Tag Archives: author

Capturing The Move Higher In 3-Month Deposit Rates

Summary What we’re trading and how. Full disclosure of trade entry, objective and strategy. If the Fed’s expectations for rates are right this position will appreciate from $2,050 at 0.82% to $5,000 at 2.00% by December 19, 2016. Linked is an interactive risk/reward spreadsheet enabling you to experiment with any potential outcome for this trade or your own trading criteria. I’ve included instructions on how to use the interactive risk reward spreadsheet. Three-month deposit rates outside the Treasury system (Eurodollars) are the most liquid futures contract on the board. Open interest (contracts outstanding) is greater than the Dow, S&P, Gold, Silver, Crude Oil, Gasoline, Euro-FX, Yen, Pound, Canadian and Australian dollars combined. (6.9 million versus 11.3 million) Click here if you’re not familiar with what this rate is, how it’s set and the underlying futures contract. Capturing the move higher This simple trade runs through December 19, 2016. Short the December 2016 ( GEZ16 ) 3 month rate futures contract at 99.18, trading this rate higher from 0.82% contract value $2,050. Objective = 98.00, rate 2.00% contract value $5,000 consistent with the lowest of the Fed’s disclosed expectations . Click here to enlarge the rate, price valuation chart below A short 99.18, B objective 98.00. (Video 1:59) Last objective guidance of where Fed Chair Yellen sees the Fed funds rate and when. Source: Federal Reserve Correlation between the Fed funds and 3-month deposit rates (Eurodollars) the average for the 3 month is +.25% to Fed funds. (click to enlarge) Qualify risk/reward by experimenting with any potential outcome for this trade and match it to your current risk investments. Click here and open the December 2016 risk/reward spreadsheet. When the spreadsheet opens enable it. Click here for current quotes and charts (December 2016) enabling you to track this trade or experiment with any potential outcome for this trade using the data on the Exchange’s site. How to use the spreadsheet 1) Entry Price = short December 2016 at 99.18 (B-9) 2) Enter any contract price in cell B-3 3) C-3 Shows the rate the contract price represents 4) D-3 Initial investment 5) E-3 Net profit or loss 6) F-3 Net liquidating value 7) C-4 Deposit per contract Any entries can be changes to experiment with your own criteria. Click to enlarge Click here for the CME Fedwatch for rate expectations

Melt-Up Or Meltdown?

Summary U.S. market capitalization weighted indexes have outperformed in 2015. The largest U.S. capitalization stocks have melted up, and this trend forged ahead in 2015. Under the surface, the meltdown of out-of-favor assets has accelerated. Either a broader melt-up or meltdown scenario remains a probable outcome. A large cash weighting and an exposure to out-of-favor assets (a barbell approach) is an ideal portfolio strategy for this environment. “A dramatic and unexpected improvement in the investment performance of an asset class driven partly by a stampede of investors who don’t want to miss out on its rise rather than by fundamental improvements in the economy.” – Definition of “Melt Up” from Wikipedia “A rapid or disastrous decline or collapse” – Definition of “Meltdown” from Merriam-Webster “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.” – Sir John Templeton – 1958 Introduction I have written two articles on the stealth U.S. bear market on Seeking Alpha in 2015. In part one of this series, authored on July 9th, 2015, I examined building negative divergences in the U.S. stock market, and those divergences ultimately foreshadowed the August market sell-off. In part two , authored on December 1st, 2015, I highlighted two distinct markets under the surface of the U.S. stock market, profiling the “Winning” and “Losing” companies, and their distinctive stock prices. The conclusion of that piece suggested buying the “Losers” and selling the “Winners”, which, as a contrarian, I have openly advocated for over the last several years, with little success thus far, and a whole lot of pain. Third Avenue confirmed last week that this advice remained too early, as credit markets continued to seize up, with high-yield bond prices undercutting their August lows. As yield-chasing and bottom-fishing investors continue to be punished, the world’s central banks, with the notable absence of the Federal Reserve (who may have to shift course from their tightening rhetoric very soon), remain poised to inject further liquidity into the system. The end result is that more than any time in recent history, the markets are dually poised for a climatic melt-up or meltdown scenario. Proponents of the melt-up scenario will argue that many investors who capitulated in 2008 and 2009 remain out of the market, providing