2019: Recession or Soft Patch? Considerations at the Inflection Point

Recap of 2018, since December 16th

“There are decades where nothing happens; and there are weeks where decades happen.” - Lenin

On Sunday afternoon December 16, 2018, I wrote Looking Towards 2019: Recession or Soft Patch? Inflection Point . Here is what subsequently happened in the following 9.5 trading days into year end:

• Sunday afternoon December 16, hours after my post, Stan Druckenmiller released an Op-Ed on the WSJ titled Fed Tightening? Not Now , followed by an extensive TV Interview with BBG TV just 2 days later arguing as much (coupled with other content), on December 18th, exactly one day before The Fed.
• On December 19th the Fed “tightened”.
• US equity markets (more or less) declined in a straight line into Christmas, followed by a slight bounce into year end. As a result of this price action, Q4 2018 and the month of December 2018 are now in the history books, among the worst quarters/months/Decembers in US equity market history. In fact, Since 1923, the month of December has never been the worst month of a calendar year…until now.

Current Take and Immediate-Term Outlook

Measures of sentiment have recovered, despite poor price action

Various measures of sentiment have recovered since I wrote Looking Towards 2019: Recession or Soft Patch? Inflection Point on December 16, 2018. This recovery in sentiment contrasts against the clear and severe deterioration in price action. Even with the bounce from 2,350 on the S&P 500, buying and/or holding stocks continues to feel like what shorting stocks feels like (the true gauge for a bear market, in my view). Price action feels very unstable (just take a look at the price action within the last 5-10 minutes of the 31st).

No capitulation: Buyers AND Sellers Want Higher Prices

Historic market price action tends to climax with some very clear markers. While sentiment was certainly lower when S&P 500 briefly touched 2,350 compared to the the days leading into that day, we have still yet to see the capitulation that tends to mark the end of historic moves. And the December move was historic.

Those who were bearish into December, have flipped bullish: they want higher prices to sell and/or short into. Bulls who were bearish in December want higher, to reinforce the possibility that a bottom is in. When both buyers and sellers want higher prices, what tends to happen?

the above observations - coupled with other observations - lead me to believe that: (1) the market continues to be defined by bear market price action (I don’t care for “official” definitions of bear markets) (2) the bottom is not in.

2019 Full-Year Considerations

If the US equity market price action in 2018 – particularly Q1 and Q4 – has served the purpose of curing very high market expectations rather than pricing in the risk of recession, markets would not be irrational to start pricing in the possibility of global recession, regardless of whether or not an actual recession is to take place this year. Markets overshoot to the upside and to the downside. Some reasons markets may overshoot to the downside (reasons beyond those mentioned in my previous post):

• China and Europe Softness - China and parts of Europe of showing signs of recessionary or near recessionary conditions, as their respective markets have been signaling. What is the transmission mechanism - if any - to the US economy? US Markets may shoot first, ask questions later.
• US Deceleration - Some additional signs (beyond rates, housing, and semiconductors) of faster and/or more severe deceleration than expected. For example: “Global trade has slowed in recent months and leading indicators point to ongoing deceleration in global trade near-term.” - Fedex, December 18, 2018.
• Wealth Effects in Reverse - Do asset prices (particularly, changes in asset prices) affect the real economy? Some believe that the wealth effect is stronger when asset prices decline, rather than when they rise. On a YoY , QoQ, Peak to trough basis, financial asset prices are meaningfully down, worldwide.
• Hedge fund blowups and Family Office Conversions - If US equity prices do not immediately recover in Q1, the risk of further redemptions and more blowups in hedge funds substantially increase (as many “hedge funds” are really nothing more than levered beta…this observation, by the way, applies doubly/triply so to private equity). At what point does the institutional investor LP see the truth that many “hedge” funds (and more so private equity firms) are nothing more than rent collectors? If a hedge fund with significant short exposure (though long biased) nevertheless underperforms the S&P 500 in 2018, AND over the last 2, 3, 4+ years, why bother? Why pay ANY management fees? Perhaps the industry requires a return to capital-guarantee and/or only performance fee-only models.
• Short sellers became short squeezers - Since 2017, many formerly short only professionals have become… short squeezers. This behavior was rewarded by the market, until recently months, yet I don’t think this behavior has “unwinded” just yet. Note that this phenomenon was in vogue in 1987, in the months preceding the now famous crash of ’87.
• DIS long pitch - a recent DIS long pitch (which boils down to multiples expansion), suggests to me that the corrective action in US equity prices is not complete yet.
• Historical comparisons and analogues must look past the last 10 years - Analysis that consisted of “this hasn’t happened in the last 3-5 years” got many market participants in trouble in December.

