25 Jan Market Note: Doyle Brunson and the Orange Swan
THE DOYLE BRUNSON MARKET
The 10-2 isn’t the worst hand you can be dealt in a game of Texas Hold’Em – technically a 7-2 offsuit is – but it’s right up there. In a match-up with four other players, the 10-2 offsuit loses about 90% of the time. At the final table of the World Series of Poker in 1976, Doyle “Texas Dolly” Brunson found himself staring down at this very hand. After an A-J-10 flop paired his opponent, Jesse Alto’s, excellent starting hand with the top two pair, Brunson tried to use his decisive chip lead to muscle Alto out of the pot with an all-in push. Alto called. The Turn gave Brunson another 2, but that wasn’t enough. Then the River came up a 10, handing Brunson a Full House, the title, and the $220,000 prize money. What makes both this story so phenomenal and the hand eponymous with Brunson is not just that he won such a massive game with such a meagre hand, but that the following year at the same table in the final round of the same tournament with the same poor hand, he did it again. In an almost identical situation, Brunson picked up a 10 on the River for the 10s-over-2s Full House and the $340,000 stake.
With stock valuations and bond yields in the worst 10% of historical starting points, the market has dealt investors a 10-2 offsuit – a “Doyle Brunson.” Based on valuations alone, today is not a great time to be going all-in on the riskier segments of the capital markets, but with sentiment measures across the economy turning up and inflows into stocks recently picking up too, that is exactly what investors are doing.
Source” Toleda Blade – May 13, 1977
While we expect some hurdles in the short-term (the Turn card may disappoint, so to speak), if the Fed can stay relatively accommodative the unleashing of “animal spirits” (yes, we are almost as tired of hearing that expression as we are of poker analogies) by the incoming administration may deliver just the winning River card investors need to complete the Full-House and finish this bull market with an epic, frenzied move higher. But buyer beware: the current market environment has many – but not all – of the earmarks of a multi-year peak. Buckle up!
2016 IN REVIEW
After a rocky start to the year, global central banks came to the rescue again and helped stocks brush off a China slowdown and currency panic, a U.S. industrial recession, Brexit and a Trump win to end the year higher. U.S. stocks outperformed their global counterparts, helped by a 4% rally in the U.S. Dollar Index. The return spread between value and growth investing styles was stark. Among larger companies in the Russell 1000 Index, value stocks outperformed their growth counterparts by 10%. Within the smaller cap Russell 2000 Index, value beat growth by 20%. Developed non-U.S. stock markets trailed other major asset classes and were only able to eke out small gains in U.S. dollar terms.
Emerging markets and commodities broke their multi-year losing streaks and rallied nearly 10% and 20%, respectively. Commodity exporters Russia and Brazil led this group, as oil rebounded from its February lows to finish the year well above $53/barrel. With U.S. oil rig counts increasing and production again moving higher it appears supply/demand dynamics are balanced going into the new year. Industrial metals rallied sharply, in part because of hopes of fiscal stimulus and infrastructure spending in 2017. From its low in January the S&P 500 Metals and Mining Index ETF jumped over 175%.
Bonds rallied (yields declined) in the first half of the year and then abruptly reversed in early July. The sell-off gained momentum as inflation expectations jumped after the U.S. election, bringing their full year returns down into modestly positive territory. Less remarkable returns for the full year mask the violent reversal in bonds, interest rates, and rate-sensitive assets that started about two weeks after the Brexit vote on June 23rd. Immediately after Brexit, the market briefly priced in higher odds of a rate cut than a hike in 2016. As interest rates plumbed their lowest levels in 5,000 years, investors either moved into longer duration bonds, hoping for further price appreciation if rates kept dropping, or into bond “proxies” like high dividend stocks. From January 1st through July 8th (the high), long-term bonds rallied 20% only to drop back and end the year flat.
The reversal also dragged REITs and other rate-sensitive stocks lower in the back half of the year, causing them to lag the broad market for the full year. On the flip-side, bank stocks reversed first half losses, ultimately performing exceptionally well in the latter half of the year on excitement over a steeper yield curve and the prospect of deregulation.  Source: http://www.marketwatch.com/story/charting-the-lowest-interest-rates-in-5000-years-worst-commodity-returns-in-80-years-2016-06-14
SHORT-TERM OUTLOOK (“THE TURN”)
At 94 months, this U.S. stock bull market is now the second oldest since the 1930s and bested only by the 13-year run from 1987 to 2000. Its annualized inflation-adjusted return of 14% (17% with dividends and 231% cumulative) is better than 97% of historical outcomes over the same length of time.
