Crescat Capital December 31 2018 replace to buyers under.
We’re joyful to report estimates for Crescat’s 2018 efficiency:
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Revenue Attribution by Theme
Funding Outlook Abstract
September 20, 2018 ought to mark the closing excessive for the S&P 500 to finish the second longest bull market in US historical past. It also needs to mark the highest of the “everything bubble”, a time period coined by funding publication author Jesse Felder to explain historic valuations in each main asset class, commodities being the one exception. The all the things bubble was courtesy of experimental international central financial institution insurance policies within the wake of the Nice Recession. We expect it is just the start of the asset bubble bursting course of introduced on by the sheer extent of the bubbles themselves. In different phrases, we’re more likely to face the real-life enjoying out of economist Hyman Minsky’s “financial instability hypothesis” which portends far more unwinding nonetheless to return. There’s a pure financial cycle, together with a pure enterprise, market, liquidity, and credit score cycle that are all intertwined. Whereas nobody can predict the lengths and inflection factors of those cycles with good precision, our objective is to time them as greatest we will to be prudent stewards of our shoppers’ capital and develop and shield it over the long run.
Our macro mannequin is telling us that the bull market has lastly topped out for this cycle and that the financial system will quickly comply with. The central financial institution liquidity tide goes out whereas equities, fastened revenue, actual property, and personal asset automobiles are all at historic valuations. We strongly consider there’s nonetheless ample alternative to capitalize on the every part bubble meltdown in 2019 via choose shorts positions and “proper” defensive longs. The acute macro imbalances have solely simply begun to unwind based mostly on:
- Document international leverage in comparison with international GDP;
- Solely-recent document US fairness valuations throughout eight complete measures;
- Current report monetary asset valuations relative to GDP within the US;
- A report foreign money and credit score bubble in China;
- Historic housing bubbles in Canada and Australia;
- Document low cost valuations for valuable metals and associated mining shares;
- The second longest financial enlargement and second longest bull market in US historical past;
- Just lately historic US market-top indicator ranges on Crescat’s 16-factor macro mannequin;
- Lack of widely known international recession with corresponding low fairness market valuations, investor despondency, and capitulation essential to sign a cyclical market backside;
ecord International Leverage
International debt ranges stay traditionally elevated and, generally, considerably larger than ranges previous to the Nice Recession. Taking a look at an inventory of all nations tracked by the BIS and the IMF, virtually half of them are above the 90th percentile immediately when it comes to their historic complete debt-to-GDP ratios. See the chart under for the 26 economies at this time on the left panel which have debt to GDP at or above the degrees that preceded these of the most important credit score crises within the final 30 years. The yr, nation, and debt ranges that preceded these crises are proven within the right-hand panel.
Crescat’s US Macro Mannequin
As a part of our funding course of, we strongly depend on our personal macro fashions to determine main cyclical market tops and bottoms. Our mannequin under exhibits throughout sixteen indicators that the US inventory market is very weak to a considerable additional downturn that may lead the US and international financial system right into a cyclical recession. We confirmed this mannequin to the world on January 26, proper earlier than the primary market selloff of this yr main Crescat’s hedge funds to business main efficiency in February. Regardless that the US inventory market subsequently recovered its losses and pushed to new highs although September, this mannequin helped us to remain on track to stay internet brief US and international equities all yr. We benefitted tremendously from the current decline within the 4th quarter within the S&P 500. We additionally capitalized extraordinarily nicely on worldwide fairness shorts, notably in China, different Asian and different rising markets, Australia, and Canada, all year long.
