Research Archives - Mad Hedge Fund Trader

The Lawsuits Are Piling Up on the (XIV)

One of the most painful experiences of my half century long trading life involved the Credit Suisse VelocityShares Daily Inverse VIX Short-Term ETNs (XIV).

I was certain that the Volatility Index (VIX) would peak for the year at the Wednesday, February 5, 8:30 AM market opening. So, I shot out a Trade Alert to place only 10% of your capital into the (XIV), a bet that the (VIX) would fall. There was only a 15-minute window before the market closed during which readers could get in. A few managed to do it.

The (XIV) had just fallen from $147 to $95.00. We got in at $97.08, and it closed the day at $100. The (VIX) closed at $37. And we had made money many times selling short volatility over the past decade on spikes just like this one. The (XIV) had been the fastest growing of 3,500 ETFs over the past five years. So far, so good.

Then an hour after the close, I received an urgent call from a client. The (XIV) was trading at $14. What's up?

My initial instinct was that a major hedge fund had either gone bankrupt or had a margin call and was suffering a forced liquidation in the aftermarket.

Overnight, the (XIV) traded as low as $6.50. I later heard that Credit Suisse itself was the major buyer of volatility in the aftermarket, in fact was the ONLY buyer, and that it was deliberately attempting to bankrupt its own fund to limit its liability. Those in management in Zurich were afraid that if the (VIX) shot up to $100 it might take the entire bank down. In short, they panicked.

The next morning they issued notice that they were closing the fund in 10 days. I was certain that the managers were guilty of insider trading and securities fraud in ordering the emergency short cover, and that it was just a matter of time before the class action suits emerged.

Three months later, the lawsuit has been filed by the Gibbs Law Group in Oakland, CA, in the Southern District of New York for unspecified damages, expenses, and legal fees, with a jury trial demanded.

The last time I was involved with one of these was with the MF Global bankruptcy in 2011, where I and most of the rest of the trading community had an account.

I was initially offered 25 cents on the dollar. I refused, expecting to eventually get paid in full. I knew that the MF assets in question were never lost, they were just caught up in a conflict between U.S. and U.S. bankruptcy law that would eventually be resolved. That is what happened, and I was paid in full three years later.

The (XIV) case is much more complicated because there was a huge real loss, about $2 billion, and it involved complex mathematically constructed derivatives. Since the managers behaved so reprehensibly, and because the evidence of their misdeeds is so overwhelming, it is unlikely that the case will ever come to trial. Instead, there will be an out-of-court settlement.

If the SEC takes action it will further strengthen the plaintiffs' hands. There is currently an investigation of Credit Suisse underway and it ultimately could get banned from doing business in the United States.

My bet is that investors will get at least half their money back, if not more. But it could take years to get it, and in a class action the lawyers get a big chunk of any awards for their efforts, usually one-third. Sometimes, class actions can last as long as 10 years.

As for my own followers, most followed my advice to put no more than 10% of their capital into the trade. As it turned out, they made back the 9% loss in less than a month, half of it through selling volatility short again. But this time I used put spreads on the iPath S&P 500 VIX Short-Term Futures ETN (VXX), a long volatility play that will never go to zero overnight.

To read the suit in its entirety, please click here.

To learn more about the suit, please click here and here.

Or you can call the Gibbs Law Group directly at 510-350-9700. I'm sure they'd love to hear from you.

Trading Volatility Can Be Hazardous to Your Wealth

Get Ready for the Coming Golden Age

Diary, Newsletter, Research

I believe that the global economy is setting up for a new golden age reminiscent of the one the United States enjoyed during the 1950s, and which I still remember fondly.

This is not some pie in the sky prediction. It simply assumes a continuation of existing trends in demographics, technology, politics, and economics. The implications for your investment portfolio will be huge.

What I call "intergenerational arbitrage" will be the principal impetus. The main reason that we are now enduring two "lost decades" of economic growth is that 80 million baby boomers are retiring to be followed by only 65 million "Gen Xers."

When the majority of the population is in retirement mode, it means that there are fewer buyers of real estate, home appliances, and "RISK ON" assets such as equities, and more buyers of assisted living facilities, health care, and "RISK OFF" assets such as bonds.

The net result of this is slower economic growth, higher budget deficits, a weak currency, and registered investment advisors who have distilled their practices down to only municipal bond sales.

