the globe who remain inert to any suggestion that  the ballooning US debt load could lead to a crisis.

According to the Wharton budget model, indexing capital gains to inflation would reduce government revenues by $102 billion over a decade, with 86 percent of the benefits going to the top 1 percent. A July report from the Congressional Research Service said that the additional debt incurred by indexing capital gains to inflation would most likely offset any stimulus that the smaller tax burden provided to the economy.

Trump’s proposal is surprising as taxation of capital gains was not featured in the framework for the second round of tax cuts, released by the Ways and Means Committee last week. It is highly unlikely that Congress will pass another tax bill this year because of the slim Republican majority in the Senate.

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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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