As we present within the present chart of our macro mannequin under, even now, after the 4th quarter US inventory market selloff, our general macro mannequin indicator is simply 7 percentile factors down from its highest bubble score ever hit for US shares, three months in the past. Ought to we purchase the current dip? No. Whereas there are more likely to be regular bear market rallies after massive down strikes, and we will attempt to hedge towards these to a point after such strikes, it ought to show much more essential to not get sucked into these bull traps once they occur. We have to wait till the bear market has extra absolutely performed out and a recession has turn into extensively acknowledged earlier than we’ll need to get aggressively lengthy once more. In this respect, it ought to pay to comply with our macro mannequin and to acknowledge that at the moment our indicator continues to be a minimum of 78 percentile factors away from signaling a attainable market backside!
How you can Keep away from a Worth Lure
Don’t be fooled by speaking heads who inform you that US shares are low cost due to the ahead P/E a number of immediately. In our prior quarterly analysis letters, we confirmed eight elementary metrics that proved that the US fairness market was at document all-time excessive valuations. Worth-to-earnings multiples are a harmful “value trap” given report, unsustainable revenue margins on the probably peak of an financial cycle. The E within the ahead P/E a number of is more likely to plunge as asset bubbles within the US in equities and company credit score burst and the financial system heads into recession. It’s crucial to take a look at cyclical and margin-adjusted P/E multiples to keep away from worth traps close to the height of a cycle. Margin-adjusted CAPEs reached all-time highs in Q3 2018, greater than the prior all-time excessive in 1929 and the second-highest on the peak of the tech bubble in 2000.
Supply: Hussman Strategic Advisors
International Yield Curve Inversion
The tightening coverage by the Fed has created crucial imbalances in monetary markets worldwide. With Fed funds fee at 2.four% we now have 13 nations with 30-year sovereign bonds that yield lower than US in a single day charges. The variety of economies with unfavorable 30-year spreads relative to Fed Funds is unprecedented. The speed one can earn from holding money within the international reserve foreign money competes with all different belongings within the international credit score markets. Traditionally, as we present within the chart under, this has been a regarding improvement in credit score markets that alerts recession forward within the US and globally. The worldwide yield curve inversion is highlighting a perceived flight to security in international sovereign bonds regardless of their document low yields.
Fed vs. ECB Financial Coverage Divergence
Among the many flashing warning alerts from credit score markets worldwide, the current rate-hike in US in a single day charges illustrates a crucial divergence in financial insurance policies between the Fed and the ECB. The chart under exhibits the unfold between Three-month LIBOR vs. Euribor unfold, now at its widest distinction ever! Historical past exhibits that earlier extremes adopted coverage reversals which importantly additionally coincided with the final two US inventory market tops.
Oil Sending a Sign About Weakening Demand within the International Financial system
Oil costs plunged within the final quarter of 2018, a transfer that Crescat capitalized on in our hedge funds with brief positions in particular person oil exploration and manufacturing shares recognized by our mannequin and brief positions in each WTI and Brent crude oil futures in our international macro fund. The oil worth decline was the worst throughout a Fed tightening cycle within the historical past of WTI futures and occurred regardless of the telegraphing and announcement of a brand new OPEC provide reduce in the course of the quarter. The oil decline is yet one more one in every of many indicators of the top of the enterprise cycle. As we present within the chart under, it’s fascinating to notice how all vital drops up to now additionally coincided with drastic Fed coverage change within the following months.
Chasing Utilities is Typical at Market Tops
To sum up how lazy at the moment’s widespread cash supervisor is, hedge funds and asset allocators at giant have been crowding lengthy and obese into US utility shares in an try and be “defensive”. Likewise, market pundits have been approaching monetary TV often within the final month telling buyers to do the identical. Apparently, these teams are investing based mostly on previous, damaged market maxims relatively than doing any analysis and evaluation. Utilities are probably the most over-valued sector within the US inventory market right now in line with Crescat’s elementary mannequin.
Importantly, within the final two recessions, utility shares didn’t carry out like a defensive sector in any respect – the Utilities Choose Sector SPDR ETF (XLU) suffered a 46% drawdown from 2007 to 2009 and a 52% one from 2000 to 2002. In our view, utility shares might decline a good additional within the coming bear market and recession given their report leverage and historic excessive valuations based mostly on a mixture of elementary yield metrics resembling gross sales to enterprise worth, free money move to enterprise worth, and e-book to cost. By the best way, utility sector combination free money movement is destructive within the final four quarters. These corporations can’t even generate profits on the probably prime of a enterprise cycle. Ugh!