Fast forward six years when the reverse happens and the baby boomers are out of the economy, worried about whether their diapers get changed on time or if their favorite flavor of Ensure is in stock at the nursing home.

That is when you have 65 million Gen Xers being chased by 85 million of the "millennial" generation trying to buy their assets.

By then we will not have built new homes in appreciable numbers for 20 years and a severe scarcity of housing hits. Residential real estate prices will soar. Labor shortages will force wage hikes.

The middle-class standard of living will reverse a then 40-year decline. Annual GDP growth will return from the current subdued 2% rate to near the torrid 4% seen during the 1990s.

The stock market rockets in this scenario. Share prices may rise very gradually for the rest of the teens as long as tepid 2% growth persists. A 5% annual gain takes the Dow to 28,000 by 2019.

After that, after a brief dip, we could see the same fourfold return we saw during the Clinton administration, taking the Dow to 100,000 by 2030. If I'm wrong, it will hit 200,000 instead.

Emerging stock markets (EEM) with much higher growth rates do far better.

This is not just a demographic story. The next 20 years should bring a fundamental restructuring of our energy infrastructure as well.

The 100-year supply of natural gas (UNG) we have recently discovered through the new "fracking" technology will finally make it to end users, replacing coal (KOL) and oil (USO). Fracking applied to oilfields is also unlocking vast new supplies.

Since 1995, the United States Geological Survey estimate of recoverable reserves has ballooned from 150 million barrels to 8 billion. OPEC's share of global reserves is collapsing.

This is all happening while automobile efficiencies are rapidly improving and the use of public transportation soars.

Mileage for the average U.S. car has jumped from 23 to 24.7 miles per gallon in the past couple of years, and the administration is targeting 50 mpg by 2025. Total gasoline consumption is now at a five-year low.

Alternative energy technologies will also contribute in an important way in states such as California, accounting for 30% of total electric power generation by 2020, and 50% by 2030.

I now have an all-electric garage, with a Nissan Leaf (NSANY) for local errands and a Tesla Model S-1 (TSLA) for longer trips, allowing me to disappear from the gasoline market completely. Millions will follow. The net result of all of this is lower energy prices for everyone.

It will also flip the U.S. from a net importer to an exporter of energy, with hugely positive implications for America's balance of payments. Eliminating our largest import and adding an important export is very dollar bullish for the long term.

That sets up a multiyear short for the world's big energy consuming currencies, especially the Japanese yen (FXY) and the Euro (FXE). A strong greenback further reinforces the bull case for stocks.

Accelerating technology will bring another continuing positive. Of course, it's great to have new toys to play with on the weekends, send out Facebook photos to the family, and edit your own home videos.

But at the enterprise level this is enabling speedy improvements in productivity that are filtering down to every business in the U.S., lowering costs everywhere.

This is why corporate earnings have been outperforming the economy as a whole by a large margin.

Profit margins are at an all-time high. Living near booming Silicon Valley, I can tell you that there are thousands of new technologies and business models that you have never heard of under development.

When the winners emerge, they will have a big cross-leveraged effect on economy.

New health care breakthroughs will make serious disease a thing of the past, which are also being spearheaded in the San Francisco Bay area.

This is because the Golden State thumbed its nose at the federal government 10 years ago when the stem cell research ban was implemented. It raised $3 billion through a bond issue to fund its own research, even though it couldn't afford it.

I tell my kids they will never be afflicted by my maladies. When they get cancer in 20 years they will just go down to Wal-Mart and buy a bottle of cancer pills for $5, and it will be gone by Friday.

What is this worth to the global economy? Oh, about $2 trillion a year, or 4% of GDP. Who is overwhelmingly in the driver's seat on these innovations? The USA.

There is a political element to the new golden age as well. Gridlock in Washington can't last forever. Eventually, one side or another will prevail with a clear majority.

This will allow the government to push through needed long-term structural reforms, the solution of which everyone agrees on now, but for which nobody wants to be blamed.

That means raising the retirement age from 66 to 70 where it belongs and means-testing recipients. Billionaires don't need the maximum $30,156 annual supplement. Nor do I.

The ending of our foreign wars and the elimination of extravagant unneeded weapons systems cuts defense spending from $800 billion a year to $400 billion, or back to the 2000, pre-9/11 level. Guess what happens when we cut defense spending? So does everyone else.