The bull market has taken long-term smoothed price-to-earnings multiples (PEs) from below 14x in March 2009 to over 28x today. The price-to-sales multiple has more than doubled from 0.8x to 2x. Regardless of the valuation tool you prefer, U.S. stocks are priced at some of the richest levels in history. Valuations of non-U.S. stocks are far more attractive, but we do not see any fat pitches.
Valuations are a major concern, but they are a poor timing tool and like Texas Dolly’s 10-2 have little correlation with near-term market outcomes. Sentiment measures, however, are more useful for that as they highlight when the investing masses may have lopsided positioning. Periods of extreme pessimism often signal beneficial entry points into markets and extreme optimism the reverse. Consider where we are today:
- The Investors Intelligence Sentiment Survey for the first week of January reported over 60% bulls, a measure exceeded less than 2% of the time.
- The same survey reported 21% of investors expect a correction in the near term, one of the lowest levels in 8 years.
- The AAII Individual Investor Sentiment Index reports over 46% of investors as bullish, a reading exceeded only about 10% of the time in 10 years.
- The NAAIM Equity Exposure Index was over 100 at the end of December, a measure exceeded less than 1% of the time. · NYSE Margin Debt just eclipsed $500 billion and is just 1% below the highest reading ever.
- The Market Vane Bullish Consensus is at 65% bulls, one of the highest readings in 8 years.
- The CBOE Volatility Index or “Vix” (a measure of fear derived from option prices) is at 11.3, a lower reading than 97% of history.
- The 4-week moving average of the S&P 500 Put/Call ratio (a measure of the ratio of downside to upside option bets) just dropped below 1.25, its lowest reading in 8 years.
- The Goldman Sachs S&P 500 Futures Sentiment Indicator recently moved above 90, which indicates extreme bullish positioning.
- The December reading for the Conference Board Consumer Confidence Index, which has a high correlation with the stock market, just hit 113.7, the highest reading in 16 years.
- The NFIB Small Business Optimism Index hit 98.4 in November, the 2nd highest level in 10 years.
If all of that doesn’t convince you sentiment is stretched, consider the recent increase in the search phrase “How do I buy stocks?” on Google.
Notwithstanding the above, we believe there may still more room for the rotation out of bonds and into stocks. One crucial piece of the puzzle is missing – investors are not as heavily invested in stocks as they have been at prior market tops. According to Gallup, as of mid-2016 only 52% of Americans owned any stocks at all, which was tied for the lowest ownership percentage in at least 17 years (the history of the annual survey). There may still be a lot more people who need to ask Google how to buy stocks and chase this aging bull market.
Mutual fund flow data also shows consistent monthly outflows from both active and passive funds for the last two years. If we include exchange-traded funds (ETFs) to capture their increased use, we get a more tenuous picture (the solid lines shown above), but still not a decisive one.
The only flow data that is concerning is found when exchange-traded funds and other products (ETPs) are isolated (shown below). By this measure, inflows into U.S. stocks ramped up dramatically in the last 3 months to over $90 billion and were more than double any other 3-month period in history.
We also need to consider that demographic shifts and the preference of an aging population for bonds over stocks may be fueling outflows from equity mutual funds and that money may never come back. If we consider the average Baby Boomer reached his/her peak income years around the turn of the century, we can get a sense for the massive amount of capital that was being generated and available to be plowed into stocks in the late 1990s and early 2000s – amidst the longest and most powerful bull market of a lifetime. According to Pew Research, in April of last year Millennials (at 75.4 million) officially overtook Boomers, but it will still take a decade before they begin to hit peak incomes.
Another reason for concern is that the excessive wave of optimism since the election is based almost exclusively on expectations (hope) that the incoming president and a Republican controlled government will deliver on campaign promises. The press release from the December Conference Board Consumer Confidence survey highlights this:
’Consumer Confidence improved further in December, due solely to increasing Expectations which hit a 13-year high’ said Lynn Franco, Director of Economic Indicators at The Conference Board. ‘The post-election surge in optimism for the economy, jobs and income prospects, as well as for stock prices which reached a 13-year high, was most pronounced among older consumers. Consumers’ assessment of current conditions, which declined, still suggests that economic growth continued through the final months of 2016. Looking ahead to 2017, consumers’ continued optimism will depend on whether or not their expectations are realized.’