a wall of worry to climb. Advocates of the meltdown scenario believe that stock market divergences have been developing for years, setting the stage for a historic unwind, as low-conviction investors bail out of their thinking that stocks are the only game in town. Which direction will the market break, and how should investors position their portfolios? Thesis Melt-up and meltdown scenarios are equally plausible for U.S. equity investors. Thus, a barbell approach, where a high cash weighting is combined with extreme out-of-favor assets remains the best approach. QQQ> SPY> RSP> IWM In the U.S. stock market in 2015, a bigger market capitalization has correlated very positively with outperformance. This can be illustrated by looking at the performance of the PowerShares QQQ ETF (NASDAQ: QQQ ), which is designed to track the performance of the NASDAQ 100 Index, which counts five of the world’s ten largest market capitalization companies among its largest holdings, Apple (NASDAQ: AAPL ), Alphabet (NASDAQ: GOOGL ), Microsoft (NASDAQ: MSFT ), Amazon (NASDAQ: AMZN ), and Facebook (NASDAQ: FB ). These aforementioned companies are weighted more heavily in the PowerShares QQQ ETF, than they are in the S&P 500 Index, as measured by the SPDRs S&P 500 ETF (NYSEARCA: SPY ), and their weightings in the respective indexes are responsible for a large portion of the outperformance of the QQQ (up 8.06% YTD) over the SPY (down 0.35% YTD) as shown in the charts below: An equal-weighted version of the S&P 500 Index, which is represented by Guggenheim S&P 500 Equal Weighted ETF (NYSEARCA: RSP ), is disadvantaged by its lower relative weighting to the biggest market capitalization companies, and it is down over 4% in 2015. Moving further down the market capitalization spectrum, U.S. small capitalization stocks, which are prominently measured by the Russell 2000 Index, represented by the iShares Russell 2000 ETF (NYSEARCA: IWM ), are down over 5% in 2015. From the charts above, clearly the performance of the U.S. stock market in 2015, has been heavily influenced by investor flows and fund flows to larger companies, who are perceived to offer an attractive combination of safety and growth potential in a slowing global GDP world economy. AAPL, AMZN, GOOGL, FB, MSFT = Amazing It cannot be overstated how important Apple, Amazon, Alphabet, Facebook, and Microsoft have been to the performance of the U.S. stock market in 2015. These five stocks and one other, Netflix (NASDAQ: NFLX ), have accounted for the vast majority of the market capitalization gain in the S&P 500 Index, and the resilience of their stock prices in the face of broader market weakness, has kept the market capitalization indexes from showing far greater losses on a year-to-date basis. Visually, the contrast of their stock charts is stunning to see, so I have included charts of AMZN, GOOGL, and MSFT as follows: By itself, Amazon has added $150 billion dollars in market capitalization in 2015. That is amazing, especially when it was viewed as overvalued by a majority of investors entering 2015. The ominous takeaway from the dominance of a handful of stocks is that this concentrated leadership often marks the tops of bull markets, and one only has to look back to March of 2000, when six stocks accounted for the entirety of the gain of the S&P 500 Index, to see a similar, negative reference point. A Meltdown Alongside A Melt-Up? While the broad market averages bounced back strongly following their August 2015 lows, high yield bonds, as measured by the SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK ) and iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA: HYG ), only managed a weak recovery, and have subsequently made new lows as shown in the charts below: Many analysts have attributed the unrelenting sell-off in high-yield bonds to the ongoing carnage in the commodities sector, specifically the energy market, which had extensively used high-yield financing. The fall of oil, as measured by the United States Oil Fund (NYSEARCA: USO ), seems to add credence to this thought process. Crude oil, which is down nearly 50% in 2015, after a difficult 2014, and natural gas, which is represented by the United States Natural Gas Fund (NYSEARCA: UNG ), down nearly 50% as well, which is shown in the chart below, both demonstrate how difficult the operating environment has been for energy firms. The end result is that stocks like Chesapeake Energy (NYSE: CHK ), the second largest natural gas producer in the U.S, and a major oil producer, with some of the best land acreage in the industry, has seen its shares devastated, down over 78% in 2015. Even better operators, like Antero Resources (NYSE: AR ) have lost over 50% of their market capitalization. The energy unwind has even spread to solar companies, which