Doug Noland: Q1: Sure Bets That Weren’t

The reality is that too much “money” spoils the game. When everyone is Crowded on one side of the king dollar trade, the boat rocks over. When the Crowd gets short the yen, it’s squeezed higher. Short the metals, here comes a squeeze. Heavily long the banks (slam dunk trade), watch out below. Underweight the emerging markets, the Crowd is forced to chase a big rally. Long the small caps versus the big caps, and the Crowd has no choice but to unwind the trade and jump aboard the S&P500 index. Run long/short strategies with similar factors to everyone else, and the Crowd is left pulling its hair out. Most importantly, focus on risk and you had no chance of outperforming the market or the passive “investing” Crowd.



An intriguing first quarter. The year began with bullish exuberance for the Trump policy agenda. With the GOP finally in control of Washington, there was now little in the way of healthcare reform, tax cuts/reform, infrastructure spending and a full-court press against deregulation. As Q1 drew to a close, by most accounts our new Executive Branch is a mess – the old Washington swamp as stinky a morass as ever. And, in spite of it all, the global bull market marched on undeterred. Everyone’s still dancing. From my perspective, there’s confirmation that the risk market rally has been more about rampant global liquidity excess and speculative Market Dynamics than prospects for U.S. policy change.

It’s not as if market developments unfolded as anticipated. Key “Trump trades” stumbled – longs and shorts across various markets. The overly Crowded king dollar faltered, with the Dollar Index down 2.0% during Q1. The Mexican peso reversed course and ended the quarter up 10.6% versus the dollar, at the top of the global currency leaderboard. The Japanese yen – another popular short and a key funding instrument for global carry trades – jumped 5% . China’s renminbi gained 0.84% versus the dollar. WSJ headline: “A Soaring Dollar and Falling Yuan: The Sure Bets That Weren’t”

Shorting Treasuries was another Trump Trade Sure Bet That Wasn’t. And while 10-year yields jumped to a high of 2.63% on March 13, yields ended the quarter down six bps from yearend to 2.39%. Despite a less dovish Fed, a hike pushed forward to March, and even talk of shrinking the Federal Reserve’s balance sheet – bond yields were notably sticky. Corporate debt enjoyed a solid quarter. Investment grade bonds (LQD) gained 1.2% during the quarter, with high-yield (HYG) returning 2.3%.

The S&P500 gained 5.5% during Q1. And while most were positioned bullishly, I suspect many hedge funds (and fund managers generally) will be disappointed with Q1 performance. There was considerable Trump Trade enthusiasm for the higher beta small caps and broader market. Badly lagging the S&P500, it took a 2.3% rise in the final week of the quarter to see the small cap Russell 2000 rise 2.1% in Q1. The mid caps (MID) were only somewhat better, rising 3.6%.

Technology stocks had been low on the list of Trump Trades going into the quarter, perhaps helping to explain a gangbuster Q1 in the markets. The popular QQQ ETF (Nasdaq100) returned 12.0% during Q1. The Morgan Stanley High Tech index rose 13.5%, and the Semiconductors jumped 11.6%. The Biotechs (BTK) surged 16.0%.

A Trump Trade darling entering 2017, the financials struggled during Q1. March’s 4.0% decline reduced the bank stocks’ (BKX) Q1 gain to an unimpressive 0.3%. Somewhat lagging the S&P500, the broker/dealers (XBD) posted a 5.4% Q1 advance. The NYSE Financial Index gained 3.7%, while the Nasdaq Bank Index dropped 3.1%.

King dollar bullishness had investors underweight the emerging markets (EM) going into 2017. A weakening dollar coupled with huge January Chinese Credit growth helped spur a decent EM short squeeze. Outperformance then attracted the performance-chasing Crowd. By the end of March, EM had enjoyed the best quarter in five years (from FT).

March 31 – Financial Times: “Capital flows to emerging markets have continued to surge ahead after a strong start to the year, with cross-border portfolio flows in March at their highest monthly level since January 2015 and broad capital flows to China turning positive in February for the first time in almost three years, according to the Institute of International Finance. The IIF… said flows from non-resident investors into EM bonds and equities were an estimated $29.8bn in March, up from $17.2bn in February…”

A Bloomberg headline from the final day of the quarter: “Rupee Caps Best First Quarter Since 1975 Amid $12 Billion Inflow.” India’s equities (Sensex) posted an 11.2% Q1 gain. A short squeeze also helped Turkish stocks (Borsa Istanbul) to a 13.8% first quarter rise. Latin American equities enjoyed a spectacular start to 2017. Stocks rose 6.4% in Mexico, 8.0% in Brazil, 15.2% in Chile and 19.2% in Argentina. With the notable exception of Russia, Eastern Europe’s equities also enjoyed a solid Q1.