I can tell you from personal experience that staying friendly with someone is far cheaper than blowing them up.

A Pax Americana would ensue.

That means China will have to defend its own oil supply, instead of relying on us to do it for them. That's why they have recently bought a second used aircraft carrier. The Middle East is now their headache.

The national debt then comes under control, and we don't end up like Greece.

The long-awaited Treasury bond (TLT) crash never happens. The Fed has already told us as much by indicating that the Federal Reserve will only raise interest rates at an infinitesimally slow rate of 25 basis points a quarter.

Sure, this is all very long-term, over-the-horizon stuff. You can expect the financial markets to start discounting a few years hence, even though the main drivers won't kick in for another decade.

But some individual industries and companies will start to discount this rosy scenario now.

Perhaps this is what the nonstop rally in stocks since 2009 has been trying to tell us.

Dow Average 1908-2018

Another American Golden Age is Coming

The Market Outlook for the Week Ahead, or Taking Another Bite at the Apple

Diary, Newsletter, Research

What happens after markets test the top end of a range? They test the bottom end of the range. So, the game here is to pick where and when is the next short-term top.

Now that Q1 earnings are out of the way, there is no major positive driver of the market for two more months, until the end of July, when the Q2 earnings start to roll out. And they will be good.

That leaves us only geopolitical shocks and chaos from Washington as the major market influences, and none of those are going to be positive. When traders shift from a focus on earnings to fear, the result is usually negative for share prices.

One major event that occurred last week but was totally ignored by the media was the administration's trade negotiating team scampering back from China completely empty handed. They called his bluff. So, the trade war is still on, it's just moved from the front burner to the back burner. Don't get complacent.

And here is the worrisome issue for the bulls. Q1 earnings were up 25.5% YOY, one of the best in my long career. Revenues accounted for 8.3%, margin improvements 8.1%, new tax breaks 7.6%, and share buybacks 1.5%. This means that 35.6% of the total earnings were from one-time only benefits that aren't going to be there next year.

Given that the global economy is slowing down, revenue and margin improvement will probably drop by half next year. That means the best case for Q1 2019 earnings will show a drop from 25.5% to only 8.2%.

It's not a matter of IF the market will top out, but WHEN. Enjoy the bull move while it lasts. It isn't going to be there next year.

I decided to sit out the current leg up in the market. I didn't think it would be big or sustained enough to squeeze in another round trip. Besides, after shooting out 26 Trade Alerts in April earning an eye-popping 12.54% profit, not only was my staff exhausted, so were the followers.

My year-to-date return stands at a robust 19.30%, my trailing one-year returns have risen to 55.59%, and my eight-year sits at an 295.77% apex.

And remember, the market is making this move in the face of rising oil prices and interest rates, always bull market killers.

Of course, nobody at Apple (AAPL) cares about any of this one wit, as its stock blasted through to new all-time highs every day last week. Steve Jobs' creation is on a race to a $1 trillion market capitalization and was worth $930 billion at the market high. That's when Apple will have the same GDP as Russia or Australia.

The dividend yield has fallen to 1.56%. The company is increasingly being viewed as a luxury brand commanding a much higher multiple than the 9X that it earned when it was perceived as a lowly hardware company. By the way, Ferrari (RACE) has a price earnings multiple of 39X versus Apple's current 16X ex-cash.

I'll be raising my target for the stock from $200 to $220 as soon as I get time to write the report. Steve Jobs must be smiling down from Heaven. By the way, this service first recommended Apple as a strong "BUY" in 2010 when the shares traded at $10. That's a gain of 1,900%. Click here for the link.

Apple's stellar gains were part of a much broader move back into technology, which we expected. It turns out that the semiconductor cycle IS NOT ending after all, as predicted by the neophyte coverage of UBS.

Suddenly, all is forgiven at Facebook (FB), as the shares are now 2% short of an all-time high. Amazon is going from strength to strength, with Amazon Web Services' cloud business now accounting for an impressive $50 billion of sales and is growing at a breakneck 50% a year.

It all goes back to my seminal rule of investing that has worked for my entire 50-year career. While much of the rest of the U.S. economy is slowly fading from the scene, TECHNOLOGY ALWAYS COMES BACK!

The last of the Q1 earnings reports will dribble out this week.