 

 

Looking Towards 2019: Recession or Soft Patch? Inflection Point

Though the year is not over (9.5 trading days remaining for US equity markets), I have been thinking and preparing for 2019 since mid November. I called it a year then, and went on a three week hike (mixed with some business). I feel very refreshed and relaxed, after what was a very difficult year for me (evidently, I am not alone). I have not written a post publicly since April/May (in hindsight, both posts reflected the right idea).

Current Take and Immediate-Term Outlook

Measures of sentiment are poor yet us equities grind lower 

According to various measures of sentiment (no need to point out the ‘usual suspects’), sentiment is bad. I believe that some of these measures of sentiment are already at or below levels where US equity markets have tended to bounce or even bottom, at least within the last 5 years. Yet markets continue to grind (grind, and not flush) lower, though the indices remain at levels higher than the lows from earlier this year. This suggests two things: (1) the last 5 years’ of price action is not sufficient to understand current price action (and therefore, price action with a much larger ‘N’ than n=5, must be studied) and  (2) US equity markets have not bottomed.

Equities grind lower yet there is a notable absence of fear, panic, or capitulation

What has been notable about the price action in US equity markets in recent months is the lack of visible fear, panic, or capitulation. Rather, I sense unhappiness, frustration,… even weariness. There have been countless commentators, strategists, etc. anticipating bottoms in the last two months, but no fear/panic. In fact, all 10 strategists surveyed by Barron’s in recent days expect the S&P 500 to rise next year: https://t.co/pI3tyzL9aQ These qualitative observations also lead me to the belief that US equity markets have not bottomed.

The above observations lead me to believe that the best thing that could happen for those desiring a 2019 rally: a flush/capitulation, occurring before year end (in the absence of major historical, 9/11-like event). The worst thing that could happen is that we bounce into year end.

2019 Full-Year Outlook: Soft Patch or Recession? Inflection point 

One might say that the US equity market price action in 2018 - particularly in Q1 and Q4 - has served the purpose of curing very high embedded economic/profit growth and market expectations starting in 2017 and continuing into 2018, rather than pricing in recession.  The corrective price action has also helped US equity markets to “catch up” with the rest of the world’s equity markets (all down between 15%-25%, with China markets as one of the worst performers), though our equity markets still remain way ahead of rest of the world’s equity markets. US equities have been the only game in town.

More evidence points to soft patch versus recession, as of now

“Soft patch” or “deceleration” seem to be the most accurate words to describe the present and expected state of the US economy/corporate profits in the current and coming quarters, based on current and available information. That is, evidence points to the US economy and corporate earnings continuing to expand next year, albeit at a lower rate of change. A soft patch is not a recession, though it is an inflection point.

Soft patch as inflection point: precursor to recession or resumption of more aggressive expansion

Just because most evidence points to soft patch rather than recession, does not mean caution is not warranted. We are at an inflection point (a point where the previous growth trend may resume, after this pause, else we enter into recession). I personally don’t believe that it will take much to tip us over into either direction. An exogenous positive/negative event might be sufficient to move the needle. Here are some exogenous factors outside of the business cycle, that may tip us over.

What might tip us over in either direction: considerations for 2019

• China - I believe US investors are severely underestimating the importance of the Huawei CFO arrest from earlier this month, and possible resulting negative 2nd order effects. On the other hand, a recovery in the China macroeconomic picture and/or a Shanghai Accord 2.0 (thought some have cast doubt on China’s ability to ‘save the world’ this time around) would be positive.
• Europe - A major and likely cause of volatility in Europe is set to occur next year. It may end up being nothing more than a tapebomb. And no, Brexit is not what I’m referring to.
• USA - Impeachment or similar would be a major tapebomb. On the other hand, the absence of impeachment, coupled with sound policy enactment would be positive. Two more rotational considerations: There are two fund flow factors that will add downside pressure to Tech, private + public.