The most recent NFIB Small Business Optimism Index press release follows the same theme:
Small business optimism remained flat leading up to Election Day and then rocketed higher as business owners expected much better conditions under new leadership in Washington, according to a special edition of the monthly NFIB Index of Small Business Optimism, released today. ‘What a difference a day makes,’ said Juanita Duggan, President and CEO of the National Federation of Independent Business (NFIB). ‘Before Election Day small business owners’ optimism was flat, and after Election Day it soared.’
The question is how much of Trump’s policy agenda will he be able to deliver on. Fiscal stimulus will be a major theme for the next few years, but there is a lot of hope and buildup and some practical limitations to what can be achieved and how quickly. Trumps emphasis on private-public partnerships (“P3s”) instead of federally-funded projects may be more effective longer-term but structuring these partnerships takes time. In addition, while there is significant room for increased infrastructure investment, there are not a lot of “shovel-ready” projects just sitting on the shelf. At the end of the day, we believe increased infrastructure spending is more a story for late 2017 at the earliest.
We also doubt fiscal stimulus from abroad will be able to goose global growth. With a debt-to-GDP level of over 250% and an overall budget deficit as far as the eye can see, Japan is in horrible financial shape and has little room for additional stimulus. The Euro area is in a similar situation with average debt-to-GDP ratios above 90% – well above the 60% limit imposed by the Maastricht treaty.
According to the Tax Policy Center, Trump’s plan would add over $6 trillion to outstanding debt over the next decade and more than $20 trillion over 20 years excluding the impact of higher interest costs on the debt. Accurate or not, these expected increases in the debt will create hurdles for many Republicans and suggests any tax plan will be thinned-down.
For individuals, eliminating the estate tax and proposed changes to marginal rates would disproportionately help higher income groups. Estimates show the bottom 40% of earners would only receive a tax cut of less than 1% versus as much as 6.5% for the top 1%. These lower income groups have the highest marginal propensity to spend. There is also the issue of timing related to tax changes. The economic benefits of lower taxes for consumers will likely be felt at the earliest in late 2017.
Corporate tax rate reform is another key item on the agenda. According to the OECD, if federal and state taxes are included, the U.S. has a marginal corporate tax rate of about 39%, by far the highest in the industrialized world. However, due to various deductions and accounting shenanigans, the effective tax rate for non-financial U.S. companies is far lower than the headline number. According to national accounts data, these companies had tax rates of just 25% as of June 30, 2016, which is in-line with the median across the 34 other OECD economies. Further complicating the outlook is the fact that until there is certainty around Trump’s policy agenda, businesses may not be inclined to deploy capital.
Source: Deutsche Bank
We are more optimistic on the regulatory reform front, but again the new administration will have its work cut out for it and any progress made will probably only be felt later in 2017. Trump has already backed away from his promise to completely repeal the Affordable Care Act. Coming up with a feasible replacement will take time.
Despite our near-term concerns, the move to reduce corporate taxes, remove deductions and close loopholes should be beneficial for business confidence and profits. Smaller companies could benefit disproportionately to the extent the playing field is leveled and any tax arrangement encourages a repatriation of corporate cash held offshore, which would likely be used to pay down debt, for buybacks, and for acquisitions. These actions would be good for stocks, but have little impact on the economy longer term. Likewise, any other fiscal stimulus will have a positive, but likely transitory, impact on the economy.
MEDIUM-TERM OUTLOOK (“THE RIVER”)
To understand our more optimistic medium-term outlook for markets, we must begin by discussing just how stifled small businesses felt coming into the election and then the magnitude of the pendulum swing that will take place in Washington in 2017.
Prior to the election, the Uncertainty Index component of the NFIB Small Business Survey was at a 42-year high. The 13,000 business owners sampled cited rising healthcare costs, excessive regulations, and income taxes as the top three problems faced.
The 2016 issue of Ten Thousand Commandments (an annual snapshot of the U.S. regulatory environment) estimate the total annual cost of all U.S. regulations at $1.89 trillion. According to the report, if they were a country, U.S. regulations would represent the 9th largest economy in the world. Another measure of how heavy-handed the last administration was can be found by counting the 87,297 pages in the Federal Register (the official registry of all government agency rules, proposed rules, and public notices). By this measure, small businesses have just endured 7 of the 8 most regulated years in history. As of August 2016, there were 4,063 regulations in the pipeline and 800 of those impacted small businesses.