On Monday, May 14, at 3:00 PM, we get a deluge of Feds speakers, now that the quiet period from the last meeting is over.

On Tuesday, May 15, at 8:30 AM EST, we receive the April Retail Sales, which has been red hot as of late. Home Depot (HD), a long-time Mad Hedge favorite, reports.

On Wednesday, May 16, at 8:30 AM, the April Housing Starts. Cisco Systems (CSCO) reports.

Thursday, May 17, leads with the Weekly Jobless Claims at 8:30 AM EST, which remained unchanged last week at 211,000, a 43-year low. At 10:00 AM EST, the April Index of Leading Economic Indicators is released, a compilation of 10 forward-looking statistics compiled by the private Conference Board. Applied Materials (AMAT) reports.

On Friday, May 18, we wrap up with the Baker Hughes Rig Count at 1:00 PM EST. Deere & Co. (DE) reports.

As for me, I'll be working in the garden this weekend. It's time to plant the pumpkins if I want nice jack-o-lanterns by Halloween, the tomatoes are thriving, and I will have an ample supply of fresh pepper this coming winter.

Good Luck and Good Trading.

Rolling in the Clover

Farewell to David Rockefeller

Diary, Newsletter, Research

Watching Sotheby's sell off the possessions of David Rockefeller, the memories came flooding back.

A Picasso went for a staggering $115 million, while a Monet fetched $80 million. A leather easy chair estimated at $300 sold for $8,000.

I've seen then all, either at the downtown headquarters of Chase Manhattan Bank, which Rockefeller turned into an art museum, or at dinner parties at his posh Upper East Side mansion.

I was sitting across the desk from Bob Baldwin, the chairman of Morgan Stanley. It was 1982, and I was 30 years old.

He carefully studied my resume in his hand. Then he picked up the phone and hit a button on speed dial to call David Rockefeller.

Rockefeller, the chairman of Chase Manhattan Bank, picked up.

Baldwin said, "I have a John Thomas sitting in front of me." He paused a second, and then hung up.

"He says you're alright," and Bob offered me a job on the spot to get the firm into the international equity business.

That's how I started a long and illustrious career at Morgan Stanley.

I eventually became one of the most successful traders in the company, and at one point accounted for 80% of equity division profits.

It is also where I learned the knowledge that I am passing on to you today through the Diary of a Mad Hedge Fund Trader and my trade mentoring service.

I have David Rockefeller to thank for getting me started.

So, it was with a heavy heart that I learned that he passed away recently at the ripe old age of 101.

Rockefeller was the youngest grandson of oil baron John D. Rockefeller, the founder of the Standard Oil Company. The modern-day spin-offs include ExxonMobil, Chevron, Amoco, and parts of British Petroleum.

The Sherman Antitrust Act was passed specifically to break up Rockefeller's oil refining monopoly.

Rockefeller was America's first billionaire.

Rockefeller could have had an easy life of moneyed leisure in high society.

He chose otherwise.

He grew up in a Manhattan 54^th Street mansion attended by armies of nannies and servants, where his parents dressed black tie for dinner every night.

He remembers his doting grandfather, John D., who only gave him dimes "to keep us thrifty."

His mother founded the New York Museum of Modern Art in 1929, for which Rockefeller became chairman in later years.

He took the trouble to get a PhD in Economics from the University of Chicago in 1940, supporting Franklin Delano Roosevelt's deficit spending to end the Great Depression.

The family was horrified, as FDR's 90% maximum tax rate substantially whittled down the family's fortune by the time John Kennedy repealed it in 1962.

I got to know David Rockefeller well during the 1970s when I covered U.S. banking for The Economist magazine, and he spearheaded Chase Manhattan Bank's aggressive international expansion.

Rockefeller became the unofficial ambassador for the brash, unvarnished capitalism of the day. He wreaked establishment.

For a decade, whenever I interviewed major world leaders, such as Zhou Enlai of China, Ferdinand Marcos of the Philippines, Emperor Hirohito of Japan, or Margaret Thatcher of Great Britain, I would often bump into Rockefeller on the way out.

It was a bygone era, when major clients were courted primarily through the social register.

Eventually, international business came to account for 80% of Chase Manhattan's total profits.

It is perhaps fitting that Rockefeller was an early supporter of the construction of the original World Trade Center in downtown Manhattan, just walking distance from his bank.

