Market Strategy – Canaccord

The lack of security features on Internet of Things (IoT) devices could have fatal consequences, according to expert testimony at a recent House Energy and Commerce Committee hearing. As reported by Technology Review, computer security experts testified that computers used in hospitals and other sensitive facilities to control elevators and ventilation systems feature poor security. As a result, these connected devices are vulnerable to hacking, like the webcams, camcorders, and baby monitors that were attacked to cause a widespread Internet outage in the eastern U.S. in October. However, an attack on a hospital could have far more serious consequences than lost Internet access,

and result in the loss of life. While the Dept of Homeland Security and National Institute of Standards and Technology have issued guidelines on securing IoT, some believe the government needs to create a regulatory body to test and approve IoT devices and set universal device standards. The growing adoption of IoT devices will continue to underscore the importance of security, thus benefiting IT hardware and supply chain companies with strong security offerings, including HPE and IBM, as well as those companies manufacturing IoT devices.


JPM – Early Look – 12/5/2016

  • Market update – the Italian referendum outcome, while “bad” as far as risk sentiment is concerned, was also very consistent w/market expectations (the magnitude of the loss may have been a bit larger than anticipated but regardless “No” was expected to emerge victorious and contrary to other recent political events like Brexit or Trump, Renzi’s resignation isn’t likely to represent a seminal shift in either Italian or European politics).
Greg Blotnick - Lights
Greg Blotnick – Lights


  • Markets saw brief weakness following the Italian referendum news but have quickly reversed – the EUR hit 1.05 but has since rebounded to 1.06+ (it is flat-to-down small), US futures touched 2179 but have since rebounded to ~2200 (up ~7-9 points), and Eurozone equities are up ~1%.  Asian markets finished in the red, a function of timing (i.e. they closed before the post-referendum dislocation abated) and to a lesser extent the Taiwan/China news from the weekend (Trump talked to the Taiwan president late on Fri in a significant breach of protocol and decorum and he followed that up w/a tweet Sun night critical of China; while Trump’s team and the media are playing down the Taiwan call, the Washington Post said it was premeditated and deliberately provocative).  With Italy out of the way the calendar of major macro events left on the 2016 thins even further (other than the ECB on 12/8, FOMC on 12/14, and 2017 guidance from industrials such as GE, there aren’t many scheduled catalysts left this year).  However, the recent Trump trade/foreign policy comments does represent an underappreciated source of risk while his fiscal/regulatory agenda may be moderated/delayed as it makes its way through Congress (in fact the Taiwan developments and the Trump trade-related comments/events of the last week are arguably more incremental than the Italian referendum in that the former hasn’t been a big area of focus while the latter was very expected).
  • Calendar – the focus for Mon 12/15 will be on the US non-manufacturing ISM (10amET), Fed speakers (Dudley, Evans, and Bullard), and some analyst meetings (BDC, HA, BSFT, JCI, JUNO, Roche, and SLG).
  • Eurozone equities – the SX5E and SXXP saw brief weakness at the open before quickly rebounding (each is now up ~1%).  All the major sub-groups are higher but autos, insurance, luxury, and retail are outperforming.  Real estate, energy, and utilities are lagging (but each is still trading higher).  The Italian FTSEMIB is underperforming the rest of Europe (but is only down small).  The SX7P bank index is up ~0.75% although Italian banks are lagging.  Luxury stocks are outperforming (Swatch, Christian Dior, Richemont, etc.)
  • Treasuries/sovereign bonds – TSY yields are up small (2 and 10yr yields are up 2 and 3bp, respectively).  In Europe, Italy is the big focus – 10yr BTP yields are up ~12bp to 2.01% (keep in mind though that they are lower than the recent high of 2.13% set back on 11/24).  10yr yields are largely higher across the board in Italy (even Bunds where 10yr yields are up ~5.5bp).
  • FX – the DXY rose overnight after the Italian news but has faded from its highs and is now up ~20bp.  The EUR hit ~1.05 overnight but has since bounced to ~1.06 (flat-to-down small).  The JPY was flat at the time of the Japanese close but has since come for sale (it is off ~60-70bp vs. the USD).  The NZD is down ~80bp after the unexpected resignation of the country’s PM.
  • Asia – most of the major Asian markets finished in the red: Japan (TPX -0.75%, NKY -0.82%), HK (Hang Seng -0.26%), HSCEI -0.71%), mainland China (SHCOMP -1.21%, Shenzhen -0.78%, CSI 300 -1.69%), Taiwan (TAIEX -0.31%), Korea (KOSPI -0.37%), Australia (ASX 200 -0.8%), and India (up ~0.5%).  India was the only major market to see gains.  If the Asian bourses could have stayed open for a few more hours they likely would have performed better but unfortunately they had to close in the hours immediately following the referendum.  Asia-specific news was pretty quiet although the Trump/Taiwan/China news from the weekend did seem to weigh on sentiment a bit.  The services PMIs didn’t have a huge impact on trading.
  • Japan – it was an extremely quiet session to start off the week with a Risk-Off mood after a “no” vote in Italy. NKY traded lower as $/¥ couldn’t reclaim its ¥114 level after the dip over the last weekend post US NFP and ahead of the referendum. The rotation into Beta has run out of steam with Banks -1.8%, Insures -0.8%, Other Financials -1.4% lagging. On the flip side, Cyclicals remained strong as all commodity-related including Shippers +0.3%, Trading cos +0.3%, Machinery +0.1% rose on the back of iron ore, crude, and coking coal. In single stocks, SUMCO +3.8% rose on news Chinese Group may acquire wafer maker Siltronics as consolidation reignited hope for wafer price hikes. CHUGAI fell 2.2% on Shire’s report of adverse events FEIBA when used with a biosimilar to ACE910 for hemophilia (Roche/Chugai). SQUARE ENIX rose +3.5% on weekend Final Fantasy 15 sales updates. FAST RETAILING fell -2.2% on WTE SSS in November showing the divergence in 1H and 2H November results in the sector. Within retails, Ryohin Keikaku -0.3%, Adasria -4.4% slumped on inline Nov. SSS while only United Arrows +0.9% bucked the weak trend.
Greg Blotnick - Metals
Greg Blotnick – Metals
  • Hong Kong/China – HSI headed slightly lower -0.26% following a series of macro headwinds (Italy and Trump/Taiwan).  SHCOMP underperformed on fear of trade/currency war with the US (Trump’s Sun night tweet didn’t help).  Sector wise Rails -2.1%, Steel -1.9% and Infrastructure -1.7% plays were hit the most while Macau gaming stocks +2.1% were the clear outperformer. Macau ripped on ongoing re-rating and headed back towards 52-week highs; JPMorgan’s DS Kim raised PTs across the board to model the secular growth (Galaxy +2.5% Wynn +3.5% Sands +2.05%). For the HK insurers, Daily reported that China Unionpay card Nov overseas insurance deals plunged, AIA +0.55% reacted negatively and came off its highs. In the HK props CKP -1.26% fell hard after the announcement it will acquire aircraft leasing operations from CK Hutch -0.43%. Additionally CK Infrastructure -0.31% made a firm offer to acquire Duet Assets for A$3/ share, or a 28% premium. In the auto space, BYD -3.42% broke down on further speculation of EV subsidy cuts; Brilliance +1.31% pushed higher on growth expectations.  Lonking reacted very positively to the positive profit update up 7.50% in a red tape.
  • US macro updatetying all the recent moving pieces back to the SPX results in a relatively unchanged outlook.  Improving nominal growth (a trend underway well before the election), anticipation of the Trump/Ryan fiscal/regulatory agenda, favorable seasonality, and performance anxiety/chasing from people left behind by the post-11/8 rally are acting as tailwinds but headwinds include higher yields, a stronger USD, very elevated political expectations, and growing headline risk around trade/foreign policy.  Central banks have been an afterthought lately but two important decisions will be made in the next two weeks as Draghi and the ECB (on Thurs 12/8) announce the fate of the post-Mar APP (the market is anticipating a 6 month extension at the current EU80B pace) while Yellen and the Fed (on Wed 12/14) not only hike rates (which is widely expected) but update their 2017 dot and growth forecasts to account for the myriad recent economic developments (improved nominal growth, 4.6% UR, the potential for stepped up fiscal stimulus, etc.).

