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DAVE JANNY APRIL 2016 INVESTMENT LETTER 2016 VOLUME 4 “MARCH MARKET MADNESS” “Charts courtesy of StockCharts.com” One of the most exciting events of the year, sporting or otherwise, always seems to be the NCAA Men’s Basketball Tournament. It is known as March Madness. This year’s tournament didn’t disappoint. The Final featured betting underdog Villanova versus consensus favorites the University of North Carolina. The tournament was particularly exciting for my family since we had a rooting interest in Villanova. My son Matt is a junior at “Nova” and I of course have “invested” more than a couple of dollars in tuition. Matt had the once in a lifetime experience of being at the Final Four in Houston to firsthand witness all the excitement and the “Nova” national championship. The “final’ game will go down as one of the best and most exciting tournament games ever, punctuated by two incredible shots in the waning moments of the game. If you watched it, you know exactly what I’m talking about. 1 The tournament itself was marked by games that featured great comebacks, last second shots and other exciting moments typical of March Madness. The thrill of victory and the agony of defeat seem even more dramatic in the single elimination college format. Speaking of March Madness, I would describe the global market action in March as “March Market Madness”. As I had detailed in my March Investment Letter, I felt we were in a sharp but potentially short bear market rally. Again, some of the sharpest rallies occur in bear markets. Reminiscent of a college basketball game, marked by two distinctly different momentum based halves, the sharp market correction of the first half of the 1st quarter was followed up by an equally sharp second half of the 1st quarter rally. The net effect was actually not much net change in the S&P 500 for the year thus far. (Reuters) To add to the “Madness”, the rally phase was marked by generally negative news. According to the IMF, all four of the major global central banks (U.S., Europe, Japan and China) downgraded economic forecasts for this year and next as well. Earnings forecasts were generally revised down again.(Morgan Stanley) We sadly experienced the Brussels terrorist attacks. Ultimately I view this rally as a great asset allocation opportunity. I believe the stock market rally is a short term “gift” in the context of a broader bear market equity environment. I’ll explain the situation in the backdrop of a “March Market Madness” theme. THE “SWEET SIXTEEN” CONCERNS There is still much to be concerned about in the investment world in what I still assert is a central bank bubble. I’ll list these concerns from the #16 seed (lowest current concern) down to the #1 seed (most salient concern). Just as is the case for the NCAA Tournament Committee, seeding is difficult (there are always some controversial seeds). I’ll try to do my best. #16 seed – “Cybersecurity” The whole realm of technology is increasingly becoming an important component of all countries’ national security. The recent Apple/FBI debate is just the beginning of a larger debate that will get only more complicated on the fine line between privacy and national security. Cybercrime is rapidly becoming a common and frequent occurrence. Cybersecurity will continue to be an important investment theme. CNBC had a good 3/9/16 interview with Fred Kaplan speaking about his new book “Dark Territory: The Secret History of Cyber War”. It shows how prevalent and potentially dangerous the issue is. I urge you to watch it. http://video.cnbc.com/gallery/?video=3000499167 #15 seed – “Brexit” Polling in the UK suggests that there is a legitimate chance that citizens may opt out of the European Union. (Brexit Poll Tracker, 2016)It’s been termed “Brexit”. The Europeans are very concerned, as it would cast a negative light on the European Union and possibly influence talk of other potential exits that could create uncertainty and volatility in European markets. . Trying to portray an image of “unity” has been of utmost importance to pro-European Union politicians. The vote is in June and can certainly create much media attention between now and then. #14 seed - “Geopolitics and Islamic Terrorism” Global markets have shook off terrorist incidents as well as other negative geopolitical events such as Syria, Iran, Ukraine and North Korea, thus far. Geopolitics is 2 always a risk, but the world seems to be a more complicated place than ever. Thus far, the terrorist attacks have actually caused rallies (Ismailidou, 2016), but I think it could be a lot different if the frequency or size of the attacks in the West would increase. Despite increased security, the possibility of more attacks would not be that much of a surprise. #13 seed – “U.S. Presidential Election” The election probably hasn’t had a huge impact on the markets thus far, but that could potentially change. The rise of Donald Trump and Bernie Sanders most certainly has its’ roots in a wave of populism brought on by dissatisfaction with the political establishment. Neither party seems to be satisfied with their potential nominees. This