I used to meet Rockefeller in his cavernous office on the 65^th floor of the Chase Manhattan building near Wall Street. He sat behind a polished hardwood desk the size of Montana.

Also known for his immense art collection, almost every floor of the building was decorated with favorite pieces from his personal collection. There was even a Chagall on the way to the men's room.

In perhaps the greatest compliment every paid me, he told me he had 70,000 names in his Rolodex, and I was one of them.

Wow! To be in David Rockefeller's Rolodex! Did you get that mom?

Rockefeller was always charming and gracious to a T. He was the guy who was friendly to everyone, with a great sense of humor, even when he didn't have to be.

He was offered the post of U.S. Treasury Secretary by multiple administrations and turned them down every time. He preferred to spend more time on his prized collection of beetles instead, the largest in the world.

He worked well into his 90s and maintained an office on the 56^th floor at Rockefeller Center, which his father had built to create jobs in New York during the Great Depression.

Because I was one of a handful of Morgan Stanley officers who spoke fluent Japanese, I was recruited to the team that sold Rockefeller Center to the Japanese for $1.3 billion in 1989. It was one of the largest real estate transactions in history at that time.

The last time I saw Rockefeller was at a gala black tie event for his 90^th birthday at the Museum of Modern Art, where tables were selling for $90,000 a piece.

Rockefeller used the event to announce a staggering $100 million gift to the museum.

So, thank you David Rockefeller for all your help, and a life well lived.

They don't make them like you anymore.

You will be missed.

The End of the Iran Nuclear Deal and Your Portfolio

Diary, Newsletter, Research

My first contact with Iran was during the horrific 1980-88 Iran-Iraq war. I was a war correspondent for The Economist magazine living in the Kuwait Hilton.

Early every morning, hotel staff hurried down to the beach to clean up the remains of shark-eaten bodies that had washed up from the pitched battles overnight. It was essentially a replay of WWI. More than 1 million died, and poison gas was a regular feature of the conflict.

You are either getting killed yourself, or are having a fabulous day today because of the end of the U.S. participation in the Iran Nuclear Deal, depending on your sector exposure.

If you own energy producers, like the oil majors we have been bullish on for several months, including ExxonMobil (XOM), Occidental Petroleum (OXY), and Chevron (CVX), you are sitting pretty.

If you own energy consumers, such as Delta Airlines (DAL), and Consumer Staples (XLP), which we have been dissing to the nth degree, you are taking it in the shorts.

But what happens beyond today?

For the short term, you can expect nothing to result from the American abrogation of the treaty, which even the administration's own Secretary of Defense, Marine Corps General James Mattis, strongly advised against.

Three years into the agreement, very little trade between Iran and the U.S. actually took place. The big Boeing (BA) aircraft order never showed. American oil companies were gearing up to bid on the reconstruction of Iran's oil infrastructure. But so far it has been all talk and no do.

If you were looking forward to getting a great deal on a new Persian carpet you're out of luck. But there is an ample supply of used ones on the market.

At the end of the day, the Iranians would rather do business with Europe, treaty, or not. It is the natural trading partner, is close, and most of the Iranian leadership was educated at continental universities.

The European Economic Community (EEC) offers far larger export subsidies than the U.S. ever would. Remember, Iran was once a quasi-British colony. And let's face it, Iran never trusted the U.S., given our coddling of the previous Shah.

It is most likely Europe, Russia, and China; the other signatories will continue with the treaty in its current form. China will take all the oil Iran can produce, no questions asked. Russian interests are the same as Iran's, higher oil prices.

Yes, the U.S. has threatened to blacklist any bank financing trade with Iran going forward. There is absolutely no way this will work, unless the U.S. wants to ban American trade with Europe, its largest foreign customer.

If they try it, Fortune 500 companies will land on Washington like a ton of bricks, which earns up to 70% of their earnings from foreign sales. In the end all this will do is cut the U.S. out of the global economy.

Longer term, geopolitical risks will undoubtably rise. Iran will almost certainly ramp up its attempts to overthrow the government of Saudi Arabia, still the largest single source of American oil imports. It also has no cost of continuing mischief in Yemen and Syria. Iran already has a dominant influence in Shiite Iraq, which we fought a war to hand over to them.