RBC on Trump – the 2017 playbook

December 5, 2016
2017 Outlook – The Trump Playbook


greg blotnick rbc.png
Trump On Rally
Interest rates and inflation expectations have jumped over the past five months on the back of a tight labor market and the promise of Trump’s pro-growth policies. While the market’s recent rotation might seem abrupt, the S&P 500 is up only 3% since election day, leaving it with substantial potential upside.
2017 S&P 500 Price Target of 2,500
In our post-election report “A Whole New World – Biggest Paradigm Shift Since Reagan”, we wrote, “we believe that rising earnings and multiples will push equity returns into the double digits from our previous high-single-digit baseline.” Consistent with this view, we are initiating a 2017 price target of 2,500, representing 12.4% potential upside (before
dividends) from our current target of 2,225. See pages 4–5 for details.
EPS to Reaccelerate (2016: $119, 2017: $128, 2018: $140)
Following two years of near-zero growth, we expect profits to re-accelerate. A better
operating environment for Financials and Energy should contribute to faster growth in 2017 (+7.6%). 2018 EPS growth (+9.4%) assumes a 2–3% impact from Trump policies. This place holder for changes in taxes, regulation, and spending is quite modest, in our view, as an adjustment to corporate taxes alone could easily double this impact.

Upside to Multiples
Our 2017 year-end target is predicated on a 17.9x multiple on 2018E profits. 2016’s target
assumes 17.4x on 2017E EPS. We believe multiples will advance more quickly than earnings over the near term, as analysts wait for clarity on Trump policies before adjusting estimates. Markets Advance/Rotation in the Early Innings Small Caps and Financials are leading the broader market, up 10.6% and 12.3%, respectively, since the election. The market has been quick to reward low-P/E stocks and those with higher price volatility, as well as names with higher effective tax rates and more domestic business models.

10-year Treasury yields are up 53 bps since election day, 102 bps since July’s low. Bund and
JGB yields have not kept pace with Treasuries, resulting in a stronger dollar.


Cut The Corporate Tax Rate to 22%

Good argument by Barrons

Cutting Top U.S. Corporate Tax Rate to 22%

Cutting corporate tax rates will boost the U.S. economy. But Trump’s 15% target is too low.

November 26, 2016
If President-elect Donald J. Trump and the new Congress are serious about firing up the U.S. economy, they will move swiftly to cut the corporate tax rate, now the highest in the world.

That one step would have far-reaching effects. It would make American businesses more competitive in the global arena. It would reduce the massive amounts of time and energy now wasted on tax-avoidance maneuvers. And it would bring home to these shores trillions of dollars of profits earned by U.S. corporations overseas and now housed in kinder tax jurisdictions.

Trump seems to appreciate all of that. On the campaign trail, he proposed slashing the rate that businesses pay on income from 35% to 15%. That might be too much—it could significantly reduce the government’s tax haul and add to the nation’s already unacceptable debt burden. Barron’s recommends a cut to 22%, which would be revenue-neutral, allowing businesses to produce just enough additional taxable income to offset the effect of the lower rate. And getting a 22% cut through Congress would be easier than 15%.

THE IDEA OF A revenue-neutral cut in the corporate income tax harks back to 1978, when economist Arthur Laffer was first cited as arguing that some tax cuts could generate enough added economic growth that the government would not lose revenue over the long term. Laffer also noted that most tax hikes generate less revenue than a conventional “static” analysis indicates, and most tax cuts lose less.

Laffer’s “dynamic” analysis covers all of the behavioral changes likely to result from a cut. To begin with, if the tax collector claims a lower share of income, there is an incentive to produce more income. Second, a lower rate means there’s less incentive to spend time and effort avoiding the tax.

That second factor—less tax avoidance—applies with special force to a rollback in the corporate income tax.

While granting tax breaks to big corporations goes against the grain of American populism, so should ceding the economic advantage of lower corporate rates to every other major industrialized country. And given the huge sums involved, it’s not hard to see why American companies operating abroad actively shop for low-tax jurisdictions.

Take corporate “inversions,” which many lawmakers deride as un-American. In an inversion, a U.S. multinational company is acquired by a company domiciled in a low-tax country, such as Ireland or Canada, where top rates are 12.5% and 26.7%, respectively. Profits earned in the U.S. continue to be taxed at the domestic rate, while those made elsewhere are subject to lower rates.

Democrats have cynically sought to outlaw inversions, rather than lower domestic tax rates, which would solve the problem by eliminating the reason companies seek out other residences. In effect, it’s a form of protectionism, and it doesn’t work.

Another tax-avoidance strategy is to locate subsidiaries in low-tax jurisdictions and to keep accumulated profits offshore; hence the roughly $2 trillion held abroad by U.S. corporations that are loath to repatriate this money because it would be subject to high U.S. taxes. Here again, a lower rate would bring revenue back to the U.S., rather than stranding it abroad.

Then there is the tricky business of transfer pricing. For example, a U.S. company purchases materials from a subsidiary in Ireland, where the tax on corporate income is much lower. Within limits, the price of the purchased materials will be exaggerated, thus reducing the profits of the U.S.-based company and boosting the earnings of that firm’s subsidiary in the low-tax jurisdiction.

THROUGH TRANSFER PRICING, then, prices on intra-corporate sales and purchases are set too high or too low, depending on the direction of the transaction. While Washington has tried to deal with cheating in this area—a wasteful exercise in itself, leading to costly litigation—it is obviously impossible to determine “correct” prices.

A tax reduction would reduce all of these incentives, generating more revenue for the U.S. Treasury. And by encouraging greater investment in the domestic economy, it would generate more revenue by resulting in more profit.

The Washington, D.C.–based Tax Foundation has argued that Trump’s tax-cut plan would result in a decline in government revenue because it “will encourage more investment and result in businesses deducting more capital investments, which would reduce corporate taxable income.” But over a 10-year time horizon—which the Tax Foundation itself studies—more capital investment will yield more profit and hence more taxable income.

And in the shorter run, there is the tax revenue generated by secondary effects. More revenue would come from shareholders, as they benefit from greater dividends and capital gains. And more would come from corporate employees, as they benefit from higher wages and salaries generated by higher spending on capital investment.

Over time, and taken all together, the revenue effects from a tax cut could even be positive. Meanwhile, the boost to economic activity would be palpable. Most of America’s trading partners have already discovered the dynamic supply-side effects of this tax cut.

Over the past 35 years, other countries have trimmed their top corporate rates by a far greater proportion than the U.S. Virtually every comparison between the burden of corporate taxes in the U.S., including state and local levies, and the rest of the world has shown that America’s burden is higher than most.

