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When Everyone Is Sure They Know What’s Going To Happen, They’re Wrong

MillersMarketMusings  |  Miller

What A Long Strange Trip It’s Been

Sometimes the light’s all shinin’ on me,
Other times I can barely see
Lately it occurs to me what a long, strange trip it’s been

-The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir

In my last note, May the Odds Be Ever in Your Favor, I wrote “The bond market is, probabilistically speaking, an underdog to perform well over the next 2-3 years.” Since then, the 10 year US Treasury bond has fallen over 3.5%, and the yield has risen over 58 basis points from 1.75% to 2.33% as of the close yesterday.  For investors who bought the 10-year thinking they were going to earn 1.75% for the next ten years, losing over two years’ worth of income in a month must sting a bit. And if they don’t change, they’re going to get stung again.

Could rates pull back a bit?  Sure. It’s been a big move, fast.  But as another writer I respect wrote recently, “Interest rates go from 15% to 1.3%, then go to 2%, and you think you missed it?” Retail investors who have piled into bond alternatives like Utilities and Staples in an ill-informed yield chase are going to be in for a shock when they get their November statements in a few weeks. Long-time readers know that we have been short both sectors via the XLU and XLP for awhile, and those bets have paid off.  We’re not saying the move is done, but the risk-reward is now more balanced, and we’ve been paring them back. (We’re out of the XLP short completely).  One trade we still like is our short in foreign sovereign debt.  This short is working (down 4.7% since election day) and I think will continue to work. Negative interest rate policies are just dumb, as they eviscerate wide swaths of the economy, from pension plans to insurance companies and regular savers. I like being short stupidity, and being short negative yielding bonds is a way to do it.

On the flip side, U.S. banks are on fire. The KBW Regional Bank ETF (KRE) is up 17.1% since election day (full disclosure: I was long XLF and KRE calls before election day and am still long over half the position). Higher rates are only part of the story, and arguably, the least important part. Yes, higher rates are great for most banks, as they can finally earn a spread on their lending. Low rates were terrible for net interest margins (NIM), but with rates moving up, banks can earn a decent return again. This will in turn spur more lending, which will help the economy, particularly small businesses, where funds were tougher to get.  But the big benefit for banks will be in regulatory relief.  Right now, the two big numbers for banks are $10 billion and $50 billion. Not to go into too much detail here, but those are the two asset levels at which onerous fees (particularly at the $10 billion level) and regulations (at the $50 billion level) kick in. There seems to be a general consensus that the Dodd-Frank bill has been overly burdensome on small community banks, with compliance costs through the roof and loan growth to small businesses and individuals (via mortgages) anemic.  A revision or removal of some of the worst of the regulations, particularly for mortgages, will be very beneficial for consumers.  (Bernanke himself had trouble getting a mortgage once he left the Fed – that’s about all you need to know about the state of banking regulations in the U.S.)  Greater mortgage availability will drive home building and construction, which will also benefit the economy overall. (Some will argue that higher rates will crimp mortgage demand due to higher costs. I disagree.  It will crimp refinancing, but whether a mortgage costs 3.5% or 4.0% doesn’t matter much when you can’t get one at either price.  A mortgage you can get at 4.0% is much better than one you can’t get at 3.5%.)

Another big benefit for financial firms? (Arguably the biggest?)  Elizabeth Warren has been sidelined.  The prospect of Senator Warren becoming Treasury Secretary Warren was frightening for financial markets, and was a non-zero probability if Hilary Clinton had won the White House.  The idea of Warren being free to implement her anti-business policies was a frequent topic of conversation among investors I speak with, and now that she is relegated to gadfly instead of policy maker, banks are a much more attractive investment.