 

Being Skeptical of Skepticism: The Best Kept Secret of Short Selling

Introduction

This holiday weekend has given me the opportunity to be reflective/introspective of the last 10 years of my life. As a result, I feel the itch to write about a few specific topics that have been on my mind for the last 1-2 years.

I suspect this post will be most relevant to and best understood by those who possess the genetically defective “short seller gene”; probably applicable to bona fide contrarians as well. If a wider audiences finds this post useful, entertaining, etc. - all the more better.

The Best Kept Secret of Short Selling

I will get straight to the point: I believe the best kept secret of short selling is… to become skeptical of one’s (and others’) skepticism. It is to be doubtful of doubts. It is to harness this preternatural gift of short selling that is ordinarily used by the short seller to identify fraud/fads/failures (while others see nothing), and instead, use this gift to identify cases where one’s or others’ suspicions of fraud/fad/failure are misplaced… and climb walls of misplaced worry. The best kept secret of short selling is to go long, with a long-term orientation.

One of the most useful talents that short sellers tend to naturally exhibit: what might make for a bad, maybe terrible long investment. Short sellers, in theory, can do a far superior job versus the long only investor, of filtering out what NOT to invest in, waste time in (e.g. value traps).

I will posit that not only is this the best kept secret of short selling, it is actually critical + necessary for survival, for most people… otherwise, one risks experiencing crippling financial losses, career instability,  household turmoil, mental illness, and even, suicide.

Becoming comfortable with consensus and trend following

I have naturally contrarian tendencies (oddly enough, I avoid using the word ‘contrarian’ as I find many pretend contrarians who use the word dozens of times a day), but have found that the status quo is actually often correct: it pays to be with the consensus most of the time.

Without me knowing it, I started testing this ‘best kept secret’ in 2011… though meekly. While I have slowly become emboldened over time, I remain somewhat meek. My primary mistake has been selling longs prematurely: I probably felt that if the market was showing some validation of my position, I must sell. Yet the biggest money to be made would’ve been to hold on to longs, even as they became consensus positions - even ‘crowded’ positions - over the course of several years. I should have continued being skeptical of my own skepticism.

My best friend has jokingly said that if I sell a long position, it will double over the next 2 years. I bet that if I can learn the ability not only to hold onto a position as it becomes accepted by the mainstream - but to size up the position as it works in my favor - I’m inclined to believe that good things will be happening to me.

 

Complicating Factors and Important Context

• Some might assert that the existence of this post itself would imply we are at a peak in risk asset prices, or in late stages.  I keep an open mind to that possibility…yet, these thoughts have been on my mind and put into practice for several years now.
• My above thesis might sound fine and dandy in theory, but in practice, I’ve found that some people are just naturally inclined to buying stocks, while others are just inclined to shorting stocks (though the latter is a tiny minority). Habits/character are difficult (maybe impossible) to change.
• I’ve seen some short sellers (and former short sellers) whose long books seem to be exclusively dedicated to short term short squeezes. They don’t have a fundamental view of the business nor do they care. In addition to some real ethical + legal questions, I think the bigger money is made in looking for long term longs.
• It would be incredibly naive and intellectually arrogant to dismiss the possibility that my thesis is NOT shaped/coloured by an US-centric view of investing. A US-centric view of markets, blind to the experiences/history elsewhere, is dangerous. Macro matters.
• I think if you take my thesis, that “The best kept secret of short selling is to go long, with a long-term orientation” to its natural limit, you approach global macro. I think global macro is the ultimate expression of this thesis.
• In practice, it is often difficult to gauge what the sum total and incremental doubt/skepticisms are, embedded in current market prices.
• As much I love to joke about it, I am not implying that short sellers should stop shorting stocks, and become long only investors. Far from it. The short sellers needs to continue practicing short selling precisely because the practice of short selling can make the short seller a competent - maybe even dangerously good - long investor.
• It is said that “being contrarian is not sufficient - you must also be correct” - to which I would add this corollary: “Being skeptical of skepticism is not sufficient - you must also be correct”

Buying the dip: slowly getting back into the pool

I’m currently feeling the same way I felt in mid January / early February 2016 about us equity markets: I’m a marginal buyer of US equities, and believe that on balance, being a buyer from current levels and below will look smart 6-12 months out.