For example, as the chart shows, the top rate in the U.S., which combines the federal rate of 35% with four added percentage points for states and localities, comes to 39%. That’s higher than the combined rates for Germany (30.2%) and Japan (30%), and much higher than the United Kingdom’s (20%) and Denmark’s (22%).

Critics of corporate tax reductions point to the many loopholes that creative accounting already exploits. But according to one study, the effective corporate tax rate, which factors in these loopholes, still leaves the U.S. as No. 2 in the world in terms of its corporate tax burden, and noticeably higher than Canada and even “socialist” Sweden.

Harvard University economist Gregory Mankiw argues that corporations themselves are not the beneficiaries of tax cuts, contending that they are not really taxpayers, but rather tax collectors. It’s therefore an open question as to which of the corporate stakeholders is bearing the main burden of the tax. Many would say that it’s the company’s stockholders, with bondholders also contributing; others might say that the company’s customers pay up, as well.

Cato Institute senior fellows Chris Edwards and Daniel J. Mitchell take that idea a step further in their 2008 book, Global Tax Revolution, where they make the plausible argument that, in today’s world, the taxpayers are mainly the workers. “The burden of corporate taxes in the globalized economy,” they observe, “mainly falls on average workers in the form of lower wages. If U.S. and foreign semiconductor and pharmaceutical companies are not building factories in America because of higher taxes, it is American workers who lose.”

BUT IF YOU CAN RUN, you can’t hide. Companies have to pay taxes to some jurisdiction. If corporate rates across countries have been lowered over the years, then those who doubt the Laffer effect will expect that revenue from this tax has declined, especially given the tendency for companies to flee to lower-tax jurisdictions.

Barron’s tested this idea by updating a statistical run originated by Cato fellows Edwards and Mitchell. The results not only confirmed the Laffer effect but if anything, showed that a decline in the corporate tax rate seems to bring a rise in revenue, rather than a fall. In other words, instead of being revenue-neutral, the proposed cut might even be revenue-positive.

For 19 countries in the Organization for Economic Cooperation and Development—including the U.S., the U.K., Ireland, France, Japan, Germany, Switzerland, Denmark, Sweden, New Zealand, and Australia—Barron’s used that organization’s numbers to calculate a simple average, over time, of the top rate on corporate income, as tracked by the first line in the nearby chart.

In 1981, the earliest year for which data are available, the average top rate was 47.6%. By 2014, the most recent year for which data are available, the average had plunged to 27.4%. This decline of more than 20 percentage points came with only partial participation by the U.S., whose top rate, including state and local, fell by only 10.6 points over this period, to 39.1% in 2014 from 49.7% in 1981.

The decline in the average over each of these intervals was widespread. Fifteen out of 19 nations had lower top rates in 1995 than in 1981, and 18 of the 19 had lower top rates in 2014 than in 1995.

This collective race to the bottom conceivably could have brought a decline in revenue, but it seems to have brought just the opposite. The OECD provides figures for each country on revenue from the corporate tax, as a percentage of each country’s gross domestic product. From these figures, Barron’s calculated a simple average for the 19 countries for each snapshot year.

The figures are sensitive to the strength in the global economy; slow growth tends to lower revenue as a share of GDP, while faster growth leads to higher revenue. But the pattern is unmistakable. In 1981 and 1985, when the average tax rates were highest (47.6% and 47.8%, respectively), the tax takes as a share of GDP were at their lowest (2.1% and 2.3%). In 2000 and 2005, the tax takes were at their highest (3.5% and 3.3%, respectively), while the rates were among the lowest (35.4% and 31.1%).

Perhaps most decisively, the average tax rate in 2014 was at its lowest, at 27.4%. The tax take in 2014, at 2.7%, reflects slow growth. But in 1995, the take was at 2.5%, even though the average tax rate was more than 10 percentage points higher, at 37.5%.

“Despite complaints that corporate tax cheating is rampant and getting worse, these trends show the reverse. Tax avoidance seems to have fallen, which is one of the beneficial effects of rate cuts that all sides of this issue can support,” says Cato’s Edwards.

WHAT SORT OF REDUCTION works best? Out of concern for rising debt and deficits, and for the need for the White House and Capitol Hill to focus on the much harder task of cutting spending, Barron’s proposes a conservative approach.

In their Sept. 29 white paper, “Scoring the Trump Economic Plan,” Trump economic advisors Peter Navarro and Wilbur Ross propose reducing the top federal rate on corporate income to 15% from 35%. However, if the tax is meant to pay for itself, that 15% target may be too low.

A 2007 study by American Enterprise Institute scholars Alex Brill and Kevin Hassett (“Revenue-Maximizing Corporate Income Taxes”) found that there is indeed a Laffer effect with respect to lowering corporate income taxes. They estimated “about 26%” as the “revenue-maximizing point,” where revenue would actually run positive.

Barron’s favors this 26% target, which translates into 22% on the federal level, factoring in the extra four percentage points for corporate income taxes levied by states and localities. In order to bring the overall corporate tax rate to 26%, then, this means lowering the top federal rate to 22% from its current 35%, assuming the extra four percentage points remain unchanged.

Advisors Navarro and Ross address another issue: They propose a one-time “amnesty rate” of 10% to induce repatriation of the $2 trillion in profits that U.S. corporations are keeping offshore.

Since these companies have already paid taxes in the host countries where the money was earned, a case can be made for a zero rate. However, given concerns about possible revenue losses over the short term from a cut in the top rate, Barron’s favors the compromise of a 10% charge.

Last week, The Wall Street Journal reported that U.K. Prime Minister Theresa May endorsed a move to lower her nation’s top corporate rate from 20% to 17% by 2020. Other countries might respond with further cuts in their rates, which could give Trump support to get to 15%. Meanwhile, we favor 22%, because it encourages companies to invest more, while not reducing tax revenue.


Warren Buffett’s Meeting with University of Maryland MBA/MS Students – November 18, 2016


Warren Buffett’s Meeting with University of Maryland MBA/MS Students – November 18, 2016

 (Notes primarily taken by Professor David Kass, Department of Finance, Robert H. Smith School of Business, University of Maryland.  Additional notes taken by Beija Fu, Yanting Ma, and Shiyue Wu were also included.)

Warren Buffett (WB) (age 86) met with 20 MBA/MS or undergraduate students from each of eight universities/colleges, including the University of Maryland, on November 18, 2016.  (The other seven universities/colleges represented were, in alphabetical order, Boston University, Columbia University, Concordia (Montreal), Grinnell College, Marquette University, St. Louis University, and Yale University.)   Mr. Buffett responded to 20 student questions over 2 ½ hours.

Prior to responding to the questions, WB mentioned that his hearing is not as good as it used to be.  He said that recently he stood across the room from Charlie Munger (age 92) (CM) and said “Let’s buy General Motors at 33, do you agree?”  Since there was no response, he moved closer and repeated the same statement.  Again, no response.  Then he went very close to CM and repeated his statement.  CM replied “for the third time, yes!”

WB also invited all of the students to Berkshire’s next annual meeting in Omaha.  “Since Berkshire has invested in airline stocks”, the students “should fly first class to the annual meeting”.

Question 1:  What qualities do you look for in hiring people?

