Portfolio Warping

361 Capital Market Commentary | November 11th, 2019

So the Fed cuts rates three times and pauses. Then, the Fed’s Charles Evans suggests that they might let inflation run toward 2.5%. Throw in a few economic green shoots, and some hopes of a China trade deal, and now global bond prices are under pressure, yield curves are un-inverting and cyclical stocks have lifted their heads off the mat and are now getting up on one knee. The global stock market’s long-time love with U.S. large cap momentum stocks is now switching toward U.S. and international cyclical value stocks. Not a good time right now to be long a defensive portfolio of dividend paying utility, consumer staple and REIT stocks. But holy cow, this investment warp is great for your down-and-out cyclical stocks.

Hope and fear of missing out has grabbed hold of the markets as we head into the last eight weeks of 2019. We have no good update on a China trade deal. We also need a NAFTA trade replacement deal soon. And don’t forget that the U.S. Government will shut down next week unless there is an agreed upon budget deal. Looks like the global auto tariffs just got kicked down the road six months which is better than nothing. On the political front, Senator Warren’s healthcare plan continues to worry voters and even caused Mayor Mike Bloomberg to grab the POTUS paperwork. Also, there are the public impeachment proceedings which begin this week, but will likely get little attention.

For the markets, it really looks like they are going to try and tack on some performance before the year is done. Money is moving into risk assets and portfolio managers are picking up their trading activity. Big players are seeing this outperformance in value and cyclicals and wanting to take part. This is good. I think that the investing world is tired of the same five to ten U.S. megacap stocks dominating the positive performance screens. Time for a change.

Cyclical stock outperformance has now made a ‘higher high’ versus defensive stocks which is a good sign…

Cyclicals vs Defensives

Since bonds peaked at the beginning of October, cyclicals have taken off…

While defensives (Utilities, REITs and Consumer Staples) have suffered.


J.P. Morgan’s top quant called the bottom in cyclicals this summer and is ramping his excitement…

Investors should keep buying cheaper or cyclical stocks because the latest rally is just the start of an unwind of a massive fear trade that’s gripped assets from fixed income to commodities, according to JPMorgan Chase & Co.’s strategist Marko Kolanovic.

Value shares, or those traded at a lower price relative to profits or book value, will continue to outperform through the first quarter of next year, Kolanovic predicted, noting that the rally in recent months has been mostly driven by short sellers buying back shares to cover bearish bets. With economic data improving and the initial phase of a U.S.-China trade deal in sight, money managers will be forced to abandon their defensive posture and embrace cyclical shares that will benefit from a growth recovery, he said.

“This first leg of the rotation was limited to short covering by levered speculators, with little long only assets flowing into cyclicals and value,” the strategist wrote in a note to clients. “The larger rotation by real money managers will likely happen only after the phase one trade deal is signed, and rotation should continue during the seasonal Q1 value and small cap inflows.”


Value stocks start outperforming

Even Cliff Asness wants to sin a little and overweight value stocks…

After cautioning about value stocks for years, Cliff Asness, founder of quantitative fund manager AQR Capital Management, wrote in a blog post on Thursday that it is time to buy value again. “For a long while, even as value suffered, we cautioned against upping the value weight,” wrote Asness, saying it had been hard to time when market trends might shift in favor of value, and that the group wasn’t inexpensive enough to make such a bet.

But things have changed, he said. The first eight-plus years of value’s recent losing streak were “rational.” wrote Asness, as the more-expensive companies’ much stronger fundamentals justified their higher prices. During the past two years, however, value stocks have been losing for what he called irrational reasons.

“Value fundamentals have not come in worse over this recent painful period, it’s prices alone that have gone the wrong way,” he explained. “When losses are due to price moves, not fundamentals, and occur over shorter periods, that is when things actually cheapen.”

After measuring in multiple ways, Asness concluded that value is currently quite cheap compared with history. And those investments are not crowded, or in demand among many investors, at all, he argued.


Could this shift to value be a new set of rules?

Quote from Bob Farrell, Merrill Lynch

Highly likely that many investors are behind in this move…

The shift in sentiment means previously unloved areas of the market, including small caps and cyclical companies, are back in vogue. European stocks, energy companies — all are rallying. In a reversal from the first nine months, financials and industrials have been among the top-performing sectors during the latest leg, with banks up almost 10% so far this quarter. Value stocks are also back from the dead.

Defensive plays, on the other hand, are getting smoked. A long-duration fixed income ETF that saw money come in throughout the year is losing ground, as are low-volatility funds. A strategy that bets this year’s winners will keep on winning is also being drained of assets.

“This rally caught everyone by surprise,” John Mathews, who oversees UBS Group AG’s private wealth and ultra-high net-worth business in the Americas, said in a Bloomberg TV interview. “Our clients have been defensive, they got back into the markets, but many of our wealthy clients today, they’re waiting for some sort of a pullback or opportunity to deploy cash at a better time.”