Not to be overlooked in a Trump presidency is the prospect for lower corporate tax rates. This is more or less important for some sectors than others (pharma companies and some large international tech companies and manufacturers have been pretty good at reducing their tax rates already), but what sector is pretty tax-inefficient?  Regional banks again.  On average, they pay an effective tax rate of over 33%.  A lower corporate tax rate falls right to their bottom line, boosting 2018 earnings estimates by 10-15% or more depending on the company.  Is most of this already baked into their stock prices after this 17% move?  It sure seems that way.  That said, I think banks have room to move a little higher, probably after a short-term pullback, as the combination of better loan growth, lower regulatory costs, higher interest rates and lower corporate taxes is a powerful tailwind to their earnings growth.

Sittin’ and starin’ out of the hotel window
Got a tip they’re gonna kick the door in again
I’d like to get some sleep before I travel,
But if you got a warrant, I guess you’re gonna come in

-The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir

This doesn’t mean that the U.S. stock market is just going to go on a tear. There are lots of companies and sectors that are adversely affected by higher rates or a stronger dollar, or have been a haven in a low-growth, low-rate world. Besides the already discussed staples and utilities getting hammered, stocks that were a safe haven, like FANG (Facebook, Amazon, Netflix and Google) have been weak since election day, as they were a source of funds for investors looking to move into financials.  I’m personally a big fan of Google and am a buyer here, and bought a little Amazon last week for a trade. However, I’d be avoiding companies that get a lot of their income from overseas, as foreign markets are still stagnant at best, particularly in Europe, and the prospect of higher rates and stronger growth in the U.S. is making the dollar stronger every day.  I think we are just at the beginning of a strong dollar regime and that investors that try to fight it will be in a losing trade. Interested in companies that are losers in this?

You may have noticed that I haven’t spent any time talking about Trump’s infrastructure plans. While I do think the U.S. desperately needs to spend money on infrastructure, particularly bridges that need repair and some airports (been to La Guardia or Kansas City airports lately?), I don’t think the impact will be that meaningful in the near-term to the economy (longer-term it’s a net positive), and the stocks that benefit most have already had massive moves, so chasing that play from here is not a good risk-reward.  I’d wait for a market correction to get involved, or look for second and third-level effects for investing ideas.

Truckin’, like the do-dah man Once told me “You’ve got to play your hand”
Sometimes your cards ain’t worth a dime, if you don’t lay’em down,

The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir

Here’s the hand we’ve been dealt: rates are going higher, which is good for financials but bad for multinationals.  At some point, higher rates may become a self-correcting, circular type of process wherein higher rates start to impact discount rates on equities, limiting how far they can rise, at the same time that they support a stronger dollar, which hurts exporters and those with large overseas sales.  Net-net?  A U.S. stock market that treads water, in my opinion, with a continual rotation among sectors based on money-flows and relative improvements in earnings.  In past letters I have repeated that “currents were shifting beneath the surface of what appeared to be a calm stock market. In particular, I repeatedly stated that banks were a buy and utilities and staples were a sell.”  Well, that trade is getting very stretched.  I’d look for the market overall to trend sideways to down, with the possibility of a 10% or more pullback in the next quarter or two being fairly high The market is liking what it’s hearing from Trump so far, but the market shifts have been massive beneath the surface of an S&P 500 that is up just 2.1% since election day, making further progress increasingly difficult on an overall market basis.

Busted, down on Bourbon Street, set up, like a bowlin’ pin
Knocked down, it get’s to wearin’ thin They just won’t let you be, oh no

The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir

All of which brings me to this, again – watch your VAR.  The U.S. ten-year bond is off -3.13% since election day, -3.56% since my last letter and down -5.4% since early July.  In the less than two weeks since the election, the international bond ETF (BWX) is down -4.7%, Staples (XLP) are off -4.2% and Utilities (XLU) nearly -6%.  Over the same time frame, Banks (KRE) are up 17%, Financials overall (XLF) are up over 10%, Industrials (XLI) are up over 5%, and Homebuilders (XHB) are up over 6%.  Think everyone got this right?  Me neither.  Volatility has gotten cheap again, with the VIX falling from over 22 on November 4th to 12.85 at the close on Friday.  The pins are set up for a correction.  I’d be prepared before they get knocked down.  Because VAR moves just won’t let you be.

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