WB: Berkshire has only 25 people at headquarters, but 360,000 employees.  The managers of Berkshire’s 70 businesses choose their own people.  The qualities they look for are intelligence, energy, and integrity.  But the most important quality in a manager is having a passion for the business.  It is not IQ but passion for their businesses that make Berkshire’s 70 managers stand out.  When WB was 23 years old, he was rejected by Ben Graham for a job. Years later he received a letter saying the “next time you come to NY stop by my office”.  WB went the next day.  He never asked about pay.  You should take a job that you would take if you didn’t need a job.

Question 2:  What is the percentage of S&P 500 companies that are getting better?

WB:  WB has been on the board of directors of 19 public companies.  3G Capital has added discipline to Kraft Heinz and Anheuser Busch InBev.  Jeff Bezos is the best business person he has ever seen.  The quality of management has improved and they are paid better.  The CEO’s main responsibility is capital allocation.  Director fees are now about $300,000 – $400,000 per year and directors generally do little.  Berkshire’s directors buy stock in Berkshire with cash (rather than stock options used by most companies).

Question 3Are you concerned by the size of the national debt?

WB:  The gross debt of the U.S. is 100% of GDP, but the net debt (subtracting trust funds) is less, at 70%+ of GDP.  Our net debt was as high as 120% of GDP in World War II and as low as 35% -38% in the Reagan years.  As long as our debt is in dollars, it cannot cause us any problems. (We can always print more dollars.)  Taxes have accounted for 16% – 20% of GDP over time.  Medical costs today represent 17% of GDP, up from 5% in 1970.  The next highest country spends only 11% of GDP on health care.  Corporate taxes equal 2% of GDP down from 4% in the past.

Question 4:  Question about Joe Rosenfeld (Grinnell College)

WB:  WB was a trustee of Grinnell College for many years and Joe Rosenfeld at Grinnell was a hero of Buffett’s.

If you know who someone’s heroes are, then you will know how they will turn out.

(WB also mentioned that the most important decision we will ever make is in choosing a spouse.  “If you want a marriage to last, marry someone with low expectations.”)

Question 5:  What is your opinion of active vs. passive management?

WB: Passive management is active management in aggregate.  The S&P 500 represents the aggregate result of America.  Nine years ago WB made a $1 million bet (for charity) on the Vanguard S&P 500 (very low fees) against a fund of funds (hedge funds).  The S&P 500 has substantially outperformed the hedge funds.  One-half of the gross returns of the hedge funds has gone to the managers.  They have underperformed by 40%.  The portfolio managers are getting rich while failing their investors.  Find well-managed companies that grow over long periods of time and leave them alone.  That’s mostly a passive approach.  Buy and hold.

Successful investors need to have the right temperament.  Those with high IQ’s frequently panic.

Question 6:  What is your opinion of Dodd-Frank?

WB:  We are less well equipped to handle a financial crisis today than we were in 2008.  Dodd-Frank has taken away the Federal Reserve’s ability to act in a crisis.  In 2008/9 Ben Bernanke said he will do whatever it takes and only he could have stopped it (financial crisis).  Money market funds equaled $3 ½ trillion or 50% of the $7 trillion of deposits in U.S. banks.  This could have been the “greatest run” of all time.  Ben Bernanke was able to draw from the Emergency Stabilization Fund set up in 1933 with respect to gold.   In 2008, President George Bush said the 10 most important words ever in economics:  “If money doesn’t loosen up, this sucker is going down.”  But Dodd-Frank took this option away from the Fed.  Fear is contagious.  It paralyzes.  Confidence comes back one at a time, not by a stampede.  Both General Electric and Goldman Sachs were “in the domino line”.   We were lucky we had the right people.

Question 7:  What impact have the fixed income markets had on stocks?

WB:  Interest rates are to asset valuation as gravity is to matter.  It will take a lot of movement in interest rates (similar to Paul Volcker in 1981-2) before stocks are too high.  The interest rates on 30 year Treasury bonds have declined from 14 ½ % to 2 ½ % from 1982 to 2016.  Recently, the 30 year Treasury moved from 2.6% – 2.8%.  Stocks are cheap if long term rates are at 4%, four to five years from now.  “We are buying more shares than selling everyday unless interest rates move appreciably higher”.  A profitable trade would be to short the 30 year bond and go long the S&P 500 (assuming no margin calls).  But this is difficult to do on a big scale.  Borrowed money causes more people to go broke than anything else. Charlie Munger has said, smart people “go broke from liquor, ladies and leverage”.

Question 8:  Question about Jamie Dimon and best practices for asset managers

WB:  Discussed this topic in conjunction with the Economic Club of Washington.

Question 9:  Why doesn’t WB invest in tech companies?

WB: Ted (Weschler) and Todd (Combs) each have about $9 billion to invest. One or more invested in Apple. With Apple, people get hooked on things that they like.  WB has a competitive edge within his circle of competence (which does not include tech companies).   His circle grows wider over time but outside of his circle tech people know better than he does.  WB mentioned that he did not invest in Microsoft even though it had no cost of goods sold and was earning a “royalty on the world” since the world needed its operating system.

Question 10:  Is there a fundamental (investment) wisdom that you disagree with?

WB: Investing hasn’t changed much over time.  There were 15 students in Ben Grahams’s class (where WB was an MBA student at Columbia).  He focused on cash over 2- 3 years and certain returns.  A stock is a bond with coupons on it.  Berkshire Hathaway is a stock with coupons attached.  Several years ago WB invested in 15 South Korean companies selling at two times earnings.  He didn’t know much about the companies except for their low valuations. He purchased a diversified portfolio.  It worked out very well.  If you invest in good companies, you do not need to diversify.  Anyone with an IQ above 130 should sell off the excess above that level.

Question 11:  If you started with $1 million today, how would you invest it?

WB: “If I had only $1 million today, then something has gone terribly wrong.”  Today, with $1 million, he and Charlie would probably invest in four stocks.  When he graduated from Columbia (MBA), he had 75% of his net worth invested in Geico (then called Government Employees Insurance Company).  He started his investment partnership in 1956 with $105,000 and it was worth $105 million when he closed the partnership in 1969/70.

Question 12:  What qualities do you admire in others?

WB: Choose someone (among your friends and classmates) whom you would want 10% of their future earnings.  Someone who is generous with a good sense of humor and you would want to be led by them.

Question 13:  What is your opinion of high frequency trading?

WB: High frequency trading does not bring anything to the world.  It doesn’t hurt Berkshire.  WB recommends a tiny transaction tax.

Question 14:  What impact have the central banks had on stock markets?

WB: Central banks have pushed down interest rates and have affected the whole world. Europe needed negative interest rates.  The Federal Reserve’s balance sheet was $1 trillion 10 years ago and is $4 trillion today.  If WB could be reincarnated, he would like to come back as Chairman of the Fed.  It provides the fourth largest source of receipts to the U.S. Treasury.  It paid dividends last year (to the U.S. Treasury) of $117 billion.   It is the largest hedge fund of all time.  Its net worth of $4 – $5 trillion consists of $2 ½ trillion in Treasury securities and the Fed is responsible for over 3% of U.S. receipts.  Central banks have never been more important and no one knows how this (negative interest rates) will play out.   Where there is chaos there is opportunity.

Question 15:  What are your views on Tim Sloan (new CEO at Wells Fargo)?

