The Trail Turns Darker…

361 Capital Market Commentary | January 27th, 2020

Just when the weather for investing looked perfect, someone decided it would be a good idea to order from the ‘Very Exotic Meat’ section of Grubhub’s Wuhan menu. Even though many had warned the city that something like this could occur, the wild meats markets were allowed to continue to operate. Now the whole world gets to participate in the very bad last supper of some adventurous diner. Past pandemics have created opportunities for investors and this one will likely follow the same pattern. Although this Coronavirus has a twist in that many who were contagious had no symptoms, and because of the Chinese New Year, five million of Wuhan’s visitors left the city this month. So expect the number of patients to continue to climb. And if traveling to Asia, please take all precautions.

This sudden risk-off shift in the markets is coming at a time when CTAs and risk parity funds are positioned maximum long, U.S. hedge funds are leveraged up to the highest levels in a decade, and U.S. mutual fund managers have record-low cash levels. So, if equity prices continue to fall while volatility rises, expect many of these participants to raise cash to try and keep their returns in the green. Also watch oil prices, which as they fall toward 2019 lows, will weigh on energy corporate credit prices. And falling even faster are energy stock prices which are all wearing cement shoes right now.

As the Coronavirus spreads, Iowa is only a week away from picking their Democratic and Republican nominees for the race to be POTUS 2020. The only safe bet for the winner of the Democratic caucus is to pick a candidate whose name starts with a ‘B’. It will be a curious event for the markets if Bernie grabs the 1st place ribbon. Also on deck is a FOMC meeting this week, but expect the Fed to remain on hold and get an earful from the President. Just not much reason to do anything on rates right now as we watch the inflation datapoints in this very tight job market. Also, big corporate earnings reports continue but the markets have been very distracted by the virus. Hopefully, some great earnings will emerge to distract us from the fastest growing economy in the world shutting down.

Maybe Ken Jennings?

Tweet from @tracyalloway

Wuhan’s virus has pushed the markets into a risk-off position…

These charts are updated for Monday’s closing prices. Stocks and oil for sale. Bonds and gold seeing buyers.

Stock Charts

A look back at past flu bugs…

@RenMacLLC: 50-years ago the techno-thriller “The Andromeda Strain” hit the NYT Best Sellers list. Today Corona is cooling sentiment, but what’s the history of pandemics on SPX?

Past Flu Bugs

China transportation is shut down for their biggest week of the year…

Tweet from @onlyyoontv

Imagine closing down all Chicago rail lines to our most efficient U.S. bullet train traffic…

@HayekAndKeynes: Wuhan is connected to every major Chinese city by high speed rail.

Wuhan High Speed Rail Map

When China pauses, everything pauses…

Tweet from @jsblokland

And the biggest commodity in the world is broken and declining another 3% today…

WTIC Light Crude Oil

This loss of Macau will hit definitely hurt WYNN, LVS and MGM…

Tweet @C_Barraud

Stock investors’ greed quickly turns toward fear…

But just don’t blame the Wuhan wild meat market. There was also a Bernie surge, the Baghdad embassy attack, new steel and aluminum tariffs, Bolton’s soon-to-be book and the highly levered, collapsing energy industry to factor in.

Extreme Greed/Extreme Fear Chart

And just like that, someone’s Bat Snake Civet soup appetizer caused a 65-year record to be broken…

One of the Longest Streaks Ever Without Back-To-Back Losses

As the ETF industry ‘parties on’ in Florida this week, here are some thoughts on passive versus active investing…

There is no bigger discussion in the investment management world today than the takeover of passive investment management at the expense of active. For equities, the market share lines crossed at the end of last year putting passive on top. This trend has been in place since the Global Financial Crisis (GFC), but really accelerated in the middle of the decade, helped by the markets ongoing annual positive returns, and the increasingly correlated returns among equity components leading to investors preferring to buy the lowest cost investment vehicles available (which were index mutual funds and ETFs). According to Goldman Sachs, since the GFC, $2.8 billion has left U.S. active mutual funds while passive has gained $3.0 billion. The charts show a pretty seamless transfer from one pocket to the other.

Investor flows from active to passive

This shift in assets has left its mark in the U.S. equity markets. Some would argue that new money flowing into passive is evenly spread through the buying of the indexes components (from buying a 4.8% Apple Inc position down to a 0.1% H&R Block position) and thus no company’s market cap is overly rewarded over another. While this is true of the index buying, what is forgotten is that the assets being sold are not from a blind large index. The assets being redeemed are either from poorer performing asset classes or strategies (like small caps or value stocks) or from active portfolio managers who run portfolios that have much lower market cap concentrations than the S&P 500 (or the index they are benchmarked against). They might even own several stocks which are outside of their index and thus penalized during this 10-year rush into the passive indexes. (Unless of course they are a small cap fund running a 5% Apple Inc. position in which case they likely crushed it.)