election season, which already has been one the craziest ever witnessed, is likely to get even more bizarre and divisive and could easily impacts markets as we get closer. #12 seed – “The Reach for Yield” One of the objectives of Quantitative Easing (QE) by the U.S. Fed, as well as other central banks, is to potentially make “risk” assets, such as equities more attractive. Central bankers felt that if stock markets rallied, economic growth would follow. That has not been the case. Global economic growth forecasts have underwhelmed every year since the Financial Crisis. (Fels, 2016) As I had detailed in some of my 2016 Investment Letters, stock market performance in 2015 was tougher than the indices would imply. High yielding assets were particularly hard hit. Conservative savers and investors, faced with historically low interest rates, have chosen “reaching for yield” in riskier assets. (The Experts: Finding Income Despite Low Interest Rates, 2016). The worst may be yet to come in another stock market down leg when many investors could panic when they may finally realize they may be holding riskier investments than they want. #11 seed – “High Yield Spread Widening” All last year my Investment Letters talked about credit concerns building as yields on non-investment grade securities were rapidly rising. The same thing happened in 2000 and 2007, typically, one of the more reliable warning signs of problems to come. The energy sector, where much of the bad lending occurred, has been at the forefront of the concerns. “Spread widening” makes it more difficult for entities to borrow new money and refinance existing loans. If the economy continues to weaken, this “concern” can move towards the top of the headlines. #10 seed – “U.S. Earnings Slowdown” We’ve already had a recent streak of disappointing quarters of earnings growth. 1st quarter earnings season is about to begin and indications don’t appear very good again. Ultimately rising earnings are a key ingredient for a rising stock market. Not only are earnings not rising, but as I’ve pointed out in a number of my recent Investment Letters, the quality of those earnings is deteriorating. There was a good article by Michael Hiltzik in the 3/18/16 LA Times that talks about SEC scrutiny on the non –GAAP earnings issue that I’ve been writing about. http://www.latimes.com/business/hiltzik/la-fi-hiltzik-silicon-valley-accounting-snap-htmlstory.html 3 Below is a chart that illustrates the quality issue I referenced above. The spread between GAAP and non –GAAP earnings is getting very wide. Measuring P/E ratios using GAAP earnings produces a very large ratio, much different than the P/E ratio using non-GAAP (pro-forma) earnings. #9 seed – “U.S. Corporate Stock Buybacks” One of the biggest buyers of stocks in the U.S. has been the corporations themselves. Historically high levels of corporate stock buybacks occur at market peaks (see 2000 and 2007). Corporate stock buybacks have masked some of the earnings and revenues problems of the last couple of years, what market watchers have termed “financial engineering”. This time around, alarmingly, corporations have been borrowing more than ever to execute those buybacks. Another problem with spending that much on “financial engineering “ is that it takes away from long term productive spending and investment for corporations. It has been recently identified that most corporate buyback occurs in the second half of a quarter since there are more buyback blackout periods around earnings in the first half of a quarter. Not only that, but corporate buyback activity has been identified as one of the biggest buying influences in our stock market. Maybe not so coincidentally, that explains some of the wide performance divergence in the 2016 1st quarter. Lu Wang had a great a3/14/16 article on Bloomberg about this topic that I urge you to read: http://www.bloomberg.com/news/articles/2016-03-14/there-s-only-one-buyer-keeping-the-s-p-500-sbull-market-alive #8 seed – “Slowing U.S. Economy” One of the most watched economic forecasting tools for GDP estimates is the Atlanta Fed GDP indicator that I often cite. The estimate for the 2016 1st quarter has 4 recently plunged to only 0.1%. As recently as 2/12/16, the indicator was calling for a 2.7% number for the first quarter. This comes on top of a disappointing 2015 4th quarter GDP performance. What makes it even more disconcerting is that last year’s winter’s weak numbers were blamed on cold weather. This year’s warm weather should have been a positive factor. Optimists are trying to tell us that our economy is still better than others, but I believe the reality of the situation is that we have a weak economy. # 7 seed – “Energy Prices” Stock markets in recent weeks have been tied to the daily moves in oil prices. Oil has staged a significant rally, not coincidentally in tandem with the stock market, since the mid February lows in the mid $20s to the current level in the low $40s. There has been persistent production cut rumors in the market during that whole rally. There has also been some recent U.S. dollar weakness which has helped commodities in general. (Cunningham, 2016) The rally has been so large that you’d think some of it has to be attributable to short covering. (Kee, 2016) Coordinated production cuts may be hard to come by because many energy dependent countries as well as companies need to continue to pump to keep cash flow going to service high levels of debt and expenses. With global economic forecasts continuing to drop, it might be tougher for markets to rally. If energy prices start to drop, for whatever reason, it is likely that that would adversely impact stock prices. #6 seed – “Janet Yellen Change of Game Plan” Since my last Investment Letter, Janet Yellen had two high impact speeches. 