WB: One-third of the country does business with Wells Fargo (WFC).  WFC broke a bond of trust, but the number of depositors will be higher one year from now.  Its balance sheet is $1 trillion – $2 trillion.  Former CEO John Stumpf created an incentive system with perverse consequences.  He should have acted quickly, but he did not.  John Gutfreund at Salomon Brothers in 1989 also was slow to respond.  One should face up to a problem fast.  “Get it right, get it fast, get it over”.  WFC will do fine over time.  Berkshire has not sold any of its shares.  Charlie says: “an ounce of prevention is worth a ton of cure”.

Question 16:  Question about Ajit Jain and insurance.

WB: WB was very lucky in January 1950 when he took a train from New York to Washington, DC on a Saturday morning to visit Geico. Since his hero Ben Graham was chairman of Geico, he wanted to learn as much as he could about it. He knocked on the door and a janitor came out.  WB  didn’t know that people in Washington did not work on Saturdays (as they do in Omaha).  WB asked: Is there anyone here besides you?  Fortunately, an executive (who later became CEO), Lorimar Davidson, was there and then spent the next 3 – 4 hours explaining the business of insurance.  It transformed WB’s life.  Berkshire bought National Indemnity in 1967.  In 1986, Ajit Jain walked into his office on a Saturday.  Today, 30 years later, Ajit runs Berkshire’s reinsurance business and talks to WB every day.  Ajit “reinvents business hourly” (after 9/11) as compared to Geico which has had the same business model since 1936.  Ajit’s business will be very different 10 years from today.  Berkshire offers its employees $1 million per year for the rest of their lives if they can predict which teams will be in the “Sweet 16” in the annual March Madness (college basketball).  The average policy at Geico costs $1700/year.  Some Geico employees have 4 times the productivity of others (selling policies) over the phone.  “When talking to someone on the phone, put a photo of the person you love most on your desk and talk in the way you would talk to that person”.

Question 17:  Will technology replace human intelligence?

WB: Technology will not get rid of the human element of fear and greed.  You cannot program a computer to produce a durable competitive advantage nor create passion for employees. Berkshire is not at a disadvantage now.  WB prefers Ted (Weschler) and Todd (Combs) over computers.

Question 18:  What was WB’s biggest mistake and what did he learn from it?

WB: His initial three businesses are now out of business – (1) Berkshire Hathaway – textiles, (2) Blue Chip Stamps, and (3) Retail division – department store in Baltimore. He has made some “people” (hiring) mistakes.  The worst part of his job is having to terminate an employee.  He regrets “things I haven’t done even though I thoroughly investigated, but I didn’t do”. (Errors of omission rather than errors of commission)

Question 19:  Why has Berkshire invested in airlines?  Doesn’t WB avoid cyclical industries?

WB: WB will not discuss his recent investments.  But he almost lost a lot of money in US Air Preferred (1989).  For a while he could not sell his holdings for 25 cents on the dollar, but did end up selling it for 200 cents on the dollar years later and made a big profit.  Normally smaller positions (under $1 billion) are Ted’s or Todd’s.

Question 20:  What is the most important skill in finance?

WB: The most important skill in finance is salesmanship.  That’s how you convince someone to marry you and that’s how you get a job. The most important quality to do well is temperament which would permit the control of fear and greed which have ruined many.  Anyone who has become rich twice is dumb.  Why would you risk what you need and have for what you don’t need?  If you are already rich, there is no upside to taking on a lot more risk, but there is disgrace on the downside.

Finally, WB concluded by telling the students to “vote for me and not Charlie at the annual meeting.”




Wilbur Ross – Infrastructure Finance

The Trump Private Sector Financing Plan

The Trump infrastructure plan features a major private sector, revenue neutral option to help finance a significant share of the nation’s infrastructure needs. For infrastructure construction to be financeable privately, it needs a revenue stream from which to pay operating costs, the interest and principal on the debt, and the dividends on the equity. The difficulty with forecasting that revenue stream arises from trying to determine what the pricing, utilization rates, and operating costs will be over the decades. Therefore, an equity cushion to absorb such risk is required by lenders. The size of the required equity cushion will of course vary with the riskiness of the project. However, we are assuming that, on average, prudent leverage will be about five times equity. Therefore, financing a trillion dollars of infrastructure would necessitate an equity investment of $167 billion, obviously a daunting sum.

We also assume that the interest rate in today’s markets will be 4.5% to 5.0% with constant total monthly payments of principal and interest over a 20- to 30-year period. The equity will require a payment stream equivalent to as much as a 9% to 10% rate of return over the same time periods. To encourage investors to commit such large amounts, and to reduce the cost of the financing, government would provide a tax credit equal to 82% of the equity amount. This would lower the cost of financing the project by 18% to 20% for two reasons.

First, the tax credit reduces the total amount of investor financing by 13.7%, that is, by 82% of 16.7%. The elegance of the tax credit is that the full amount of the equity investment remains as a cushion beneath the debt, but from the investor point of view, 82 percent of the commitment has been returned. This means that the investor will not require a rate of return on the tax credited capital. Equity is the most expensive part of the financing; it requires twice as high a return as the debt portion, 9 to 10% as compared to 4.5 to 5.0%. Therefore, the 13 percent effective reduction in the amount of financing actually reduces the total cost of financing by 18 to 20 percent.


By effectively reducing the equity component through the tax credit, this similarly reduces the revenues needed to service the financing and thereby improves the project’s feasibility. These tax credits offered by the government would be repaid from the incremental tax revenues that result from project construction in a design that results in revenue neutrality. Two identifiable revenue streams for repayment are critical here: (1) the tax revenues from additional wage income, and (2) the tax revenues from additional contractor profits.


markets · tech

What Does Tracking Error Mean for Your Money? Greg Blotnick, CFA

Source: Greg Blotnick – What Does Tracking Error Mean for Your Money?

By Jeff Brown | Contributor

Nov. 7, 2016, at 9:00 a.m.

Investors who study their index funds closely eventually learn of tracking error – the difference between the fund’s performance and that of the underlying index it follows. Since index funds own the same securities as their benchmark indexes, there should not be much difference.


But aside from knowing that a small tracking error is better than a big one, is this something we should really care about?


“Ultimately, tracking error is one factor among several you should consider when deciding to purchase any index fund.” says Anthony D. Criscuolo, planner and portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida.


In most cases, tracking error causes an index fund to do worse that it’s benchmark rather than better, and small reductions in returns can add up to significant money over many years of compounding.


And in some cases, the error can be enormous, says Greg Blotnick, a hedge fund equity analyst in New York. He notes the wide tracking error of exchange-traded notes designed to follow the CBOE Volatility index that measures volatility in the Standard & Poor’s 500 index.


The most popular examples are the iPath S&P 500 VIX Short-Term Futures (VXX), the VelocityShares Daily 2x VIX Short-Term ETN (TVIX) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY), he says. These products are designed for intra-day trading and hedging, not as long-term holdings. Some use leverage to amplify results, which can magnify losses.


“If you had invested $400,000 in UVXY when it was first introduced (several years ago) you would have less than $100 today,” Blotnick says.


Despite those examples, ETFs generally have very small tracking errors. That’s because fees are very low, and, since ETFs are traded like stocks, they do not have to buy and sell securities to meet investor purchases or sales, so it’s easier for these products to march in lockstep with their underlying indices.

Actively managed funds typically use market indexes as performance benchmarks. But because their goal is to beat the benchmark rather than mirror it, their holdings may be quite different from the benchmarks’ performance.


Do Actively Managed Funds Really Pay Off for Investors?

A potential for excellence also means higher fees.

While that’s a cause for concern if the managed fund trails its benchmark, this is simply poor performance and not the same sort of tracking error found in index funds.