seemingly have the world’s political tailwinds at their back. This is best evidenced by the dramatic decline in SunEdison (NYSE: SUNE ), a company I recently authored a contrarian article on , whose shares have fallen precipitously since making their highs in July of 2015. The high-yield bond market, commodities, and a large number of dislocated stocks clearly show that there has been an ongoing meltdown, which has been partially obscured by the outperformance of a narrow group of mega capitalization technology stocks. A Fork In The Road With a large number of stocks already in their own bear markets, which can be defined as being off 20% from their highs, but the broad market indexes still far from a bear market, what is the best course of action for investors? There are two possible, probable scenarios that are as different as night and day. First, in an optimistic light, the correction in asset markets may have already run its course. If the market leadership stocks can simply tread water, any improvement in the economically sensitive, out-of-favor sectors of the market, could initiate a rotation that propels broad market indexes to new highs, climbing the proverbial wall of worry. Market analysts that reference this scenario, often recall an overvalued market getting more overvalued, similar to the NASDAQ market in 1998 to 2000. This is the melt-up scenario. The second scenario is decidedly more bearish. Its interpretation would be that the weakness in commodity prices is foreshadowing the next recession. Thus, high-yield bonds, at their current levels, could be fairly priced, not mispriced, and if that is the case, they are indicative of a fair value of 1,650 for the S&P 500 Index, which would be an 18% decline from its closing price on December 11, 2015. Under this scenario, with valuations where they are today (see the below chart from Ned Davis), the markets could gather momentum on the downside, so the ultimate sell-off could cut much deeper, hence the risk of a meltdown. (click to enlarge) The Barbell Approach On December 7th, 2015, I authored a portfolio strategy article on Seeking Alpha, which has generated a terrific commentary section, titled “Why A 90% Cash Portfolio Will Probably Outperform”. In this article, I investigated the merits of an extreme portfolio approach given the uncertain environment, where 90% of an investor’s portfolio was kept in cash, and the remaining 10% was invested in a concentrated portfolio of deep-value, distressed equities. The graphic I produced to illustrate the merits of the portfolio is replicated below: (click to enlarge) On December 7th, 2015, I also lau nched ” The Contrarian “, a p remium research service on Seeking Alpha. As part of my research service, I have several model portfolios that I am tracking with real-world transactions, so that readers can see a working example of my portfolio theory. One of the portfolios I am tracking with positions is the “90/10 Portfolio”, which I am posting an update on today. With the S&P 500 Index retreating 3.7% for the last week, the “90/10 Portfolio” was actually positive for the week. While admittedly this is a small sample size, it shows the benefit of this extremely conservative/aggressive approach. Conclusion Large-capitalization stocks are the locomotive that keeps pulling an otherwise unhealthy market train forward up a steep hill. Active managers continue to struggle, as has been the case for nearly this entire seven-year bull market, as a narrower and narrower group of stocks have led the market averages higher. The negative divergences could be signaling the start of a significant downturn, or the general apathy and frustration towards a large swath of individual stocks could signal a significant wall of worry to climb in the future. The prevailing thought in the markets is akin to this quote from Steven Roge, in the previously linked Bloomberg piece on Third Avenue, “The past few years (have not) been a good time to be a contrarian investor…Investors in that group have been trying to catch a falling knife that keeps on falling.” Reversion to the mean is one of the most powerful forces in the financial markets. Today, a reversion to the mean in the broad market indices would imply seven years of zero-to-negative returns. For out-of-favor assets, however, a ‘reversion to the mean’ trade could spark a powerful upside move that is unexpected given the current headwinds facing the out-of-favor companies. A barbell approach works in this environment. From my perspective, for the first time since 2009, it is an ideal time to be a contrarian, and today that would mean a barbell approach heavily weighted towards unloved assets, like cash, and out-of-favor equities, like commodity stocks. For more information , please peruse my research in “The Contrarian”.