A glance at the 15-year returns of major strategies below notes the headwinds that active players have been fighting to keep their assets under management. Small cap and value strategies have typically outperformed over the long term, but over the last 5 years they have been sources of cash as investors have left and hunted for better returns.

@nosunkcosts: Smallcaps have had the worst risk-adjusted returns for 15 years. That’s gotta make the lives of active managers harder.

Small Caps 2005-2019

Active managers can’t wait for the turn. It has been tough for them to run a diversified fund when the top five stocks make up 17% of the index. If they are running a diversified portfolio then by SEC rules their top five positions cannot make up more than 25% of their assets. And often a fiduciary like a pension fund or endowment will give you a sideways glance if you are too concentrated at the top of your fund.

So say that you had perfect visibility on 2020 and knew that the five stocks below were all going to significantly outperform. The best you could position would be a 5% weight into each name. Or maybe if you knew the exact winner you could put 21% into that stock which leaves 4% to be spread over the other four holdings. But again, placing 21% into a fund with large institutional weightings would probably get you fired. So bottom line, it has been difficult for active managers to gain an edge on the index when they can’t significantly overweight the largest and best performing holdings in that index. Large cap portfolio managers would rather own underweights in the top five stocks and overweights in their favorite remaining 495 names.

SPX Weight

Five Largest S&P 500 Stocks

Below I have listed the annual performance of the top five market cap names from the previous year end. Let’s call this portfolio the “I Love Passive” Portfolio. As you can easily see, the “I Love Passive” top five portfolio has easily outpaced the S&P 500 itself since the flows out of active and into passive have accelerated. In fact, the ILP Portfolio has won for the last six years and is off to the races again in 2020. Barring a catastrophic fraud at one of the top five companies, I’d expect this strong performance to continue as long as active assets are being shed to passive. One would think that at some point the valuations of the top market cap companies in the index would put a pause on the mega-cap outperformance. But remember, the index doesn’t discriminate by valuation. It only acts by percent weight in the index, so if another dollar comes into the S&P 500 index fund, it will buy another $0.048 of Apple Inc.

So what will end this party? We know with certainty that money flows will chase performance. So, if there are some outsized forces that could cause small cap stocks, value stocks, cyclical stocks, foreign stocks, or any other non-S&P 500 stock to outperform, then eyebrows would be raised, and anxious investors could shift. Maybe this would be the result of a buyout wave of smaller companies with little multiples by larger companies with big multiples. Or, maybe it would be caused by a dramatic change in the global economy that led to new shortages of certain goods and services or emerging monopolies caused by regulatory changes. Or, maybe a dramatic decline in the U.S. dollar that would cause a shift to multinationals with more global earnings, or even foreign-based companies exhibiting better growth prospects.

We won’t know what caused the pause in assets moving to passive until after it happens. But when it does, look for the megacaps in the big indexes to be challenged and for active investors everywhere to scream like their favorite team won the championship on the final play. Until then, the asset management industry can watch a few firms (that shall remain nameless) eat all of the cake while scrambling for the crumbs. Everything is cyclical and someday active management will come flying back with forks and knives in hand.

Largest Stocks 2017-2020 Largest Stocks 2013-2016 ILP Portfolio Return I Love Passive Return vs. SPX Total Return

And it will end when it ends…

@AlbertBridgeCap: And in factor news… Flows continue to flock into perceived low-volatility low-beta safe-havens, and with that into more momentum and growth – at the continued expense of value. Not a US thing. Not a European thing. It’s a human thing.

Factor News

Even equity portfolio managers see what is driving the market…

Even Equity Portfolio managers see what is driving the market
(BofA Global Research)

Apple, Google, Microsoft, Amazon, and Facebook…

Global Technology
(BofA Global Research)

Meanwhile, no one ever talks of inflation anymore…

Tweet from @TayTayLLP

It is a peak earnings week for the S&P 500…

Most Anticipated Earnings Releases

Goldman Sachs’ Current Activity Indicator moved higher this month…

Now will corporate earnings and calls reflect the upward trajectory?

Current Activity Indicator

Also seeing some better data out of Germany…

ZEW Germany Assessment of Current Situation

A Bernie surge is not what the markets want…

@TheStalwart: Bernie Sanders is SURGING on the betting markets. Soaring past Joe Biden over the weekend.

Democratic Presidential Nomination

What if your recent food ordered delivery was not actually from the favorite restaurant that you wanted to buy from…

Grubhub, Seamless and Yelp had better shut this down before someone gets sick and dies from an unsanitary rogue kitchen.

Tweet from @chezpim

Speaking of businesses with no barriers to entry, Google and Facebook love them…

Tweet from @Bill_Gross

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