3/16/15 was the Fed Meeting and then 3/29/16 was a speech at the New York Economic Club. Keep in mind that the December 2015 Fed meeting featured a ¼ rate hike and forward guidance of four more rate hikes for 2016. Other Fed officials had and have generally supported that “hawkish” view. Both Yellen appearances turned out to be” dovish“, and the NY Economic Club speech could even be considered “uber dovish”. The Morgan Stanley FX team put out a report titled “Who Let the Doves Out”. Here’s an excerpt: “Chair Yellen could not have been clearer in suggesting that the Fed will keep US real rates lower for longer, citing international factors and the potential negative feedback loop into the US economy as the main reasons for adjusting its policy stance.” “It has broadened its reaction function beyond its traditional inflation and employment targets to include international factors, citing particularly weaker global growth indications and their impact on US corporate earnings.” Art Cashin in his 3/30/16 Cashin’s Comments included a great summary by Craig Torres of Bloomberg on conditions that Yellen needs for future rate hikes: “The Yellen Speech – Let’s start out with a helpful outline from Craig Torres of Bloomberg. Here’s a bit of what he wrote: In one of her most detailed policy discussions this year, Yellen gave investors a list of conditions they need to watch for future rate hikes. Here they are: 5 Foreign economies and their financial markets need to stabilize. The dollar can’t appreciate further. That would depress inflation and exports, and hurt U.S. manufacturing. Commodity prices need to stabilize to help foreign producers find a better footing for growth. The housing sector needs to make a larger contribution to U.S. output. Inflation is a two-sided risk: Yellen is skeptical that the recent rise in core inflation, which strips out food and energy, “will prove durable.” She is watching closely.” With all those conditions, it looks like it could be very tough for the Fed to raise rates this year. #5 seed – “The European Bazooka” Mario Draghi came out with his bazooka at the 3/10/16 ECB meeting. Porter Stansberry in his 3/10/16 Stansberry Digest described it this way. “According to the financial media, European Central Bank ("ECB") President Mario Draghi pulled out the big guns this morning… In a statement following the ECB's March meeting, Draghi announced a major change to the bank's open-ended quantitative-easing ("QE") program. In particular, Draghi said the ECB would now be buying 80 billion euros of bonds every month. That's an increase of 20 billion euros a month, topping expectations of an increase of 10 billion to 15 billion euros. The program is also expanding to allow the central bank to purchase investment-grade European corporate bonds. For comparison, at the peak rate of QE here in the U.S., the Federal Reserve was buying approximately $80 billion a month for a little more than a year. As of this morning, the ECB has matched that rate… and there's no end in sight. In addition, Draghi announced that the ECB was slashing interest rates again. Most notably, the central bank pushed deposit rates – the rate it charges commercial banks to keep their extra reserves at the ECB, which was already negative – even further into negative territory, from -0.30% to -0.40%. Draghi also announced a new program of "cheap loans" to European banks, which the ECB hopes will stimulate lending to businesses and consumers. As one money manager put it to the Wall Street Journal, "This has all the hallmarks of the ECB having thrown the kitchen sink at the problem." We couldn't help but wonder, though… What if the kitchen sink isn't enough?” As big as the bazooka was, the Euro currency has actually rallied and not declined as intended since the announcement. European stock markets are relatively flat since then. (Hobbs, 2016) It is possible that these central banks announcements are losing their ability to move markets. #4 seed – “China Credit Reacceleration” The Chinese are facing a problem that is requiring them to “walk the tightrope” The economy is slowing, but the People’s Bank of China (PBOC) doesn’t want to devalue much because there is capital flight occurring amongst wealthy Chinese. Currency devaluation 6 would probably accelerate the flight. In the meantime the route the PBOC is taking is to reaccelerate credit growth. Remember this is on top of the largest episode of credit growth that the world has ever seen. It is causing real estate prices amongst major