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In his latest quarterly letter to clients, Greenlight Capital’s David Einhorn reported that the funds declined 1.6 percent in Q4, bringing the total 2017 return to 1.6%, far below the S&P’s 21.8% and does something few hedge fund managers do: apologize to his clients, saying “this must be frustrating to you, our Partners. It is certainly frustrating to us.”

As he often, Einhorn begins his letter with a sports reference, only instead of his preferred pastime, poker, this time he uses fantasy baseball:

David began playing fantasy baseball in 1985. In fantasy baseball you draft a “team” of individual players from different real-life major league teams at the beginning of the season and compete against teams picked by your friends. The player whose team does the best across a variety of statistical areas wins. In the pre-internet and even pre-ESPN Baseball Tonight days, you tracked players using newspaper box scores. Unless you saw the game, there was no other easy way to find out how your players did. To get a clue, you might get the scores from the local TV news. If you owned the best hitter on the Blue Jays and you saw the Blue Jays scored 10 runs, there was a good chance that the next day’s box scores would bring good news for your team. A teenager could fall asleep to that kind of happy thought.

However, once in a while the morning box score would reveal that despite the Blue Jays scoring 10 runs, your slugger had an uneventful and useless 1 for 5 game. It’s disappointing and feels worse than if your player had the same result in a game where the Blue Jays were shut out (unless you are also a Blue Jays fan). And, it doesn’t matter if  your player was swinging well and hitting the ball hard every time or whether his evening was marred by ugly strikeouts, pop-ups and double plays. 1 for 5 is 1 for 5. Fantasy baseball only counts the statistical results.

Why the analogy? Well, because as Einhorn admits, “Our quarter and year felt just like that” and explains:  “We had a non-descript result in a period where it seems like most around us did much better. This must be frustrating to you, our Partners. It is certainly frustrating to us.”

And, yet, as we were in the batter’s box so to speak, it felt like we were swinging well and hitting the ball hard. We just didn’t deliver a satisfactory result on the scoreboard. There were plenty of nights we happily went to sleep with company results that matched our non-consensus expectations, but it didn’t translate into a win the following day.”

What kept a lid on gains? Well, when you are short some of the biggest “bubble stocks” – which crushed it in 2017 – there will be several. He explains:

The biggest losers for the year were our short positions on the “bubble basket” and Caterpillar (CAT). It’s tough to look at full year losses on Amazon (+56%), athenahealth (+26%), Netflix (+55%) and Tesla (+46%) when we believe all those stocks appeared priced with little margin for error entering the year, and none executed well or met fundamental expectations in 2017. CAT did reduce its cost structure and benefitted from a modest improvement in demand, which led to a series of quarters that exceeded expectations. However, CAT’s current stock price projects a rebound in sales and earnings that is unlikely to occur given the end-market conditions in mining and energy.

So now what? Well, it’s time to look forward according to Einhorn, who says that “it’s a long season and we are ready for the next game. Let’s see what happens.”

But before that, one more mea culpa from the hedge fund manager who recently warned  that  “None Of The Problems From The Crisis Have Been Solved.” Of note: the ongoing hurdles that value investors everywhere have to face:

Despite it being a good year in the market, it was a challenging environment for our investment style. We do not mimic any index and we can think “outside the box.” We have a value orientation and we take comfort from the margin of safety afforded by the low valuations of our long investments. Though most people understood our last quarterly letter as tongue-in-cheek and while we certainly don’t believe value investing is dead, it is clearly out of favor at the moment. Last year the Russell 1000 Pure Growth Index outperformed the Russell 1000 Pure Value Index 38% to 4%.

That said, Einhorn hopes to stick it out, and “while it feels like we have been running face first into the wind, we don’t intend to capitulate and are sticking to our strategy of being long misunderstood value and shorting ‘not value.‘”

Some other highlights from the latest Greenlight letter:

• Took small position in Twitter in the fourth quarter on the potential for future revenue growth; Shares of Twitter briefly erased losses on the news
• Took small position in Ensco as shale oil supply growth will unlikely be able to meet global demand, leaving offshore drilling to fill the gap
• Initiated large long position in Brighthouse Financial with shares trading at 40%-50% discount to similar companies with normal capital return policies
• Repurchased stake in Time Warner when the stock fell in response to the U.S. government opposing sale to AT&T; “we think that the Department of Justice has a weak anti-trust case and the merger is likely to go through”
• Exited positions in Hewlett Packard Enterprise, Rite Aid, VanEck Vectors Gold Miners ETF, ISS A/S and “closed an unsuccessful short in Deere”
• Biggest losers on the year were short positions on “bubble basket” and Caterpillar; says General Motors remains significantly undervalued
• At year-end, the largest disclosed long positions in the Partnerships were AerCap, Bayer, Brighthouse Financial, General Motors and gold. The hedge fund had an average exposure of 107% long and 66% short.