The chart under exhibits the 12-month correlation between the S&P 500 and utility shares rising after reaching its most destructive degree because the begin of the tech bust and the International Monetary Disaster. That is precisely how bear markets manifest: First, the S&P 500 will get wobbly, however utilities nonetheless rise. Then, S&P 500 crashes and utilities comply with to the draw back. It seems to us that utility shares have topped out for this cycle on 12/13/2018, simply as buyers piled into them. They’re down 6.Three% since and we’re comfortable to have taken the opposite aspect of that commerce by way of XLU put choices. We expect it’s nonetheless very early in coming downturn for utility shares.
Breakout in Gold-to-Oil Ratio Sends Macro Sign
One other key macro inflection provides to our near-term bearish conviction for US equities and company credit score. The strikes between gold and oil is one thing we monitor intently. For us, the development of this ratio serves as a bellwether to the inventory market and the financial system. Earlier breakouts in gold versus oil have corresponded with inventory market crashes and proved to be nice occasions to play the continued widening of this unfold. The current spike above its three-year resistance line helps our views that there’s additional draw back in fairness markets globally.
The Fed is Probably Executed Climbing Curiosity Charges for this Cycle
The downturn in international fairness and credit score markets that gained traction in This fall deserves shut consideration. The three massive developed-market central banks are nonetheless appearing like it isn’t an issue. Mario Draghi simply introduced that the European Central Financial institution will lastly finish its QE this month whereas the Financial institution of Japan has been stealthily signaling an impending taper. In the meantime, the Fed continues to sign additional tightening in 2019. The Fed Funds futures market begs to vary and has despatched an essential sign of an impending enterprise cycle downturn based mostly on plunging yields during the last two months. In accordance with the Fed Funds futures market, the chance of any rate of interest hike in any respect in 2019 is now lower than 10%. The in all probability of a reduce by the top of the yr is now larger than the chance of a hike as proven within the desk under. Buyers ought to take notice that the Fed Funds futures market is a way more dependable indicator than the Fed’s personal dot plot which nonetheless exhibits two hikes in 2019. When it will get to assembly time, the Fed not often likes to go towards the futures market.
Valuable Metals: A Deep Worth Setup
We strongly consider based mostly on our valuation and timing fashions that we’re on the precipice of a US fairness market meltdown that would pressure the Fed to behave much more aggressively then post-2008. Subsequently, for us, there isn’t a higher time to personal valuable metals than now as costs are traditionally low cost relative to the worldwide fiat financial base which is now near $19 trillion. With the present valuation setup, a looming Fed stimulus cycle is extraordinarily bullish for valuable metals!
The chart under exhibits that commodities have underperformed the S&P 500 for the final decade. Given how overvalued fairness markets are, we expect this unfold close to historic low-levels justifies our lengthy publicity to valuable metals in all our methods as the first commodity phase that may profit from the approaching inventory market and financial downturn.
On the lengthy aspect of our portfolios, we expect valuable metals commodities and mining shares can act as true defensive havens to not solely shield capital however to capitalize on the upcoming bear market. Gold and silver mining corporations personal priceless gold within the floor and, in lots of instances, are producing and producing constructive free money movement immediately, even at depressed gold and silver costs. Many of those shares are deep-value performs with vital upside potential.
The ratio of the S&P 500 to the Philadelphia Inventory Change Gold and Silver Index of mining shares just lately retested its early 2016 report excessive from which it rallied 200% in simply 7 months. The chart under illustrates this double prime within the S&P 500 versus gold and silver shares. Valuable metals mining corporations have already begun to rise in This fall whereas the S&P 500 declined. All Crescat’s methods benefited from this nascent transfer up in valuable metals within the quarter. We consider gold and silver are establishing for a serious upward inflection.