“Actively managed funds do not attempt to duplicate an index,” says James B. Twining, wealth manager at Financial Plan in Bellingham, Washington. “Instead, they generally strive to outperform it. In other words, they seek tracking error on the upside.”


So true tracking error is mainly a worry for investors in index mutual funds and exchange-traded funds.


Usually, the chief culprit is the index fund’s fees, or expense ratio – money taken from the fund’s assets to pay for staff and other management costs, Criscuolo says.


“If an index fund operates at full efficiency, you would still expect the fund to trail its underlying index by however much it charges the investor in fees,” he says. “The underlying index has no fees, but the index fund does. All else being equal, a less expensive fund will have lower tracking error.”


Error also creeps in if the index fund does not actually own all the securities in the index it follows, he adds, explaining that this is particularly common in bond funds that include hard-to-get securities.


“Some index funds rely on sampling to save on trading costs,” Criscuolo says. “Sampling can introduce tracking error, positive or negative, into a fund’s performance. Similarly, funds that track relatively illiquid securities, such as commodities or currencies, face greater price volatility.”

Human error and plain old luck can also contribute, according to Nicholas Yrizarry, CEO of Nicholas Yrizarry Wealth Management Group in Laguna Beach, California. Rising markets can attract a flood of new investment in the fund, forcing the manager to buy more securities, affecting the fund’s costs, while the index itself does not buy or sell.


“Other common factors that affect tracking error are cash drag, rebalancing frequency of the underlying index, and securities lending by the index fund,” Criscuolo says.

Tracking error can clearly matter to big institutional investors trading very large volumes and fretting over even the tiniest price variations. But what about ordinary investors likely to hold an index fund for years, or even decades, for college or retirement?


Small investors are indeed wise to look for how tracking error may affect their results, Criscuolo says, noting that the simplest way is to look at the fund’s performance over time versus that of its index, figures available on fund company sites and data services like The more the fund’s performance lags the index’s, the bigger the problem.


For the past five years, the granddaddy of index funds, the Vanguard 500 Index Fund (VFINX) returned an average 13.38 percent a year, while the S&P 500 returned 13.54 percent, according to Morningstar. That small difference is almost entirely explained by the fund’s 0.16 percent expense ratio.

Meanwhile, the Rydex S&P 500 Fund Class A (RYSOX), tracking the same index, returned just 11.70 percent a year, trailing the index dramatically. The chief cause: a 1.55 percent expense ratio, a whopping charge for an index fund.


Why do people buy expensive index funds with large tracking error when there are better alternatives? Either they’re not looking closely or their advisor has talked them into it. The Rydex fund also charges a 4.75 percent load, or $4.75 for every $100 invested, to cover the advisor or broker’s sales commission. The Vanguard fund, and many from other firms, can be purchased directly from the company with no commission.


Investors who want to get into the details of tracking error can look at figures like R-squared, a measure of how well the fund’s movements track the indexes, and Beta which shows how the fund’s risk compares to that of the index, Criscuolo says.

While tracking error is a minor disappointment with most index funds, it can be catastrophic in extreme cases, and is a window into how well the fund is managed, and whether the fund is providing all the efficiencies indexers promise. With managed funds, it shows whether the managers have drifted away from their game plan. Among funds that are similar in most respects, the one with the smaller tracking error is generally the best choice.

dying industry · markets

RBC’s McElligott – Big Picture

OVERNIGHT / MACRO: Chief Risk Officers still in charge of trading books apparently, with DAX and Estoxx -0.9% so far today / SX7E EU Banks -5.5% on week as crowded tactical longs built in recent weeks are purged, NKY -3.1% on the week, CL1 through $45 cleanly to the downside, $/Y under 103 and shorts from Yuan to GBP to USTs being covered in front of next week’s obvious event risk, as the lessons from the Brexit vote (outlined in the “RBC Big Picture” yesterday) are mechanically applied.

greg blotnick - LS equity index.jpg

Rates have gone from “THE” story to complete background, banging-around the gravity of the 1.80 absolute level as leveraged fund shorts are covered into the ‘risk-off’ move of late, but aren’t terribly-squeezed as the overseas real $ demand drivers are largely ‘hand-sitting’ until after the election.  That said, the UST curve steepening has been real of late (2s10s, 2s30s and 5s30s all through their 200dma’s to the upside).  As suchwe see that S&P Financials are the only sector that quarter-to-date is positive at +1.1%.


This lack of a larger more meaningful fixed-income rally against the risk-asset selloff is clearly a negative performance driver for risk-parity funds, while too we can assume that shorter-term ‘vol control’ allocation models continue to drive negative price impact via their stock weightings (sliding allocation / leveraging scale), as spot vol’s grind higher saw a larger ‘grabbier’ move yesterday.  5 day realized SPX vol has traveled from 1.385 last Friday (pre FBI) to yesterday’s closing level at 5.0…for relativity, that’s a not-so-chillaxed +261% move in five sessions.


Despite that fact that nearly every discretionary trader I speak with wants to “buy a Trump sell-off”, it’s painfully ironic that the de-risking driver revolves around this ‘constant re-pricing’ of Trump’s odds higher / tighter.  I laid-out the thought process around trading various election scenarios yesterday so I won’t delve back into that…but I will say that speaking with folks who embedded with polling-dynamics / polling-analytics teams, the recent and profound momentum-swing into Trump from HRC is a force that is exceedingly difficult to stop this close to “go time.”  As such, there is a real belief by many that key bell-weather States of Nevada, Ohio, Iowa and Nevada have tightened / shifted in his favor “real time.”  Add in similar observations in Pennsylvania, and you could suddenly get to the required 270 electoral college votes.  Based on this ‘coin flip’ bringing back the Brexit memories, CRO’s have to take books down aggressively and unemotionally so as to avoid ‘accidents’ come Wednesday….even if the qualitative muscle-memory and intuition tells them that Trump would likely ultimately be a tactical “buy.”


Unfortunately this morning, we have “this” bleeding into the fragile investor psyche on top of already jangled nerves: Sources: U.S. intel warning of possible al-Qaeda attacks in U.S. Monday.”  And worth reiterating from yesterday’s note: on top of the increasing sense that this current US election risk-event overhang will linger for weeks and months to follow, we catch another reminder of “what’s to come” between now and year-end, as just now, we get this headline: Italy Referendum: Yes 38%, No 39%, Undecided 23%: Ixe Pol.”


THE CURRENT INSANITY OF SINGLE-STOCK BEHAVIOR: Apologies to pure macro readers for so much stocks focus of late, but it continues to be accurate to say that all of the action is taking place in equities right now…and stick with me, because there is  some good macro thought-below.  Man was yesterday a bizarre one in US equities….and even stranger, it’s happening in a relative vacuum, as the rest of the macro / cross-asset universe is lulled to sleep with much tighter ranges on the day..


The behavior in equity vol is one thing (as tails were massively bid yesterday—SPX 1m 80% moneyness was +10.2% on the session, while ‘vol of vol’ is now +34 vols / +40.1% over the past 8 sessions)…but the price-action in single-stock was the stuff we haven’t seen since the Q1 market-neutral factor unwinds ripping through the pod-shops…where for a stretch in late Jan / early Feb, teams / books were being blown-out on daily basis around the Street.


