03/19/19

Will Hedge Funds Reinvent Themselves?

By: Kent Engelke | Capitol Securities

A hedge fund pioneer whose quantitative models became the basis for today’s algorithmic trading models is on the verge of throwing in the towel.  David Harding is credited with pioneering the quantitative models in the mid-1980s, models that are now greatly replicated and are failing miserably because of the popularity of trend-following and risk-based parity models. 

Harding commented that he now has to “reinvent himself” given the “perceived efficiency of computers that systematically buy and sell according to programmed instructions,” trading on information that is perhaps nothing but noise.

Many market luminaries have commented about the impact of high-speed computer-based trading that has destroyed historical benchmarks, creating a false sense of liquidity.

Over the past three years, a record number of hedge funds have closed while capitalization-based passive ETFs have flourished. To put it differently, the best and brightest minds in finance are going out of business while the passive no-brainer investment funds focusing almost entirely on capitalization are doing great. 

Wow!  Talk about an imbalance. Will this massively overcrowded strategy follow the same path as hedge funds? If history is a guide, the answer is yes. A basic premise to this strategy—if you can call passive buying a strategy—is to find more people to buy more of the same over-owned companies. Sometime the buyers will exhaust themselves or conditions will change.

The greatest investors have been big picture people, focusing on the substance of geopolitics and macroeconomic research versus thoughtless style.

Many are focused on today’s commencement of the two-day FOMC meeting. As widely known, the Central Bank radically changed direction on January 8th adopting a “patient” outlook regarding monetary policy following a tumultuous December. Two weeks earlier, the Fed was focused upon a more active monetary policy including increasing bond sales.

No change is expected but I am certain every word will be parsed. 

I continue to argue that growth will continue to surprise on the upside, strength that may again alter monetary policy expectations.

Markets were quiet relatively quiet yesterday. Will the calm extend into today?

Last night the foreign markets were up. London was up 0.59%,  Paris was up 0.50% and Frankfurt was up 0.87%. China was down 0.18%, Japan was down 0.08% and Hang Sang was up 0.19%.

The Dow should open nominally higher awaiting numerous central bank announcements. The 10-year is unchanged at 2.60%.

12/13/18

Tectonic Change And Henry Blodget




By: Kent Engelke | Capitol Securities

Many times I have commented that geopolitical changes are tectonic. Globally, the policies and politics that have dominated since the conclusion of WWII are under attack as the commoner feels abandoned by the government. There is a general distrust of all governments, the result of regulatory fiat instituted by unelected bureaucrats.

In many dimensions, it is urban vs rural. Elitist versus commoner. A case can be made that four of the five largest democracies are in the beginning throes of a gunless revolution. England’s May. France’s Macron. Germany’s Merkel. America’s Trump.

In many regards, instability is the order of the day hoping that this instability does not lead to widespread violence.

What does the above have to do with the markets? Everything. The markets are dominated by multinational technology companies. The assumptions surrounding their business models have been shattered and the companies are fighting to maintain the status quo.

For example, Apple states that if Chinese tariffs rise to 25%, Apple would relocate its production facilities. As noted several times, over 90% of iPads and iPhones are manufactured in China. Wow! Talk about impacting profits, an impact perhaps magnified by slowing sales.

The above paragraph perhaps partially explains the volatility based upon trade comments; volatility amplified by the market dominance of these companies.

Radically changing topics, globally speaking, there is $7.76 trillion of negative real bond yields, up $2 trillion from October according to Barclays. In mid-2016 there was a record $12 trillion of negative real yields. Typically, negative real yields correspond with inflationary growth as funds gravitate to the real economy from financial assets.

Bloomberg writes after hedging out currency risk, the yield on the 10-year Treasury dropped to minus 0.4%, the lowest since the funding markets blew up during the 2008 financial crisis.

Some would argue the surge in the number of bonds with negative real yields is the result of trade fears that will slow global economic activity. Some would also argue the rapid selling of investment grade rated debt over the past month that has created the greatest surge in investment grade credit spreads since 2016 is also the result of fears of a slowing economy.