March 31 – Bloomberg (Lilian Karunungan): “All of Asia’s emerging-market currencies, apart from the Philippine peso, strengthened this quarter as optimism over the region’s economic outlook lured inflows. India’s rupee led the advance in March. Regional equities had their best three months since 2010.”

Chinese stocks for the most part posted a solid Q1, with the Shanghai Composite gaining 3.8%. China’s growth-oriented ChiNext index declined 2.8%. Stocks gained 6.0% in Taiwan, 6.6% in South Korea, 5.1% in Indonesia, 6.0% in Malaysia, 6.9% in the Philippines and 8.6% in Vietnam.

Europe lavished in boundless free “money.”  Germany’s DAX equites index jumped 7.3% and Frances’s CAC40 gained 5.4%, yet bigger gains were enjoyed in the Periphery. Spanish stocks surged 11.9%. The Italian Mid Cap index surged 17.5%. Portuguese stocks rose 8.1%.

The quarter, however, was not kind to European periphery sovereign debt. Notably, Italian 10-year yields jumped 51 bps. Spanish and French yields rose 29 bps, and Portuguese yields gained 23 bps. With German bund yields rising only 12 bps, European debt spreads widened meaningfully.

For the most part, Bubbling equities markets only exacerbated already extremely loose global financial conditions. First quarter U.S. high-grade debt issuance jumped to $393bn, up 9% from last year’s record pace. Led by record U.S. corporate debt sales, debt issuance boomed around the globe.

March 30 – Financial Times (James Kynge and Thomas Hale): “Emerging market countries sold record levels of government debt in the first quarter of this year, taking advantage of a surge in optimism towards the developing world as trade grows at its fastest rate for seven years and inflationary pressures ebb. Data from Dealogic, a research firm, show that sovereign bond sales from emerging markets rose to $69.6bn in the first three months of the year, an increase of 48 per cent from a year ago and a record amount for a single quarter. Corporate bond sales by companies in developing countries also surged, rising 135% year on year in the first quarter to $105bn…”

March 21 – Dealogic (Olga Tarabrina): “Global M&A volume has reached $705.0bn in 2017 YTD, surpassing $700bn in a YTD period for the first time since 2007 ($903.5bn). Of this, a total of 125 $1bn+ deals, worth $454.9bn, have been announced so far this year, compared to only 94 deals (totaling $260.3bn) 5 years ago. $10bn+ deals account for $167.2bn of the total this year… US-based companies are on top of the heap of cross-border deals, with $95.8 billion in announced acquisitions so far – “the highest YTD level on record.’ … For the first quarter, ‘14 times EBITDA is what the Dealogic figures show as the median EBITDA multiple,’ explained Dealogic’s head of M&A Research, Chunshek Chan. ‘That’s something we really haven’t seen over the course of the data that we have. Historically, we’ve been bouncing between 10 and 12 times, sometimes even 13 times. So 14 times EBITDA is certainly a premium to pay for acquisitions.’”

Various indicators of bullish market sentiment went to extremes. An incredible $124bn flooded into ETFs during the first two months of the year. Margin debt jumped to an all-time high ($528bn) in February, although this pales in comparison to the amount of leverage embedded in derivative trades.

March 31 – Bloomberg (Cecile Vannucci): “Just a week ago, it looked as if the dormant CBOE Volatility Index was awakening. Fast-forward five days, and the gauge known as the VIX is closing in on its lowest quarterly average since the final months of 2006. The measure has lost 18% this year through Thursday as the S&P 500 Index climbed 5.8%.”

March 28 – Bloomberg (Vince Golle): “Americans haven’t been this upbeat about the U.S. stock market since 2000, according to the Conference Board’s latest consumer confidence report… More than 47% of respondents said they expect equities to move higher in the next 12 months, the largest share since January 2000.”

March 23 – CNBC (Evelyn Cheng): “Investor sentiment jumped to a 16-year high in the first quarter, according to the latest Wells Fargo/Gallup Investor and Retirement Optimism Index. The index… rose 30 points to hit 126 in the first quarter… The last time the optimism index was higher was during the tech bubble in November 2000, when the index was at 130.”

The U.S. economy appeared to struggle during the quarter to keep up with booming confidence. University of Michigan Consumer Confidence – Current Conditions jumped to the highest level since July 2005. The Conference Board consumer confidence index surged to the highest level since December 2000. Small business confidence rose to the highest level since 2004.