Back then, it was ‘bad-positioning’ from the buyside based on macro impact on style factors.  1) Everybody came into January ‘16 long growth & momentum (and thus, “high beta”), aka “story stocks” in tech and discretionary, along with major healthcare sector overweights (biotech / spec pharma / generic drug makers).  Similarly, there was a huge belief in “short bonds” to start the year too–as seemingly the Fed’s long-awaited rate-hiking cycle had just begun the month prior–as such, 2) there was a massive long in financials / banks on expectations of higher rates.  And to put the cherry on top, 3) there was a major quant / stat arb long in energy, anticipating a January ‘mean reversion’ (a tried-and-true back-tested phenomenon).


In hindsight, it is absolute insanity how ‘bad’ that all was—you couldn’t construct it any worse.  As such, the pain trade “went to 11,” as risk-assets were purged under the weight of the deflation scare: China came out of the gates with further Yuan devaluation, crude was -10% on the month, and UST 10Y yields were absolutely obliterated, moving from 2.30 the last day of Dec ’15 to 1.65 by Feb ’16. With all of this, growth and momentum came unglued, the move lower in rates not only crushed bank longs but also too saw a massive rotation into the (dreaded) ‘bond proxies’—‘low vol’ factor, dividend yield, defensive sectors.  You know the rest…


So fast-forward to now: what’s so incredible about the behavior witnessed over the past few days ‘under the hood’ is that relative to all of our recent drawdowns being so clearly macro-driven (deflation / reflation events of the past two years—Yuan deval, crude spasms, Yellen “weak USD policy pivot” / “Shanghai accord,” CB coordinated messaging on “curve steepening” intent, the inflation impulse bond-beatdown etc)…is that this equities move started as simple “de-risking in front of a ‘fluorescent swan’ of a binary US Presidential election”…that has now crescendo’d into a really bad VaR outbreak.


While on the benchmark index level we saw a “barely a paper-cut” 9-handle move in SPX yesterday(-0.4%)…we saw 29 US Composite names with market caps north of $25B dollars which traded -1.5% or (much) greater on the day—heavy-hitters like Kellogg, Apple, AbbVie, Humana, Liberty Global, Intel, Kraft Heinz, Charter Comm, Constellation Brands, HCA Holdings, Starbucks, Target, Anthem, Pfizer, Estee Lauder, Amgen, Lockheed Martin, CVS Health, Kroger (-3.7%), AIG (-4.0%), Allergan (-4.0%), McKesson (-4.6%) and index mega-weight Facebook (5th largest weighting in SPX, -5.6% on day).  Other popular longs like CHD (-6.6%) and THS (-19.5%!) got smoked too, while more idiosyncratic political drama crushed the generic drug maker space, with PUNISHING capitulation in MYL (-7.0%), ENDP (-19.5%) and TEVA (-9.5%) amongst others.


The tech sector has been “THE” hiding place recently for investors, on account of folks getting increasingly nervous about riding their cyclical longs much further here after the run they’ve been on (and crude rolling over sharply -9% on the WTD as the OPEC “deal” looks like anything but)–but also being hyper-cognizant of the inflation base-effect’s lagging-impact on bond prices (higher yields) and purportedly a Fed still committed to a Dec hike (with a steady-state world of course) makes putting back on the ultra-expensive ‘bond proxy’ / ‘low vol’ factor / defensive trade look quite unattractive as well.  So despite tech being such a ‘stud’ recently (XLK +10.2% in Q3), it’s received the ‘rented mule’ treatment as effectively an “ATM” of late (with ‘FANG’ -4.4% over the past 5 sessions, XLK -2.6% over past 5 sessions). 


But maybe the strangest thing experienced was seen amongst seemingly popular and thus theoretically winning short positions, where we saw huge outlier downside moves—BW (-10.3%), FSLR (-15.0%), FIT (-33.6%) and DPLO (-42.1%).  This is simply abnormal.  How do I rationalize this?  Well in ‘max pain trade’ fashion, I think that sadly many had actually given-up on these shorts over the outrageous daily-grind higher period in Q3—remember, SPX was +3.3% on the qtr, Russell 2k was +8.7% and (drumroll please….) the GS Most Shorted Basket was +14.5% on the quarter.  So what we’re seeing this week is that the right ideas that folks once had on in their short books—but were forced to capitulate on during the face-ripping rally in Q3—actually saw their short theses play-out to a tee.  The companies reported terrible quarters, and as such, were promptly hammered and punished / re-deployed by guys who originally had the trade right…but had sadly ‘tapped out!!!’  Just gutting stuff…


Ironically though this time around, we see equity market neutral funds performing very well relatively speaking to long-short or long-only.  take a look at one widely followed quant’s open-end market neutral fund against the HFR Equity Long / Short Index, ‘High HF Concentration basket’ and ‘Mutual Fund Overweights’ baskets over the past two months:



Charlie McElligott – Food For Thought

Dropping the overnight cacophony of noise out of UK Brexit rulings, ECB headlines and US poll updates…I want to instead discuss trader mindset over the past week and into next week and thereafter.


ELECTION SCENARIO FEEDBACK: I have spent the vast majority of the past week engaging some of our brightest clients in my feedback loop on (completely unsurprisingly) US election scenarios.  Here are a few key bulleted observations:


–Overall largest take-away was that this de-risking in stocks has been so orderly and grinding due to the buyside’s lessons from underestimating Brexit possibilities in June, EVEN THOUGH the odds are still in the favor of the perceived “market positive” HRC outcome.  This de-risking is thus a “slow-bleed” and not a panic-grab, as Brexit was much closer to a true “toss up” going into the vote, versus this still likely ’70 / 30’ probability for HRC.  Recall, folks were taking nets HIGHER days into that event-risk.  As you’ll see below, the performance of thematic baskets in my monitor yesterday shows that longs have been taken-down rather precipitously (although somewhat surprisingly that some shorts are currently being added to as highlighted in recent days).  I would add another complication is the timing with “peak earnings” idiosyncratic risk, which has been showing us a number of outsized price reactions, and as such is adding to an overall desire to ‘gross down’ over the longer past week time frame.


From a vol perspective, for net exposure at HFs to be cut so low so fast, and for cash to be so high now at MFs heading into the event, it makes some sense to me that there is less “panic grab” for VIX upside simply because folks aren’t all that long / don’t have that much to protect now.  That said, there are certain products and lines where the vol is rich and straddles are pricing in some large moves which I will touch-on later.  And also pretty simply, as VIX is calculated based upon 4th and 5th week SPX options strip…and as this is a ‘one week out’ event, it’s just not being “picked up.”  Thus “VOL OF VOL” (VVIX, convexity) is showing far greater relatively movement than the “underlying” VIX.  As such, “vol of vol” is probably the best sale of all (sell VIX straddles).


–Outcome-wise, all were of consensus view that you can now throw-out the ‘risk’ of a Democratic sweep…a scenario that was a very real threat as of last week at this time.  Too much momentum has been lost in the past week.


–Ironically (with regards to the swing from one end of spectrum to other), there now is a view that the seeming momentum in the Trump camp could actually create a scenario that was previously “zero delta” which is now a “non-zero” probability of a “Trump Presidency / GOP Congress” regime could produce a “right tail” economic scenario–where the tax plans and deregulation movements could get more economically provocative for both individuals and small businesses.  Again though, this remains low probability.


There was a relatively widespread view that in the case of an HRC win (where the probability was perhaps ‘down to’ 60 / 40 yday, although some might say that lack of further surprises and even stabilization per the new earlier-referenced WaPo tracking poll would see that more like a return to 70 / 30 odds in her favor as of today), that there might be a +2% upside from here on a relief-rally, as markets would essentially claw-back what has been lost over this very calm de-risking bleed. 