A few thoughts:

• The possibility of a trap door to the 2,300-2,400 zone on the S&P 500 should be taken very seriously, but you have to assume one can’t / won’t bottom tick price, and that buying should be approached as a process, rather than a snap decision.
• I don’t think we will see 2,100-2,200 levels this year, barring some 9/11 or impeachment type of event (at which point US equities will be a Super Strong Buy).
• I don’t think highs are in for the year.
• I prefer buying US equities ex FANG/Tech.
• I prefer buying US equities over foreign equities (the concurrent weakness in the USD and US equities will not persistent indefinitely, in my opinion).
• The chirping on and on in January of this year about 2018 being a near guaranteed up year based on various statistics have all but disappeared. That makes me very happy and bullish.
• Single stock short selling will, on balance, remain a gainful endeavor…even if the major indices were to melt up later this year.

I conclude this post with a story:

What the 2016 US Presidential Election Meant to Me

The week of the US Presidential elections (and on actual election day), I was on vacation (a diving trip), in the middle of the Pacific Ocean. I had spotty and slow internet. I had been very very short in the weeks preceding the election, and covered most of my short exposure prior to my vacation (this turned out to be the right thing to do, though it was a stroke of luck, not genius).

On election night November 8th, 2016, our boat was on its way back to shore. As the likelihood of Trump’s victory was increasing, S&P futures were falling… everyone around me (non markets people) were panicking, saying the US stock market would crash, that the US was doomed, etc etc… this gave me the itch to buy the dip.

I had low gross exposure, and some remaining single name short exposure. Around 10pm - 11 pm EST (I was in a different time zone), I was about to enter some buy orders (for the eminis), but stopped myself for the following reasons:

• I had slow and unstable internet (slow enough such that the real time futures quotes were somewhat delayed on my phone).
• I would be back on shore within 2-3 hours, upon which I would have stable internet.
• I thought the decline in overnight futures would carry through to the US cash open…
• I had already had an amazing year (returns wise) through November 8th, and wasn’t feeling particularly greedy at the time.

As a matter of fact, futures bottomed around the time I was going to start buying, and slowly drifted up all night, until us cash open…(I blame Icahn, Druckenmiller, and others for holding the bid!)

Bottomline: I was trying to bottom tick, and missed a huge profit opportunity. The current market character differs from November 2016, but I remain convinced that it is more costly to try to bottom tick a market, rather than approaching buying methodically.

 

Dennis Gartman: the Second most powerful man in the USA

They say that once a financial market signal is widely known, its predictive power diminishes / gets arbitraged away. over time.. yet the (inverse) Dennis Gartman would seem to defy this heuristic. This leads me to conclude that Dennis Gartman is the second most powerful man in the USA: who else has the ability to move mountains - er, markets - the way he does?

Normalization, Regime Change, and Adaptation

Some “financial experts” often claim that “history repeats” and sarcastically say “this time is different” (implying it never is)… are these heuristics correct? I think not: the Internet did not always exist, and the world has changed as a result of the internet. Cryptocurrencies have/are redefining ‘bubble’. These examples, sufficiently falsify the above-mentioned heuristics (yes, some things remain the same: we still die, we still depend on food/water to survive, etc).

For my own edification, I wanted to jot down a few disparate thoughts (that may interrelate):

• Regime Change  and Normalization - Many have been talking about regime change that would take place in markets once nominal interest rates started normalizing (i.e., return to historic averages)…. in light of the recent activity in the volatility complex, what would happen if the volatility regime were to normalize as well? 2017 was the exception, not the norm…
• Markets are adaptive because its participants are adaptive - I’ve observed that market participants’ behavioral tendencies are often coloured by the formative experiences associated with their past profits and losses… we seem to think that the same formula for success/failure in the past is what is needed for the present/future generation of profits… I have found this not to be true. As that Intel Founder famously warned: Innovate or perish.
• “Don’t invest in things you do not understand” -  I’ve heard this expression come in vogue (again) in recent days, in the aftermath of the volatility complex blowups… my friend used to say, “If you don’t understand it, you should short it.”

 

 

Short Selling: The Best Kept Secret (?)

A certain venerable gentleman (and scholar) claims to have found the “best kept secret of short selling”. What is he referring to? Is he right?