The issue at hand is the economy is not slowing. Quoting several Federal Reserve officials, the current economic environment is “robust’ and is expected to remain robust for the next several quarters.

Simplistically speaking, there is a disconnect. The other day I referenced JP Morgan research commenting about the proliferation of fake news and research reports that are greatly influencing trading… trading dominated by computers and six-word headlines.

Can I remotely suggest that such is occurring today in an attempt to sway public opinion about the dangers of changes in trade policy? Wow! This is conspiracy theory stuff.

If JP Morgan is correct about the massive proliferation of questionable news and research reports, the above does not sound outlandish. In my view, if any “credible” analyst writes comments that are found today in the blogosphere, comments that would make Henry Blodget blush, that analyst would be quickly cashiered.

Enough of the conspiracy rant, for the fourth straight day equity gains were cut in half by market close thus suggesting selling into any type of strength.

Just as an aside, late yesterday according to the LA Times, the California Public Utilities Commission will vote next month for a “texting tax” to provide funds for phone service to the poor. State regulators have proposed the tax would be retroactive going back five years.

Various business groups including Silicon Valley Leadership Group and the CA Chamber of Commerce is fighting the proposal, calling such as “dumb and unneeded.” Several consumer advocacy groups are also protesting stating it would unfairly impact those who are “less fortunate.”

Wow! If passed, would this be viewed in a similar manner as France’s fuel tax? Government data states over 80% of California have a cell or smartphone.

Last night the foreign markets were mixed. London was down 0.40%, Paris was down 0.37% and Frankfurt was down 0.12%. China was up 1.23%, Japan was up 0.99% and Hang Sang was up 1.29%.

The Dow should open nervously flat. The 10-year is up 2/32 to yield 2.91%.

12/12/18

Taxing Texting to Pay Entitlements/Cell Service for Indigents?

By: Denise Simon | Founders Code

Anyone old enough to remember the sin taxes? Well, seems California has proposed to take it to a whole new level to aid the poor… use cell phones… didn’t the Federal government do that with the Obama-phones?

Anyone remember taxation without representation? Oh, just an archaic notion anymore.

SACRAMENTO, CA (NBC NEWS) — California residents may soon have to pay a tax on texting.

According to KNTV, the public utilities commission is floating the idea to help fund programs that give low-income residents access to cell phones.

It’s not clear how much the texting tax would be or how it would be collected.

Several business groups have come out against the proposal.

One business group says the program is flush with cash.

But state regulators say the program is breaking the bank after the budget for the program has been raised 300 million dollars in six years.

The wireless industry says the texting tax would put them at a disadvantage over other free messaging services like Whatsapp, Facebook Messenger, Apple’s i-Message and others.

Mobile phone companies along with telecom providers are working to defeat this ridiculous proposal. There is no formal amount of the tax that has been announced, but frankly the poor in California actually need places to live and employment rather than cell phones. There is some chatter that just a flat fee added to the mobile service or a surcharge would be proposed versus some tax per text.

The Bay Area and the California Chamber of Commerce are looking to create a fund estimated to be in the $40-50 million range per year. Oh, wait… there is also some consideration to making these taxes retroactive going back 5 years. If that is the case, that fund would amount to well over $200 million.

A dense California Public Utilities Commission report laying out the case for the texting surcharge says the Public Purpose Program budget has climbed from $670 million in 2011 to $998 million last year. But the telecommunications industry revenues that fund the program have fallen from $16.5 billion in 2011 to $11.3 billion in 2017, it said.

“This is unsustainable over time,” the report says, arguing that adding surcharges on text messaging will increase the revenue base that funds programs that help low-income Californians afford phone service.

Telecom companies are already arguing that texting is an informational service like email and not a service under the authority of the commission’s authority.

Just imagine how much texting goes on through several platforms including iMessages, WhatApps, Skype or by Facebook. It is estimated that in one year alone, 3 trillion text messages are sent.

Often what begins in one state is later adopted in others. So, if you can stand it, it would be prudent to review the whole proposal by clicking here.