Full letter below:

 

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As military suspicions between the US and Russia escalate to levels last seen during the Cold War, both countries are trying to bolster their defenses and their military readiness to hedge against a plethora of geopolitical risks, from nuclear war on the Korean peninsula to a direct military confrontation between China and the US, or possibly Russia and the US.

In September, Russian President Vladimir Putin was accused of provoking NATO by marshaling 10,000 Russian and Belarusian troops along Russia’s western border with the Baltic states for their “Zapad” military exercises – something that prompted an outcry from NATO.

Putin has vigorously defended  Russia’s right to carry out military exercises and ballistic missile tests, arguing that both the US and NATO have been “accelerating build-up of infrastructure in Europe” in violation of the 1987 treaty on the elimination of intermediate-range and shorter-range missiles. In a similar vein, the US has accused Russia of violating the same treaty with missile tests of its own.

Meanwhile, as the US and its allies have accused Russia of meddling in Western elections, the number of NATO troops deployed near the Russian border has tripled in recent years as tensions have percolated.

With tensions at a fever pitch, the Wall Street Journal reported Tuesday that the Pentagon is developing two new nuclear missiles that would be capable of deployment from a nuclear submarine.

 

It’s also seeking to reauthorize a nuclear-tipped sea-launched cruise missile, a system that was retired from the American arsenal in 2010.

The development of the two weapons is among a broad range of recommendations in the Pentagon’s Nuclear Posture Review. Secretary of State Rex Tillerson allegedly made his “moron” comment about the president during a meeting at the Pentagon that was intended to review the US’s nuclear policy.

All of this is part of a major reassessment of US nuclear strategy and programs that was commissioned about a year ago by President Donald Trump. According to WSJ, the Pentagon is expected to formally unveil its comprehensive new plan later this month. But in the meantime, it has leaked some tantalizing details to the WSJ’s Pentagon reporter, even though the final draft of the policy hasn’t been approved by the president.

The Pentagon has dismissed an unclassified draft of the strategy that was published last week by HuffPost – which claimed that Trump wants to build a lot more nukes – as “predecisional.” Meanwhile more updated drafts are also circulating. But the plans to field the new nuclear systems have strong support in the Pentagon and are expected to go forward, according to people familiar with the review.

The plan as it stands represents a shift away from de-nuclearization and returning instead to a Soviet-era arms race mentality.

However, critics say that the development of low-power nukes is almost as dangerous as hydrogen bombs because they lower the threshold to possible use.

A major question at the heart of the Pentagon review is how to respond to military strategy and programs in Russia and China, which American officials say provide a more prominent role for nuclear weapons. In effect, the Pentagon argues that since adversaries have failed to follow the US in de-emphasizing the role of nuclear weapons, Washington needs a greater range of nuclear options to counter its potential foes, especially for carrying out limited strikes.

Russia’s decision to develop and deploy that system is described by the review as part of a Russian doctrine that calls for threatening the limited use of nuclear weapons, or perhaps even carrying out a limited nuclear strike, to end a conventional war on terms favorable to the Kremlin.

By developing a new American “low yield” system, the Pentagon review argues the US will have more credible options to respond to Russian threats without using more powerful strategic nuclear weapons, which the Kremlin may calculate Washington would be reluctant to use for fear of unleashing an all-out nuclear war. Because the new weapons it is proposing would be based at sea, the US wouldn’t need the permission of other nations to deploy them and their deployment wouldn’t violate existing arms-control agreements.

The draft doesn’t precisely define what “low yield” nuclear weapons might be, but the new Trident system might have a warhead of one or two kilotons, compared with the current system which has an explosive yield that ranges from 100 kilotons to 455 kilotons, depending on the warhead it carries. By comparison, the U.S. nuclear bomb dropped on Hiroshima, Japan, at the end of World War II was about 15 kilotons.

Critics of the Pentagon’s strategy claim that the adoption of “low-power” nuclear weapons could lower the threshold for launching a nuclear strike.

“We should be doing everything to reduce the risk that nuclear weapons are going to be used, not expanding the ambiguity of when we might use nuclear weapons,” said Jon Wolfsthal, who served as a senior official for arms control on President Barack Obama’s National Security Council.

Regardless, the review has drawn support from conservative lawmakers and pundits. “This is not about making weapons more usable; this is about strengthening deterrence so that nuclear weapons are not used in the first place,” said Robert Joseph, a senior national security official in the George W. Bush administration. “We have to think what would be credible in Russian eyes.”