On the other side of the world, China’s Credit-induced boom caught some momentum. Led by January’s record $545bn expansion of Total Social Financing, total Chinese Credit growth likely exceeded $1.0 TN during Q1. No surprise then that GDP was said to be tracking 6.8% annualized during the quarter. China’s Manufacturing index (PMI) ended the quarter at the strongest level in almost five years. And it’s no surprise that continued timid “tightening” measures have thus far had minimal impact. There were, however, bouts of instability in China’s Wild West money market that portend trouble ahead.

March 31 – China Money Network (Li Dongmei): “China’s announced outbound M&A deals totaled US$23.8 billion during the first three months of 2017, a drop of 75% from US$95.1 billion recorded during same period a year ago, as tightened regulatory controls on capital outflows limited Chinese companies’ ability to invest outside of the borders.”

The confluence of a weaker dollar, booming Chinese and global Credit, and latent financial fragilities provided precious metals a nice shine throughout Q1. Palladium jumped 17.1%, silver 14.2%, Gold 8.4% and Platinum 5.2%. The HUI (NYSE Arca Gold Bugs Index) jumped 8.2%. Bloomberg headline: “Metals Enjoy Longest Rally in Seven Years as Low Rates Lure Cash.”

There was yet another facet of the Trump Rally that faded as the quarter wore on: The notion of a fortuitous handoff from monetary stimulus to fiscal policy. Markets were supposed to begin “normalizing.” As central banks pulled back from market dominance, stock picking and active management were to grab some of their advantage lost to the passive index Crowd. We’ll wait to see the percentage of hedge fund and mutual fund managers that beat the SPY for the quarter.

As a market analyst, I saw during Q1 the unprecedented Crowded Trade Phenomenon deepen further. Way too much “money” playing the securities market game – became only more so. And while a strong quarterly gain in the indexes is celebrated by the bullish Crowd, the undercurrents must be troubling to many.

The reality is that too much “money” spoils the game. When everyone is Crowded on one side of the king dollar trade, the boat rocks over. When the Crowd gets short the yen, it’s squeezed higher. Short the metals, here comes a squeeze. Heavily long the banks (slam dunk trade), watch out below. Underweight the emerging markets, the Crowd is forced to chase a big rally. Long the small caps versus the big caps, and the Crowd has no choice but to unwind the trade and jump aboard the S&P500 index. Run long/short strategies with similar factors to everyone else, and the Crowd is left pulling its hair out. Most importantly, focus on risk and you had no chance of outperforming the market or the passive “investing” Crowd.

And it’s “funny” how this all works nowadays. Inflation has turned up, while central bank monetary stimulus is being turned down. Shorting Treasuries (and sovereign debt) should be a Sure Bet. Yet there’s this Lurking Financial Fragility issue, the Elephant in the Market. So, the bigger global Bubbles inflate, the greater the systemic vulnerability to rising market yields (among other things). Yet the more susceptible risk market Bubbles become to trouble the greater the safe haven bid – and the more downward pressure on market yields. Artificially low yields then work to spur speculation and excess, exacerbating global Bubbles and associated fragilities.

All the “money” slushing around in markets dominated by Deviant Market Dynamics continues to make it difficult for most active managers to perform. And the biggest consequence of this troubling market dilemma? Just more enormous self-reinforcing Bubble flows into ETF index products. For the most part, investors are pleased with Q1 returns. What’s not appreciated is the amount of risk that must be accepted to continue playing this game.

March 27 – Financial Times (Miles Johnson): “Hedge fund managers may be criticised for their recent returns but they have consistently displayed a razor sharp sense of timing when it comes to picking when to sell their own businesses. When Och-Ziff, the… hedge fund founded by the former Goldman Sachs trader Daniel Och, decided to sell equity to the public markets it did so near the top of the market in late 2007. Investors in that pre-crisis deal… have since lost more than 90% of their money… So what is to be made of the timing of last week’s news that Eric Mindich has decided to shut his $7bn Eton Park hedge fund and return money to investors from what he called a ‘position of relative strength’? The closure of Eton Park has a symbolic resonance on Wall Street. Once the youngest partner in the history of Goldman Sachs, Mr Mindich left the bank in 2004 to set up Eton Park. It became one of the largest launches in the history of the hedge fund industry and, emboldened by his and others’ success, a whole generation tried to follow him.”


Original Post 1 April 2017

Categories: Doug Noland, Perspectives