One more item going through the FCC:

The Federal Communications Commission says it is giving cellular carriers added authority to block text messages, saying the action is needed to protect consumers from spam or robotexts. But critics of the plan note that carriers are already allowed to block robotexts and worry that the change will make it easy for carriers to censor political texts or block certain kinds of messages in order to extract more revenue from senders.

FCC Chairman Ajit Pai’s announcement acknowledges that carriers are already allowed to block illegal robotexts. Pai did not promise new consumer-friendly blocking services; instead, he said his plan “allow[s] carriers to continue using robotext-blocking and anti-spoofing measures to protect consumers from unwanted text messages” (emphasis ours).

Despite that, Pai is proposing to classify text messaging as an information service, rather than a telecommunications service. That’s the same legal classification that Pai gave to home and mobile broadband services as part of a December 2017 vote to deregulate the industry and eliminate net neutrality rules. The FCC has not previously ruled on whether text messaging is an information service or a telecommunications service.

An FCC vote on Pai’s plan is scheduled for December 12.

12/3/18

What’s Next?

By: Kent Engelke | Capitol Securities

The G-20 meeting is over.

I believe the two greatest issues facing the markets for the intermediate future is monetary policy and the normalization of the Fed’s balance sheet. Both events will have a direct impact on earnings and valuations.

Regarding monetary policy, in my view, the markets have been spoon fed by the FOMC essentially telegraphing its intentions for the proceeding year. This has now changed, reverting back to normalcy where the data will dictate policy.

In short, the Central Bank is signaling to investors a hard truth about relying upon contradictory economic data; there are no easy answers anymore. It is going to be choppy with perhaps surprises.

The FOMC is attempting to be flexible but such flexibility will create uncertainty.

Commenting about asset sales, the Federal Reserve is now doubling the number of security sales. How will such increases in bonds available for sale impact prices especially as demand for monies by the Federal government is rising?

Higher interest rates dictate lower equity valuations unless corporate cashflows rise at a greater rate to offset the negative impact of potentially higher rates.

And then there are earnings itself. How will trade and interest rates impact the profitability of the over-owned and highly-valued technology shares? FAANG is down about 25% from its early October peak, the result of earnings that did not meet sky-high expectations.

According to the Consumer Technology Association, approximately 80% of US cell phones and 92% of US tablets and laptops are imported from China.

As noted many times, FAANG comprises a large minority of the popular indices capitalization. Late last week, legendary Vanguard Chairman John Bogle stated that he is expecting a 1.75% total annual return in a 50/50 blended account over the next decade. His rationale is similar to the concerns above; lofty valuations, massive over-ownership, rising interest rates, shrinking margins and trade concerns.

Change is the only certainty, however, I believe the financial markets are not prepared to handle change given the massive proliferation of passive investing which by definition states that past performance will be indicative of future performance. The big get bigger and the small get smaller unless there is some event that disrupts preconceived expectations.

As indicated above, the Fed has jumped off its predictable path into a policy of wilderness. Expectations will change. How will such changes be viewed?

This week is a data-filled week that can alter expectations. There are numerous employment reports, manufacturing and non-manufacturing surveys and various trade statistics. Moreover, there are some second-tier technology companies posting results as well as an OPEC meeting.

How will all be interpreted?

Last night the foreign markets were up. London was up 1.76%, Paris was up 1.06% and Frankfurt was up 2.27%. China was up 2.57%, Japan was up 1.0% and Hang Sang was up 2.55%.

The Dow should open sharply higher on the trade truce. Oil is up a 5% as Saudi Arabia and Russia extended their pact to manage the market and Canada’s largest producing province ordered unprecedented output cuts. The 10-year is off 13/32 to yield 3.04%.

11/24/18

France Is Literally On Fire Over Fuel Protests – Fractured Over National Security

By: Terresa Monroe-Hamilton

Socialism is all well and good until it makes it impossible to live, work or exist… just take a look at France. This is the second weekend that French protesters are getting frisky in the streets over fuel prices. I am told that it is between $6 and $8 a gallon over there and people are ticked at Macron. Police in Paris are using tear gas and water cannons to disperse protesters.