Company Credit score Woes
Our analysis exhibits that non-investment-grade bonds, so-called junk, are additionally traditionally overvalued. With US company debt at document ranges in comparison with GDP whereas the Fed is tightening, why are credit score spreads close to report lows? This a basic signal of a market at its peak. We researched additional into the SPDR Bloomberg Barclays Excessive Yield Bond ETF (JNK) holdings particularly, a well-liked ETF for top yield bonds. In combination phrases, the ratio of internet debt to free money movement for all JNK public corporations is now near 28x. It’s exhausting to consider the price of capital stays so low cost for companies with such slim money movement margins.
The next comparability is much more compelling for shorting junk bonds. We discover it fascinating how ETFs of funding grade bonds, such because the iShares iBoxx $ Funding Grade Company Bond ETF (LQD), have already surpassed their 2016-lows whereas junk bond ETFs like JNK are nonetheless properly above it. We now have held put choices on two junk bond ETFs in our international macro hedge fund, HYG and JNK, within the fourth quarter and nonetheless do at this time. We see this as an unimaginable alternative to capitalize from a big credit score deterioration amongst high-yield corporations and the potential for a re-test of the early 2016 lows.
China: The Grey Rhino within the Room
The Chinese language financial system stays a big focus of ours and the current turmoil in its fairness markets confirms the legitimacy of our China credit score bust thesis. Chinese language shares have now misplaced near $Three.6 trillion in market worth, accounting for near 25% of its GDP. In comparability with the Nice Recession, by the point US markets had misplaced comparable quantities, the financial system was already in a deep recession. We expect that China is already within the midst of a recession regardless of its constructive reported actual GDP numbers. We’re seeing extreme indicators of credit score tightness in China. Through the second a part of the yr, shadow financial institution lending shrank at unprecedented ranges. This has been a serious supply of capital funding for Chinese language zombie corporations.
The final M1 progress print in China was nearly 32 foundation factors away for its all-time lows. M2 progress can also be decelerating considerably, now at its slowest tempo within the historical past of the info. If over half of worldwide GDP progress for the final decade relied on China, what ought to this be telling us concerning the present macro setting?
The Chinese language banking system now claims to personal near $40 trillion value of belongings on its stability sheet. As we now have famous a number of occasions earlier than, China is sitting on a massively inflated foreign money and a credit score bubble because of the vastly overstated worth of those belongings from years of not writing off non-performing loans. As US monetary circumstances proceed to tighten, the Individuals’s Financial institution of China (PBOC) is unable to behave equally, leading to vital financial coverage divergence. As an example, see under the unfold between Fed funds price and Shibor in a single day charges at its widest degree since 2008. This provides additional strain on the yuan to proceed devaluing.
Foreign money pegs might be cussed, however they finally fail. Based mostly on their current present account modifications, the Chinese language RMB, HKD & Saudi Riyal are a few of the most overvalued currencies on the earth at present. Usually, huge declines in present accounts trigger declines in change charges because the chart under reinforces.
The chart under exhibits what we consider to be a important breakout. The decoupling of gold vs. offshore Chinese language yuan (USDCNH) is among the many biggest macro commerce alternatives on the planet at the moment. With Chinese language fairness markets in free fall, it’s turning into more and more troublesome for the PBOC to stop the yuan from devaluing towards each gold and USD. Gold in yuan phrases has lately re-tested its Three-year breakout degree, bounced off its 200-day shifting common, and shaped a golden cross. Technically, that is an extremely bullish setup each for gold and for yuan depreciation. China’s debt bomb is ticking quicker, and a yuan devaluation appears unavoidable.
We want all our shoppers and followers the happiest of holidays and a wholesome and affluent New Yr!
Kevin C. Smith, CFA
Chief Funding Officer
International Macro Analyst