According to the WSJ, the review makes clear that the US could suspend its plans to revamp its nuclear arsenal if Russia fixes alleged violation of the 1987 treaty banning U.S. and Russian land-based intermediate-range missiles and also reduce its formidable arsenal of tactical nuclear weapons.

Russia and China aren’t the only threats cited in the nuclear review. It also asserts that upgrading the US nuclear arsenal will add to the country’s ability to deter North Korean aggression.

 

“North Korea relies on hardened and deeply buried facilities to secure the Kim regime and its key military and command and control capabilities,” the review says. “Consequently, the United States will continue to field a range of conventional and nuclear capabilities able to hold such targets at risk.”

Despite the debate over the proposed “low yield” Trident missile and sea-launched cruise missile, many of the other weapons recommended by the review also were advocated by the Obama administration, including the development of a new strategic bomber and an air-launched cruise missile.

But even if the plan is approved by Trump, carrying out the modernization will require 6.4% of the Defense Department budget, up from 2% to 3% today. If the Pentagon doesn’t secure the spending increases it anticipates – something that Republicans are fighting to include in a long-term spending bill – this could heighten the competition for funds.

But as Russia continues to test powerful ICBMs that it claims can overcome NATO’s missile-defense systems – and North Korea and Iran continuing ballistic missile tests of their own – the urgency to pass a plan to upgrade US weapons systems hasn’t been this intense in years.

 

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The bad news for Steve Bannon just keeps on coming.

Not long after Bannon was bounced from Breitbart following his feud with Trump over his comments in Michael Wolff’s book, moments ago the NYT reports that Trump’s former chief strategist was subpoenaed last week by the special counsel, Robert Mueller to testify before a grand jury as part of the investigation into possible links between Trump’s associates and Russia.

And the reason why stocks dipped modestly and the VIX bounced on the news, is that the subpoena marks the first time Mueller is known to have used a grand jury subpoena to seek information from a member of Mr. Trump’s inner circle.

After excerpts from the book, “Fire and Fury: Inside the Trump White House,” were published this month, Mr. Trump derided Mr. Bannon publicly and threatened to sue him for defamation. Mr. Bannon was soon ousted as the executive chairman of the hard-right website Breitbart News.

Mueller reportedly issued the subpoena after Mr. Bannon was quoted in a new book criticizing Mr. Trump, saying that Donald Trump Jr.’s 2016 meeting with Russians was “treasonous” and predicting that the special counsel investigation would ultimately center on money laundering.

According to the NYT, the subpoena could be a negotiating tactic:

Mr. Mueller is likely to allow Mr. Bannon to forgo the grand jury appearance if he agrees to instead be questioned by investigators in the less formal setting of the special counsel’s offices in Washington, according to the person, who would not be named discussing the case. But it was not clear why Mr. Mueller treated Mr. Bannon differently than the dozen administration officials who were interviewed in the final months of last year and were never served with a subpoena.

Meanwhile, on Tuesday Bannon was testifying behind closed doors before the House Intelligence Committee, which is also investigating Russia’s meddling in the 2016 election and ties between the Trump campaign and Russia.

The NYT quotes legal experts who said the subpoena could be a sign that the investigation was intensifying, while others said it may simply have been a negotiating tactic to persuade Mr. Bannon to cooperate with the investigation. The experts also said it could be a signal to Mr. Bannon, who has tried to publicly patch up his falling-out with the president, that despite Mr. Trump’s legal threats, Mr. Bannon must be completely forthcoming with investigators.

Prosecutors generally prefer to interview witnesses before a grand jury when they believe they have information that the witnesses do not know or when they think they might catch the witnesses in a lie. It is much easier for a witness to stop the questioning or sidestep questions in an interview than during grand jury testimony, which is transcribed, and witnesses are required to answer every question.

The news will hardly come as a surprise to Trump: “the president appeared to ease his anger toward Mr. Bannon at the end of last week. When asked in an interview with The Wall Street Journal whether his break with Mr. Bannon was “permanent,” the president replied, “I don’t know what the word ‘permanent’ means.””

As a result, “people close to Mr. Bannon took the president’s comments as a signal that Mr. Trump was aware that his fired strategist would soon be contacted by investigators.”

Whether or not Bannon actually knows something that can help the Mueller probe, of course, remains to be seen.

Despite a modest blip lower in risk, stocks have promptly BTFD on the news and for now appear unbothered by this latest development involving the Trump probe.

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President Trump and China’s President Xi Jinping, held a call yesterday, according to the White House.

While President Trump “expressed hope” that the resumed inter-Korean dialogue may prompt a change in North Korea’s destructive behavior, perhaps more notable was the fact that President Trump used the call “express disappointment that the United States’ trade deficit with China has continued to grow” and made clear that “the situation is not sustainable.”