Third Avenue Focused Credit Fund – Designed To Implode

Summary Third Avenue Focused Credit Fund has been placed in liquidation by its board of trustees. The cause was the illiquidity of its portfolio of deep value high yield securities. The board could not continue to run an open-end mutual fund with such a high concentration of illiquid securities. Will there be contagion for other high yield bond funds? Yes, if they have a high proportion of illiquid securities in their portfolios. On December 10, Third Avenue Focused Credit Fund (MUTF: TFCIX ) announced that it was going into liquidation rather than redeeming any additional securities. It is in all the newspapers. Liquidation is a highly unusual move for an open-end mutual fund to make, but it appears to have been the only rational course of action open to the fund’s board of trustees in the circumstances. The fund, started in 2009, had an unusual, possibly unique investment style. It invested in deep value high-yield bonds – the sort that would not blush when called “junk” – often with the lowest ratings. Third Avenue Management, the fund’s manager, and its chairman, Martin Whitman, are highly regarded value investors. It is not a fly-by-night operation. Indeed, when the Focused Credit Fund opened in 2009, I was an early investor – though I redeemed my shares after about a year because I thought the fund was taking greater risks than I had understood when I invested. The fund had over $2 billion of assets at the beginning of 2015, but due to portfolio losses and redemptions, it was down to $789 million at December 10. Illiquidity of the Portfolio Assets of a mutual fund have two pricing mandates: (1) a mandate under the Investment Company Act that, although detailed in overall methodology, is relatively general regarding specific securities, and (2) a process under Generally Accepted Accounting Principles, which, by dividing valuation into three methodologies, is somewhat more specific. By reason of its specificity, the GAAP definition tends to prevail in the valuation of individual securities. The last SEC-filed report on the valuation of the Focused Credit Fund’s portfolio securities, as of 7/31/15, shows that of the fund’s $1,953 million of assets, $171 million was priced in accordance with level 1 methodology, $1,399 million in accordance with level 2 methodology, and $382 million under level 3 standards. By the standards of most mutual funds, only level 1 assets are deemed to be liquid – that is, capable of being sold at a price near their valuation in a reasonable period of time. The Third Avenue Focused Credit Fund had over half its assets in level 2 and almost 20% in level 3, which sometimes is called “mark to myth.” These figures stand out starkly against the SEC’s general rule that open-end funds are to limit their holdings of illiquid securities to 15% of assets or less. Strategic Illiquidity Looking at Focused Credit Fund’s holdings, it appears that the deep value methodology that the fund adopted almost necessarily led to endemic illiquidity because securities of that type trade infrequently. Looked at in that light, the fund was almost bound to implode if the lowest-rated part of the high yield market declined significantly. And that is just what happened in 2015: The lowest rated high-yield securities performed far worse than the rest of the market. In that circumstance, a high level of redemptions was predictable, and an inability to sell the portfolio’s securities at reasonable prices in reasonable amounts of time also was predictable. Under and Over Valuations – Risks either Way In a way, I am surprised that the Board of Trustees waited so long to put the fund into liquidation because the responsibility for valuing level 2 and level 3 assets falls on the board itself, including its independent members. Although the board usually defers to management and often has a subcommittee that deals with valuations, the board as a whole is responsible. Thus, for a long period of time, the board has been blessing portfolio valuations that are hard to defend, even if they were done in the best of faith. Moreover, those who cashed out and those who held on had conflicting interests. Those who cashed out benefited from higher valuations; those who held on benefited from lower valuations. The board therefore has been or will be sued every which way. Liquidation is the only way to avoid further litigation risk for valuations. It appears from reading press reports that the officers of Third Avenue Management are concerned that they may have overvalued some portfolio securities. That surprised me because looked at from the point of view of a lawyer representing the independent trustees, a role I played often over a 30-year period, and the valuations should be conservative – on the low side. But it appears that the Third Avenue people are concerned about over-valuations. However, I now see that an investment manager has incentives to place valuations of the high side because that will keep the NAV up, which will tend to fewer redemptions