Angry mobs were trying to break through a security cordon at the Champs-Elysées and violence broke out. Over 5,000 protesters were marching there. At least 13 people were arrested after getting into fights with the police. Organizers of the “yellow jacket” movement billed the latest protests as “act two” in their rolling campaign. They want an end to an increase in fuel duty on diesel. Taxes y’all. Hello California.

Metal barriers were erected to keep the violent hordes away from key buildings such as the prime minister’s official residence. Some of the protesters ripped up paving stones and threw fireworks at the police. They were shouting slogans that call for President Emmanuel Macron to resign. Perhaps Macron might want to rethink his stance on America’s ‘nationalism’.

Continue reading

11/15/18

Wow! What A Statistic!!

By: Kent Engelke | Capitol Securities

Many times I have commented about the massive proliferation of passive investing and how it is impacting trading mechanics. According to the Index Industry Association, benchmarking giants like S&P Global Inc., MSCI Inc., and the London Stock Exchange Group PLC, have created 438,000 new indexes over the last 12 months through June 30.

According to the same group, there are more than 3.7 million benchmarks globally, dwarfing the roughly 50,000 stocks that trade on exchanges around the world.

The greatest annual growth in indexes are factor based and smart beta gauges that track stocks with characteristics like momentum or low volatility and often use these features rather than market capitalization to determine how much of these companies to include in a measure.

Fixed income indexes – concentrated primarily in sovereign debt – now make up about 16% of all indexes. Two years ago, 95% of indexes were focused in equities.

Indexes focused on environmental and social concerns jumped about 60% from about a year ago.

Wow! I readily acknowledge that I do not have any idea of the capitalization or structure of each of these indexes but the data is staggering. Talk about slicing and dicing. Depending upon the source, traditional stock research departments have declined from 50% to 75% since 2008, the direct result of this massive move to passive/indexing investing.

What I find interesting is that according to Society Generale, 90% of all stocks, of which only 10% of their ownership is concentrated in ETFs, are investment vehicles similar to that of indexes. Conversely, 10% of companies comprise 90% of ETF capitalization.

In my view, today’s trading mechanics have never been stress tested. How will the markets respond to a crisis?

As widely noted, the major indices are down about 10%-12% in relatively quick order. In my view, the declines would be greater if it were not for retail investors buying ETFs in the face of selling from institutions. What happens if the retail investor stops buying, an environment that may be developing today given the lack of a recovery from the recent rout?

Will the popular indices decline another 15% to 20% which could perhaps cause a massive obliteration of indexes? Will a major sponsor experience financial issues, issues that would create the next financial crisis?

Historically, whenever there is a massive proliferation of an investment vehicle, the first time these vehicles are stress tested it typically ends poorly. Will today be different?

Commenting upon yesterday’s market activity, AAPL dragged the averages lower and is another FAANG company that is now in “bear market territory,” defined as declining over 20% from its highs. Shares peaked about a month ago. Facebook is down over 35% from their July peak and Amazon is off 22% since early September. Netflix has dropped about 33% since last June. Google is the best performer, off about 18.5% from July’s apex.

In my view, the decline of these mega-sized companies has been orderly with many not yet recognizing or accepting the magnitude of these drops, believing a recovery will imminently occur. As noted earlier, this perspective may now be changing.

What will happen today?

Last night the foreign markets were mixed. London was up 0.15%, Paris was down 0.22% and Frankfurt was up 0.08%. China was up 1.36%, Japan was down 0.20% and Hang Sang was up 1.75%.

The Dow should open moderately higher on potential trade optimism and Wal-Mart’s earnings that some stores beat. Oil is nominally higher. Goldman is suggesting crude will rebound to $75 barrel by the first quarter if OPEC reduces production by the amount it has telegraphed to the market. The 10 year is up 5/32 to yield 3.11%.

11/13/18

Will The Markets Retest Their Late October Lows?

By: Kent Engelke | Capitol Securities

Led by tech, equities declined. There are numerous uncertainties… the Fed, tariffs, earnings, inflation, political issues including impeachment and other threats, Brexit, etc.

Oil, however, initially rose as Saudi Arabia unilaterally reduced oil exports by 500,000/day in December, calling for other producers to do the same, cutting production 1 million barrels from October’s levels. Gains became losses following the President’s tweet stating: “Hopefully, Saudi Arabia and OPEC will not be cutting oil production.”