And if you are open to international stocks, Barclays has an even cheaper basket for you in Europe…

Europe P/B Relative to US

Speaking of Europe, one green shoot from a very difficult area of the world economy…

Tweet from @Schuldensuehner

This move to value and cyclicals is caused by Bond yields which are at a tipping point…

@hmeisler: Big level for the Bondaleros. Yield on 10 yr

Chart CBOE 10-Year US Treasury Yield Index

In addition to yields moving higher, the curve has also steepened at an alarming rate…

Tweet from @bespokeinvest

Only a few months ago we worried about the inverted yield curve…

US 10 Year-2 Year Government Bond Spread

But you know which sector loves rising rates and a steeper yield curve…

@hmeisler: Bank Index relative to SPX

Chart $BKX:$SPX

Gold has also seen a move…

This Morgan Stanley chart could help to explain why. In addition to a great investor risk appetite, there are also many more bonds around the world with a positive yield. So why own no yielding gold?

Gold price vs negative yielding debt

Money is now flowing into equities…

Investors flock to global stocks

This Goldman Sachs chart reminds us that equity flows have been unheard of all year…

Global Fund Flows

U.S. equities are looking past the current dip in earnings and toward a future rebound…

EPS Growth
(Goldman Sachs)

Chesapeake Energy trading less than $1 could mean trouble for the pipelines that carry its energy…

SPDR S&P 500 ETF vs Alerian MLP ETF

If you owned the largest energy company in the world, wouldn’t you also be selling right now…

Sanford Bernstein chart showing future estimated Aramco production…

Estimated Aramco production

Back in the day, investing in spinoffs was like shooting fish in a barrel…

But not anymore. Recent returns would suggest keeping or selling the unstrategic assets instead.

Decline in Spinoff Performance

What a time to be a supplier of anything to Hollywood…

Amazon wanted to make a TV series out of it, as did HBO. Michael Ellenberg’s Media Res bid; so did Fox’s FX Networks, via a partnership with Nina Jacobson’s Color Force, the studio behind Crazy Rich Asians. WarnerMedia separately pitched a feature film with producer David Heyman, who made the Harry Potter films.

FX won the auction, which closed last week, paying about $2m to option Kapoor’s books for a television series, according to people familiar with the deal. In comparison Hidden Figures, the book about three African American women who worked at NASA and which was the basis for the hit film of the same name, sold for less than $100,000 in 2014. The high pricetag for Age of Vice comes as media groups scour for ideas that can be packaged into streamable content: last week, Disney chief Bob Iger announced that FX will make shows for Hulu, the streaming service in which Disney owns a controlling stake.

Hollywood is in the midst of a costly land-grab. America’s traditional media empires are spending tens of billions of dollars as they fight back against technology groups that have ravaged their business. As the distribution model for entertainment is remade, a revolutionary ardour has seized the industry: the choice is to win the streaming battle against the likes of Netflix, or face commercial oblivion.

The immediate result has been clear: more television than ever before. There were 496 scripted TV shows made in the US last year, more than double the 216 series released in 2010. In the past eight years the number of shows grew by 129 per cent, while the US population rose only 6 per cent. The trend is set to deepen, as groups like AT&T’s WarnerMedia commission dozens of new series to convince people to sign up for their streaming services.

“This isn’t a gold rush, it’s an arms race. We don’t know if there is any pot of gold,” warns an executive at a big media group. “Once the music stops, there will be carnage. It might take three to five years, but there has to come a point when we come to our senses.”


It looks like Disney will do well in the streaming wars…

But the real battle will be over the 5 hours a week for my eyeballs. (Let’s see, 1 hour to The Mandalorian, 1 hour to The Crown, 1 hour to Watchmen, and 2 hours to Oregon Duck football?)

Streaming Views

If you have clients in Michigan…

Have them consider hiring a CPA to help them with their bookkeeping, or selling all of their real estate assets in the state.

An 83-year-old retired engineer in Michigan underpaid his property taxes by $8.41. In response, Oakland County seized his property, auctioned it off to settle the debt, and pocketed nearly $24,500 in excess revenue from the sale.

Under Michigan law, it was all legal. And hardly uncommon.

Uri Rafaeli, who lost his property and all the equity associated with it, is just one of thousands of people to be victimized by Michigan’s uniquely aggressive property tax statute. The law, passed in 1999 in an attempt to accelerate the rehabilitation of abandoned properties, empowers county treasurers to act as debt collectors. In the process, it creates a perverse incentive by allowing treasurers’ offices to retain excess revenue raised by seizing and selling properties with delinquent taxes—even when the amount owed is miniscule, and even when the homes aren’t abandoned or blighted at all.

Organizations representing property owners like Rafaeli say the practice is unconstitutional, inequitable, and unreasonably harsh. They call it “home equity theft”—a process that’s a close relative to the civil asset forfeiture laws that have been used by police departments to similarly deprive innocent Americans of their property without due process. They are now asking the state Supreme Court to restrict the practice.


Speaking of real estate, there are increasing worries about big city property values under a blue White House…

Tweet from @DonutShorts

Finally, if you haven’t seen this video of a man playing fetch with a beluga whale, it is pretty incredible…

Video of fetch with beluga whale

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