and higher management fees. If the valuations were high, then stockholders that did not redeem may have been injured because stockholders that redeemed got more than they should have. In all likelihood, the remaining stockholders have a good class action. The board finally decided it had to liquidate the fund because no matter what valuation methodology it used, it would be subject second-guessing in court. Definition of Liquid Security Over the last year, I have written about the need for a better definition of liquid security. The definition, I have argued, is too loose; therefore, it is likely to lead to some funds holding far greater proportions of illiquid securities than the SEC thought safe – or than I thought safe. The industry has fought a redefinition because it has made money from the old definition. The liabilities that are likely to flow from this event may soften that opposition, and the events will strengthen the forces of reform. Here is what I said on this subject at NexChange.com about six months ago: The genius of the form is that forward pricing at net asset value prevents investors from gaming the system. Whether the market is going up or down, NAV is NAV. (Yes, there are issues with trading in different time zones, but those issues have been minor in most cases.) But the genius of NAV depends on two things: One, that it be a reliable source of true value; and two, that the underlying securities be, for the most part, liquid in substantially all markets. Many open-end bond funds have significant percentages of assets that are liquid under the SEC’s definition of “liquid” but that in a crisis would not be liquid-that is, they could not be sold except at a price far lower than their intrinsic value. If, due to redemptions, some funds were forced to sell such assets, the NAV of all similar funds would fall more precipitously than the intrinsic value of their underlying assets would warrant. This illiquidity problem could be solved by the SEC changing its definition of “liquid asset” to make it more stringent. Open-end bond funds then would have to avoid smaller issues that would likely be thinly traded and have practically no market in a crisis. But that will not happen because the fund industry is making too much money on their bond fund products. Besides, the problem is not likely to have a systemic impact because the illiquid issues are not due immediately and the losses that investors suffer will not, for the most part, be leveraged.” The liquidation of Third Avenue Focused Fund is evidence that my fears were well founded. In the same series of articles at NexChange, I discussed the difference between interest rate risk-based valuation issues and credit quality-based valuation issues. Here is what I said. It is applicable to the Focused Credit Fund style and experience. There is a big difference between wondering whether the interest rate on a particular bond is appropriate in the current market and wondering whether the bond will be repaid. The interest rate question an investor can quantify. At any given rate (the current risk free rate is known), the value, based solely on the interest rate, tenor and repayment options, is known. The spread between the implied market rate on the bond and the market rate on a similar duration Treasury reflects the market’s judgment as to credit risk. Traders will be quick to spot any anomalies and will take advantage of them, in effect stabilizing the interest rate side of the market. But when the issuer’s ability to repay comes into doubt, no one knows what the right price is, and the market may have no floor. That is what owners of sub-prime backed RMBS and their derivatives discovered on 2008. When credit quality is unknown, there may be no market price because there may be no market.” Contagion Will there be contagion for funds that look like Third Avenue Focused Credit Fund? Yes, if they really do look like it. But I expect there are not many of those. The unusual deep value nature of the fund’s strategy met up with that class of assets falling out of favor over the last year and seeing their value drop sharply. The bigger question is whether more ordinary high-yield open-end funds will suffer from contagion. First reactions, including that of the Wall Street Journal, appear to suggest there will be contagion throughout that class of funds. How far it will go remains to be seen. The tide has gone out. Now we will see who is swimming naked – that is, who really has a higher level of illiquid securities than they claim to have. That could be quite a few. According to research using the Schwab search engine, there are 82 high yield bond funds with over $500 million in assets, 28 with over $1 billion, and 3 with over $10 billion. That looks like maybe $48 billion of assets. That is a large number, but it does not seem like enough to be a systemic threat. (Yes, that’s what they said about the subprime mortgage market in 2007.) Two of the biggest are BlackRock High Yield Fund (MUTF: BHYAX ), and JPMorgan’s High Yield fund (MUTF: OHYFX ).