Chinese cities to rapidly rise, similar to what happened to the Chinese stock market last year before it eventually crashed. The 3/28/16 Randall Forsyth column in Barron’s had this blurb from Anne Stevenson-Yang of J Capital Research; she is a highly regarded voice on China: China is another market that has rebounded with the help of the authorities. But, according to Anne Stevenson-Yang, it amounts to a "dead-panda bounce." The Chinese stock market and its currency, the renminbi or yuan, have firmed in tandem with the rosier hue taken on by markets around the globe. But in the case of China's equity and property markets, she writes in a report to clients of J Capital Research, "the root of nearly every part of the 'rebound' story is cash stoking an asset bubble, and that will not last long. It does suggest a degree of political panic." For now, the authorities are attempting to portray confidence. Curbs on margin lending and shortselling, two big culprits in last year's market debacle, are being eased. Moreover, the yuan has been guided subtly higher by the People's Bank of China this year, albeit against a weaker dollar, following last August's sudden decline. There has been a robust bounce in property speculation that Stevenson-Yang says is being likened to that of the stock market at its frenetic peak last year. Behind it is a stunning surge in governmentbacked lending to smaller banks and nonbank financial institutions that, in the first two months of this year, equaled almost half of China's reported GDP for 2015, or 36 trillion renminbi -- more than $5 trillion. In the past four months, lending by those institutions has exceeded all of last year's GDP by RMB20 trillion. "Leverage is the only idea left in the Chinese government, and is reaching truly suicidal levels," she contends. The financial pumping supports the "unrelenting jawboning from the top about the strength of the economy," Stevenson-Yang continues. While she concedes that her forecast of a further weakening of the yuan -- to 6.80 to the dollar versus the current 6.51 -- has been off the mark, she says that delaying the needed adjustments will worsen their cost and potential severity. But capital flight -- from both Communist Party elites and more modest families seeking to build wealth pools and income streams abroad, …… puts Chinese monetary authorities in a box. Pumping liquidity into the domestic economy further weakens the yuan. To counter that, the central bank sells dollars to meet the demand for foreign currency, which tightens domestic liquidity. The easiest way to sort out this conflict would be to let the yuan continue to fall. That has been the biggest bet by hedge funds this year, and it has been Beijing's aim to make the hedgies lose that wager. 7 Indeed, Stevenson-Yang says that Beijing may have to end the already-limited convertibility of the yuan to stanch capital flight. She claims that the $130 billion decline in currency reserves in January and February was a "manipulated number," to the downside, a figure that, like so much of China's data, is uncorroborated. And when the numbers and sums no longer can be juggled, the poor panda may come back down with a thud.” Anne Stevenson Yang did a great interview on ABC News that really adds a lot to those comments that I urge you to view: http://www.abc.net.au/news/2016-03-11/extended-interview-with-anne-stevenson-yang/7241618 China is a big story and eventually a big risk that can have many ripple effects on an ongoing basis. #3 seed – “ Yen Currency Volatility” By taking easing measures, central banks have been trying to devalue their own currencies. These actions are intended to give their own economy a potential short term economic boost, but this is ultimately turning into a form of ”currency wars” that are difficult to win. Historically, currency volatility coincides with stock market volatility inflection points. In last month’s Investment Letter, I pointed out that one of the potentially biggest events of the year so far was the initial rejection by the currency and stock markets in Japan of the Bank of Japan’s (BOJ) move into negative interest rates (NIRP).The yen has rallied over 10% at this point from the day of the announcement., while the Japanese stock market has been down. (Worrachate, 2016)The Japanese economy continues to struggle in a recession. This is exactly the opposite of what was intended by the BOJ. Japan has been unsuccessfully fighting deflationary forces for approximately 25 years. Jeffrey Snider of Alhambra Partners wrote an interesting fact filled 3/31/16 article entitled “The Evidence Piles Up- Japan’s Economy Keeps Shrinking, Abenomics an Abject Failure”. I’ll share a small bit with you: “In fact, no matter how many QE’s and other activities the Bank of Japan has undertaken since the Great Recession, industrial production remains 20% below the start of that year. That is not a misprint; Japan IP is still 20% smaller in the first months of 2016 than the first months of 2008 as if the whole economy just shrunk never to return (at least so long as “stimulus”). Only the financial and corporate sectors very narrowly count any of the QE’s as being “stimulus”; the rest of the country has been only impoverished.” #2 seed – “NIRP” By now you know NIRP stands for negative interest rates. Just think about that statement for a moment, negative interest rates. Of course it sounds very unnatural. In central bankers’ quest to force people into more borrowing, spending and stock market investing, NIRP was devised. It is a radical step as it distorts economics and punishes savers and pension funds amongst other entities. Have they gone too far? I’ve attached links to two excellent articles from two very savvy and experienced market progniscators, Bill Gross of Janus Funds and Stephen Roach. Bill Gross’ nickname of course is the “Bond King” while Roach is the former Chairman of Morgan Stanley Asia and current senior fellow at Yale’s Jackson Institute for Global Affairs. Must read stuff: 8 https://www.janus.com/bill-gross-investment-outlook http://www.marketwatch.com/story/negative-interest-rates-set-stage-for-next-crisis-stephen-roachsays-2016-02-18 #1 seed - “Debt Buildup” Obviously there is a lot of relation and overlap in all the “concerns” that I’ve seeded. The common denominator is “debt “. The global central bank game plan is simple, fix a debt crisis by creating more debt. This #1 seed is essentially the combined result of all the above. There is a limit to how much debt can be created before a tipping point, and I guess the world can try its’ hardest to get there. It could take longer to get there than I think, but I believe we’re rapidly approaching that tipping point that can bring with it negative consequences. With the interconnectivity of the global economy and markets, it can probably only take one of the “big four” central banks to hit that tipping point before shock waves reach the others’ shores. THE FINAL If I had to synthesize all of the above “seeds” into a “final” matchup, I would call it: “Confidence in central bankers versus global economic growth and earnings” If all these central banker interventions don’t generate improving economic growth and earnings, what’s next? More of the same? At some point, a loss of confidence in central bank actions is likely if we don’t get some real growth. As Bill Gross summed it up in his April Investment Outlook: “The real market and the real economy await a different conclusion as losses from negative rates result in capital losses, not capital gains. Investors cannot make money when money yields nothing. Unless real growth/inflation commonly known as Nominal GDP can be raised to levels that allow central banks to normalize short term interest rates, then south instead of north is the logical direction for markets.” This cycle has been stretched out further than I would have thought, but there will be a down side of the cycle. Short term you can’t tell the timing, but beyond that the market top that appears to have been forming over the course of the last 10-16 months still has a good chance to stand. UNDERDOGS BUT OUTPERFORMERS Two asset classes that I’ve been advocating in my Investment Letter have been high quality fixed income and precious metals. U.S. Treasuries continue to be a good defensive position to maintain since U.S. treasury yields, although historically low, are still significantly higher than most European and Japanese sovereign bonds. In a continued slow growth or worse environment, Treasuries would be a good place to invest. Municipal bonds have also done well. (Kosnett, 2016) Stick with higher quality bonds, particularly if credit spreads start another round of spread widening. According to Porter Stansberry: “Gold had its best quarter since 1986. The metal’s spot price was up more than 16%” 9 Gold and silver miners were the outperformers of the 1st quarter. (Sykora, 2016) I’ve documented the extended rough patch that they went through since October 2011, but they’ve had an explosive move off the mid- January bottom. (Hamilton, 2016) I’ve been labelling gold the anti-central bank asset. With a large chunk of the world’s interest rates negative, gold offers a good defensive alternative. Keep an eye on the price of gold: it perhaps is a good contrary gauge of confidence in central banks. CONCLUSION As I had indicated in my initial comments, this rally presents a terrific opportunity to reallocate your assets, lightening up on equities into the recent strength. The rally has a chance to have some more to go, but it has already come a long way in the face of the aforementioned “concerns”. In the last couple of years, it always seems like just when the market looks like it is breaking out it turns down, and conversely, when it seems to be breaking down it somehow manages to rally.. Sorry for the length of this Investment Letter, but I feel it is important to make you aware of the large number of risks that exist in our investment world. I’ve included plenty of backup documentation with all the info and links. Take some time to read them and hopefully better understand them. Good health and good luck investing! David Janny Senior Vice President Financial Advisor NMLS# 1279369 Morgan Stanley Wealth Management 200 Nyala Farms Rd. 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