As widely discussed, five weeks ago oil was $75 barrel with many firms suggesting/forecasting $100 oil in quick order, partially the result of Iranian sanctions. Last week, crude was down over 20% from those levels because of increased production/shipments. Will prices now rebound by the same magnitude in quick order?

Increased volatility is typically associated with a market top or bottom, a volatility that is today amplified by the massive proliferation of technology-based trading.

Speaking of which, most major equity averages have now retraced over 50% of the post-election surge. Will the late October lows be tested? Will the retail investors who have supported FAANG now become sellers instead of buyers?

Historically, the markets are entering into a seasonal period of strength. The question at hand is what will be the catalyst for a sustained market advance? As noted above, coverage of the multitude of uncertainties is rising.

Consensus believes political gridlock is good for the averages as the odds of any significant legislation being passed are low. I recognize this view but will also write there are considerable issues that the government must tackle but there are always considerable issues to overcome.

Ultimately it is earnings and interest rates that dictate equity direction. Government’s role is to create policies that are conducive to economic and job creation.

Returning back to a previous question, will the averages retest their lows? Bank of America said ‘yes’ based upon several technical indicators. As all know, the markets have been hijacked by technology-based trading where speed and cost of execution are valued more than liquidity and capitalization. The vast majority of these strategies have failed, producing losses anywhere between 10% and 45%.

Are the markets on the edge of yet another iteration, an iteration back to fundamental analysis where geopolitical and macroeconomic considerations are again paramount? If 89% of dollar-denominated assets have produced a negative return as per Deutsche Bank based on current strategies, the answer is yes.

Last night the foreign markets were up. London was up 0.12%, Paris was up 0.38% and Frankfurt was up 0.78%. China was up 0.93%, Japan was down 2.06% and Hang Sang was up 0.62%.

The Dow should open moderately higher on trade hopes. Oil is down for a record twelfth consecutive day following Trump’s tweet criticizing Saudi Arabia’s plan to cut output. The 10-year is up 4/32 to yield 3.17%.

11/7/18

The Midterms Are Over… What’s Next?

By: Kent Engelke | Capitol Securities

The midterms are over. There is an infinite number of opinions about the possible outcomes out there. Economics prevailed in the Senate as the Republicans increased their number of seats but lost in the House as power shifted for the first time in eight years.

In some regards, the outcome is as suggested, in other regards they are not. Personally, I thought the status quo would remain, the result of the strong precedent of voters voting their pocketbooks. In some regards, this view was correct and in other regards it was wrong. It was no “Blue Wave” but similarly the status quo was not maintained.

The immediate focus will now be the commencement of the two-day FOMC meeting and the upcoming G-20 meeting. Even though no action is expected regarding monetary policy, all Fed meetings are potentially significant. As stated, will the Fed begin telegraphing their intent to end forward-looking guidance sometime in 2019?

Regarding the G-20 meeting, at this juncture little is expected regarding trade issues between the US and China.

Equities are expected to open moderately higher as the election uncertainty is over and under the traditional belief a split Congress is bullish for equities.

The 10-year is up 8/32 to yield 3.20%.

Last night the foreign markets were mixed. London was up 1.15%, Paris was up 1.31% and Frankfurt was up 0.99%. China was down 0.68%, Japan was down 0.28% and Hang Sang was up 0.10%.

10/31/18

Will $1 Trillion Be Known As The Top For A Generation?

By: Kent Engelke | Capitol Securities

October left all bruised. Today’s rules that are based on investing models were supposed to take the guesswork out of buying and selling decisions, utilizing technology and using math to eliminate emotions. I think most will agree that such programs are now being questioned. Will October be regarded as the month that all of yesterday’s no-lose strategies failed?

Speaking of possible tops, will $1 trillion end up being known as the Top for a Generation? Two companies “Amazon and Apple” reached this plateau and the media was filled with the countdown for the next companies to make it to this stratospheric level. At the time of this writing, Amazon is down about 23% month to date and over $275 billion from its September apex. Apple is still worth $1.02 trillion but is down about 7% for the month and 9% from its peak.