Indeed – China’s Trade Surplus with the US grew notably in Trump’s first year…

The full readout is below:

President Donald J. Trump spoke yesterday with President Xi Jinping of the People’s Republic of China to discuss recent developments on the Korean Peninsula.

President Trump and President Xi acknowledged the resumption of inter-Korean dialogue and expressed hope that it might prompt a change in North Korea’s destructive behavior.

President Trump committed to sustain the United States-led global campaign of maximum pressure to compel North Korea to commit to denuclearization.

The two leaders also discussed trade issues, and President Trump expressed disappointment that the United States’ trade deficit with China has continued to grow. President Trump made clear that the situation is not sustainable.

It is unclear just what Trump will do about it but as we noted previously, it seems China is deeply worried about US trade sanctions, and more broadly the US taking  more assertive in rectifying perceived issues in the bilateral trade relations. Every Administration goes through an episode of promising to deal with Chinese trade interventions and ends up with a watered down, vague agreement. China’s pre-emptive action (with its Treasury purchase headlines) suggests that this time the level of worry is different.

Of course this week also reportedly sees the launch of the Petro-Yuan futures contract.

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Pitching hedges when the market is in the middle of a blow off top is a tough sell. But, according to Chris Metli, executive director in Morgan Stanley’s Inst. Equity Division, that’s exactly what traders should be doing, for three reasons: 1) positioning, 2) pricing, and 3) potential catalysts, which “all suggest now is an attractive time to buy Feb puts as a hedge – and it is a rare event when all align.”

Here is how one of the top Morgan Stanley cross-asset quants justifies his reasoning:

First this is not a call for the final top – positive sentiment and positioning can have momentum of their own and absent some kind of shock likely take the market higher.  But the rally is getting more fragile – as MS Equity Strategist Mike Wilson notes in Weekly Warm-up: Euphoria! (Jan 16, 2018) “The bottom line is that we have entered the late cycle euphoria stage we predicted a year ago.” and “it is more likely the S&P 500 will reach our bull case of 3,000 before it’s over. We just want to make sure investors appreciate this is higher, not lower risk than the rally we experienced last year.”

1.  The rally is getting riskier because of positioning – investors have aggressively chased beta with both futures and options.  Over the last two weeks investors have bought the 2nd largest amount of S&P 500 futures (as measured by MS Trade Pressure) since at least 2010, while at the same time net holdings of S&P 500 calls are the highest and the net holdings of S&P 500 puts are the lowest since at least 2010.

 

2. That demand for upside and lack of interest in protection has driven short dated skew down to near post crisis lows, making puts cheaper.  This flattening of skew is a sharp turnaround from the historical highs seen just last October and bucks the structural steepening of the last several years (chart above).

On one hand the flattening simply reflects a lack of demand for puts.  But it also reflects the fact that volatility is now positively correlated to spot – i.e. volatility has been rising in an up market – and a belief by market participants that vol is unlikely to rise significantly if spot falls. 

While this may hold for small declines in spot, QDS thinks that anything more than a 2% drawdown could drive a meaningful increase in vol, making puts even more valuable.  A 2% decline would certainly surprise the market, and would also be compounded by dealer demand for options – while the overall investor community doesn’t own a lot of protection, there has been some lumpy buying of puts that means in a move lower dealers will get shorter vol and need to cover (i.e. buy options).

3)    Finally there is actually a potential catalyst with a potential government shutdown this Friday January 19th, as well as the State of the Union on the 30th.  Shutdowns rarely have any lasting impact, but historically have resulted in short-term equity drawdowns, and it appears that the probability of an adverse outcome this time around is rising.

To position for a quick pullback QDS suggests simply buying Feb 2% OTM SPY puts for ~41bps (272 strike vs 277.92 ref as of Friday’s close, but should roll up to higher strike on today’s rally) to capture both potential catalysts and leave a little time value to benefit from a potential increase in volatility on a selloff.  The market implied probability of a 2% decline over the next month is only ~12%, in the 3rd percentile since 2001, and puts have rarely been cheaper.  The MS Index Trading desk has also commented on the attractiveness of SPX hedges.

 

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The Dow has tumbled back below 26,000…

 

And all major US equity markets are stumbling notably after their exuberant open…

As VIX extends its pre-market ramp above 11 to its highest in 5 weeks…

Notably, Morgan Stanley points out that over the last two weeks investors have bought the 2nd largest amount of S&P 500 futures (as measured by MS Trade Pressure) since at least 2010, while at the same time net holdings of S&P 500 calls are the highest and the net holdings of S&P 500 puts are the lowest since at least 2010.

Probably nothing.

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