The incoming administration will take a categorically more business-friendly tone. In a recent letter, Bridgewater founder Ray Dalio provides some perspective on this striking ideological shift:
This particular shift by the Trump administration could have a much bigger impact on the US economy than one would calculate on the basis of changes in tax and spending policies alone because it could ignite animal spirits and attract productive capital. Regarding igniting animal spirits, if this administration can spark a virtuous cycle in which people can make money, the move out of cash (that pays them virtually nothing) to risk-on investments could be huge. Regarding attracting capital, Trump’s policies can also have a big impact because businessmen and investors move very quickly away from inhospitable environments to hospitable environments. Remember how quickly money left and came back to places like Spain and Argentina? A pro-business US with its rule of law, political stability, property rights protections, and (soon to be) favorable corporate taxes offers a uniquely attractive environment for those who make money and/or have money.
Not only does the Trump administration represent arguably the most business-friendly lineup since at least Reagan, but the outgoing administration may represent one of the least business-friendly ones in decades. Obama inherited a climate of deep distrust and frustration with corporate excesses and Wall Street, which he was committed to reining in. His cabinet reflected that distrust, with just 5 years of C-suite business experience across top appointees. Trump represents a dramatic swing in the ideological and political pendulum back in the other direction.
Source: Bridgewater. Count includes President, Vice President, Chief of Staff, Attorney General, and secretaries of State, Defense, Treasury, and Commerce.
Without commenting on the long-term social or economic merits of the Trump administration’s proposed policies, history suggests unified pro-business governments tend to be extremely supportive of corporate earnings and markets in the medium term. The 4 years leading up to the peak of the housing bubble are a recent case in point, but similar patterns of unified pro-business administrations were present prior to the 1907 panic, the crash of 1929, and arguably the peak of the tech bubble (Republicans had control of Congress, but not the presidency).
THE ORANGE SWAN
The intersection of near-term concerns with a more constructive view of markets over the medium term (2 years) poses a challenge for investors. In response, we are advising clients neither reduce their exposure to stocks wholesale nor increase their exposure given this recent wave of optimism, but rather that they prepare themselves for a market that may run further than many think possible in order to prevent the most damaging mistake of all – abandoning a long-term plan, chasing returns and going all-in near the peak. We are also advising patience when implementing new allocations and are building a short list of assets we will add to if there is a near-term dislocation.
According to Nassim Taleb, author of The Black Swan: The Impact of the Highly Improbable, a black swan is an event that is (1) extremely difficult to predict with information available at the time, (2) of high consequence, and (3) seemingly becomes easy to predict after the fact (Taleb calls this the “retrospective distortion”). Taleb believes investors should always invest with the assumption that black swans can occur at any time, which would add a layer of prudence to even the most risk-seeking portfolio. We agree wholeheartedly with Taleb. While we were never convinced a Trump win qualified as a black swan, we are upgrading our assessment of the risks associated with the first year of a Trump presidency to an “orange swan”. We are defining an orange swan as an event that is (1) fairly easy to predict with information available at the time, (2) of high consequence, and (3) will be claimed to have been impossible to predict after the fact. Orange swans occur when unpredictable deal-men who rely on brinksmanship and hyperbole preside over a massive pro-business shift in political regimes, the first meaningful rate-hiking cycle in a decade, an economy with record debt levels, retail investors ramping up stock allocations into some of the most expensive markets in history, and an approaching trade war between the two largest economies in the world.
Like the massive chip swings that make Texas Hold’em such a popular game, U.S. investors should prepare themselves for more volatility, up and down, than they have experienced during the last few years of the bull market in stocks. With the exception of the first three weeks of 2016, the first three days after Brexit, the first three hours after the U.S. election, and the first 3 minutes after the Italian referendum, this market has been one that has punished anyone who didn’t hold their nose and buy the dip.
In the 1998 movie Rounders, Mike McDermott (played by Matt Damon) shares some advice from Doyle Brunson: ‘The key to No Limit is to put a man to a decision for all his chips’. This 94-month old bull market is starting to have the same effect on investors. The urge to go all-in may soon become overpowering for all but the most patient and disciplined of investors.
The SpringTide Investment Team
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