Yesterday equities had a tumultuous day, ending higher after a robust buying that occurred in the final 30 minutes of trading. At the close, Facebook posted results that perhaps proved to be “good enough.” I am certain the interpretation of the results will change several times throughout the day.

At the close today, Apple posts results. How will they be interpreted?

Last night the foreign markets were up. London was up 1.46%, Paris was up 2.11% and Frankfurt was up 1.26%. China was 1.35%, Japan was up 2.16% and Hang Sang was up 1.60%.

The Dow should open moderately higher on earnings and robust foreign markets. The 10-year is off 5/32 to yield 3.15%.

10/25/18

What Are We To Think Of These Warnings?

By: Kent Engelke | Capitol Securities

The NASDAQ plunged 4.4% for its biggest single-day drop since August 2011 and now is officially in “correction territory” falling 12% from its August peak. APPL, AMZN, MSFT, and GOOG comprise about 25% of the index’s value and were responsible for the majority of yesterday’s decline.

The S&P 500 and the Dow had declines of 3.09% and 2.41% respectively and are negative for the year. October is the worst month for the S&P 500 since February 2009.

The pivotal 200-day moving average on the S&P 500 fell for the first time in 2½ years. The S&P 500 has declined 13 of the last 15 days, something that has not happened since March 2009.

Many times I have commented about the outsized impact of algorithmic or technology-based trading has upon the markets. In rising markets, little regulatory attention is focused upon this domination.

Yesterday I read SEC comments about the recent increased volatility, the product of many things including the normalization of interest rates and other geopolitical events which are fluid. Typically these are things traders are meant to deal with and provide stabilization when needed.

However, today, a discussion is rising about the neutering of market making capabilities which have robbed the markets of predictable and constant liquidity. The SEC states that “it is such a potentially systemic and intractable problem” that it is largely left to academics to dismiss and the regulator hoping everything will work out.

To me, this is a powerful admission, an obvious admission to anyone who has worked on a fixed income (and equity) trading desk. It is my firsthand experience liquidity is lacking in the fixed income markets, a lack of liquidity that the academics [and perhaps regulators] believe is still present.

Historically, money center banks provide liquidity but because of regulatory fiat, money center fixed income bond inventories are down over 90% from levels of 10 years ago while the bond market has swelled three times in size.

Yesterday, I referenced former Fed Chairman Greenspan’s remarks that unfortunately ”a system” needs to come apart at the seams before any action occurs and most often “one does not see these crises arising until it is at your doorstep.”

Continuing with this theme, JP Morgan warned yesterday of the inherent dangers of index (passive) investing. The bank states there is $7.4 trillion of assets managed by passive funds around the world concentrated primarily in large-cap stocks that will exacerbate a rout.

JP Morgan states that passive investing seems to be trend following, with inflows pushing equities higher during bull markets and outflows likely to magnify their fall during corrections.

Back in 2007, the strategy’s overall size amounted to about 26% of all managed funds with about 15% outside of the US. Eleven years later those figures have jumped to 83% and 53% respectively.

JP Morgan states passive investing is “far more skewed to large caps than what their market cap would command… passive AUM in large caps is 10 times that of small and mid-caps making this asset class far more exposed to momentum selling during market downturns.”

Wow! In my view, the comments from both the SEC and JP Morgan are significant and should be reflected upon.

The next question at hand is whether the individual security outperforms the indices in this rotation of monies back to Main Street from Wall Street. In other words, will the typical no-name stock that is not owned by the ETFs (90% of listed securities comprise less than 10% ETF ownership according to SocGen) outperform, the inverse of the last 10 years?

If one uses history as a guide, the answer is yes.

What will happen today?

Last night the foreign markets were mixed. London was up 0.18%, Paris was up 1.45% and Frankfurt was up 0.48%. China was up 0.02%, Japan was down 3.72% and Hang Sang was down 1.01%.

The Dow should open significantly higher. Equities are vastly oversold, several high profile companies surprised on the upside and there are no major changes in the geopolitical environment. The 10-year is off 8/32 to yield 3.14%.