–There was dissent on “where to from there (an HRC win)” as a number of folks are pushing outright “return to bull market” case—with this moving from a ‘rates / monpol’ focused equity backdrop transitioning to an ‘earnings-driven’ one.  My pushback there remains that earnings probably haven’t moved the needle enough to re-rate stocks against the headwind that comes in the form of higher rates and their impact on the ERP.  Equities still feels “stuck” to me, even after a likely ‘relief rally.’


–Regarding a Trump win, there was some debate on the next day SPX drawdown (-2% to -3% was the general ‘max’ view, with one outlier -5%), but nearly all agreed that there was a desire to ‘buy it.’  One would come from perceived “Brexit FX benefit,” i.e. that if the Dollar re-rated rapidly lower (essentially a devaluation) that US exporters would see the equivalent benefit (which was what we saw with Brexit and FTSE of course).  The other inputs here are of course the “steroid shot” of both the tax cuts on consumption / demand, the potential for de-regulation, and of course the GDP-kicker that is a massive deficit-spending infrastructure build program.  Other views are too that if bonds were to rally on “risk off” that it makes sense to sell it (especially with the growthy / inflation-inducing policy to come), while others thought that any USD kneejerk lower should also be bot on account of longer-term potential repatriation of overseas corporate cash (part of Trump platform during election), as well as potential for big data looking a year out under the regime.  That said, all were in agreement as to the eventual very bad hangover to follow from this debt binge while cutting tax receipts and not touching entitlements.


So outside of this feedback exercise….what is always a trade of interest to me is a ‘risk reversal’ or generally asymmetrical ‘skew buying power’ trade with stock index (selling one 10% otm SPY put to finance a buy of almost 19 10% otm calls!!!) into an environment where there is a rush for protection…as evidenced currently by the front-end of the VIX curve inverting, with Nov over Dec now.  Add in the overall portfolio de-risking we have been seeing, high cash / low net exposures, rapidly collapsed sentiment as contrarian ‘bullish’ indicators—in conjunction with ‘positives’ like a pick-up in global growth (Manu PMIs) and earnings trajectory—and it seems like a pretty obvious set-up for a ripper of a rally following the election.
But here is where I struggle with this idea of “fitting” a further rally into Q4: I am increasingly concerned that a relief-rally following an HRC election scenario might be somewhat short-lived due to so much overhang: outstanding FBI investigations in the air and legal noise on ‘contesting the vote’…i.e. this isn’t going away.  I also think that if you look at the ‘windows’ to put on ‘pro-risk’ trades between now and year-end with the US election (and whatever follows), the Dec Fed hike determination, the Italian referendum, now the British Supreme Court “Brexit / Article 50 Appeal” et cetera, you end up with a lot of idiosyncratic event-risk for a fragile buyside psycheThe sequencing and thus the risk / reward isn’t extremely compelling attractive.  When I then add this to anecdotal feedback from many funds I speak with, who are verbalizing a desire to ‘end the year now’ and ‘protect gains’ (predominantly made in Q3 to get back into “up mid-single digits YTD”), I just don’t know how much willingness there is to chase or put on new risk.  That said, surviving and starting a new year ‘fresh’ in Q1 WOULD be a new opportunity to pivot more ‘risk proactive’ again. 


One observer at a macro dinner I participated in last night stated that although he understood this view on “Q4 rally reticence,” he also thought that that same Q3 performance claw-back which got many funds back to “up lower to mid-single digits” YTD has now seen a couple percent shaved off of that with the friction “getting out” over the past week.  As such, this person believed that funds sitting near zero then WOULD BE candidates to prep for performance chase into this “seasonality / buyback resumption / election relief / under-positioning / over-bearishness” rally scenario. 


It’s all food for thought.


Deutsche on 3Q Earnings Season

Some thoughts on 3Q so far and what to expect:

-Banks kick off earnings season with decent beats, but point to ongoing NIM
pressures, even with a Dec Fed rate hike, and other macro and regulatory
challenges to achieving good EPS growth in 2017. We expect the rest of 3Q
reporting season to be even more sobering. Most companies will beat the last
minute estimates, but beats will be smaller than usual and 4Q16 and 2017 EPS
outlooks will be tempered. The greatest risk of disappointment is at Consumer
stocks, Industrials, Materials and even Energy despite low expectations. We
believe Tech & HC will have among the more encouraging results and outlook.
3Q S&P EPS is likely ~$30.00 or flat y/y or up 3% ex. Energy, Fin & Real Estate
Today’s bottom-up aggregate analyst 3Q EPS estimate for S&P constituent companies as of Sept end is $29.98, which compares to $30.12 in 3Q last year. On a current constituent basis, we expect S&P EPS flat y/y or up 2% q/q. 3Q EPS growth should be 3% ex Energy or ex Energy, Fin & RE. S&P EPS growth ex. Energy, Fin & RE has slowed in recent quarters to ~3% and 3-5% seems most likely for 4Q16 & 2017. Oil prices remain a wild card for 2017, but we expect oil to avg. $55/bbl and the Energy sector to earn $48bn. The aggregate market cap of the Energy sector is $1.35trn or 28x 2017E EPS.

The direction of fundamentals matters, but what’s priced in matters most
In recent weeks, spot oil climbed to a bit over $50/bbl and 10yr Treasury yields climbed to slightly exceed 1.75%. Rising oil is good for Energy earnings and rising long-term yields better compete with dividend yields, but the direction of such fundamentals must be judged relative to the destination expected or priced by the stocks via their valuation. In the case of Energy, we believe oil must climb to $70/bbl by 2018 to justify today’s observed valuations and make their forward PE fall to about 15-16 by 2017 end from 28 today. Because we’re skeptical of $70/bbl oil in 2018, ~$60/bbl seen as more likely, we think the Energy sector will be flat to down 20% in 12-months. In the case of Utilities, we think 10yr Tsy yields must climb to 4.5% in 2018 to make the sector’s 17x forward PE fair. Because we expect the 10yr yields to stay below 2.5% in 2018, and real long-term yields not to exceed 1% for many more years, we think a 20-22 forward PE (3.0% div yield) is fair for Utilities suggesting 15-25% upside.

Consider CAPM in a 1% real Rf rate world: High dividend cyclical most at risk

Right now, 10yr TIPS yield 10bp, up from 0bp a few weeks ago, which suggests the 25bp climb in 10yr yields is mostly from higher expected inflation. PEs are influenced by real interest rates and a fair real cost of equity. We value the S&P by assuming 10yr TIPS will yield 1.0-1.5% around 2025. To this expected “normal” real Rf rate, we add a 400bp Equity Risk Premium to estimate the S&P’s overall real Ke at 5.0-5.5%. By sector, we adjust the ERP depending on its beta or cyclicality. By this method, the real Ke for defensive sectors with a 0.8 beta is 4.5% and for cyclical sectors with a beta of 1.2 about 6%. This suggest that a fair PE on normalized trailing non-GAAP S&P EPS is ~18.5 (1/real Ke), but 21-23x for most defensives and 15-17 for most cyclical sectors (1/real Ke). We don’t think low beta bond substitutes are overvalued, rather we fear many cyclicals with 3%+ dividend yields are pricey because investors are overlooking macro risks and challenges for 3%+ dividend yields.