Of course, the big winner in all of this is Russia, as it has been with almost everything else recently. Moscow loves higher oil prices, enabling Putin to deliver the higher standard of living he promised in last month's presidential election. It also gives him another opportunity to stick a thumb in America's eye, which he apparently loves to do.

Trump can threaten war all he wants, but the Iranians know this is nothing but a bluff. After 17 years of war in Afghanistan, the U.S. his little appetite for another one. Even though we are officially out of Iraq, it is still a massive drain on the U.S. budget. And we still haven't paid for the last one, unless the Chinese want to lend us more money.

In the end it will depend on how long oil will stay this high. The end of the treaty is worth at least $20 in higher oil prices. If oil continues to appreciate then it brings forward the next recession, possibly by years. Energy is a major component in the inflation calculation, which should now speed up smartly and crush the bond market, bringing higher interest rates.

Rising oil prices, inflation, and interest rates with a flagging global economy? Not good, not good.

While U.S. fracking production is rising, it can't increase fast enough to head off the current oil price spike. Production can't be ramped up faster because the U.S., with production now more than 10 million barrels a day, is oil infrastructure constrained, and much of the new infrastructure that has been added is aimed at increased oil exports, not domestic consumption. It makes a big difference.

And why are we focusing on the country that has zero nuclear weapons, primitive technology, and an economy in free fall, while ignoring the one that has more than 7,000 (Russia)? Will someone please explain that to me? Remember, Iran is a country that still relies on camels and donkeys as a major mode of transportation.

So you can take your nuclear treaty and toss it in the ash can of history. The problem is that it may cost you and your portfolio a lot more than you think.

Meet Your New Earnings Driver

Reminding You Why You Should Be Selling in May

Diary, Newsletter, Research

Followers of my Trade Alert service have watched me shrink my book, reduce risk, and cut positions to a rare 100% cash position.

No, I am not having a nervous breakdown, a midlife crisis, nor have I just received a dementia diagnosis.

It's because I am a big fan of buying straw hats in the dead of winter and umbrellas in the sizzling heat of the summer.

I even load up on Christmas ornaments every January when they go on sale for 10 cents on the dollar.

There is a method to my madness.

If I had a nickel for every time that I heard the term "Sell in May and go away," I could retire.

Oops, I already am retired!

In any case, I thought that I would dig out the hard numbers and see how true this old trading adage is.

It turns out that it is far more powerful than I imagined.

According to the data in the Stock Trader's Almanac, $10,000 invested at the beginning of May and sold at the end of October every year since 1950 would be showing a loss today.

Amazingly, $10,000 invested on every November 1, and sold at the end of April would today be worth $702,000, giving you a compound annual return of 7.10%!

This is despite the fact that the Dow Average rocketed from $409 to $26,500 during the same time period, a gain of 64.79 times!

Since 2000, the seasonal Dow has managed a feeble return of only 4%, while the long winter/short summer strategy generated a stunning 64%.

Of the 68 years under study, the market was down in 25 May-October periods, but negative in only 13 of the November-April periods, and down only three times in the past 20 years!

There have been just three times when the "good 6 months" have lost more than 10% (1969, 1973 and 2008), but with the "bad six month" time period there have been 11 losing efforts of 10% or more.

Being a long-time student of the American and, indeed, the global economy, I have long had a theory behind the regularity of this cycle.

It's enough to base a pagan religion around, like the once practicing Druids at Stonehenge.

Up until the 1920s, we had an overwhelmingly agricultural economy.

Farmers were always at maximum financial distress in the fall, when their outlays for seed, fertilizer, and labor were the greatest, but they had yet to earn any income from the sale of their crops.

So, they had to borrow all at once, placing a large cash call on the financial system as a whole.

This is why we have seen so many stock market crashes in October. Once the system swallows this lump, it's nothing but green lights for six months.

After the cycle was set and easily identifiable by low-end computer algorithms, the trend became a self-fulfilling prophecy.

Yes, it may be disturbing to learn that we ardent stock market practitioners might in fact be the high priests of a strange set of beliefs. But hey, some people will do anything to outperform the market.

It is important to remember that this cyclicality is not 100% accurate, and you know the one time you bet the ranch, it won't work.

But you really have to wonder what investors are expecting when they buy stocks at these elevated levels, over $205 in the S&P 500 (SPY).

Will company earnings multiples further expand from 19X to 20X or 21X?

Will the GDP suddenly reaccelerate from a 2% rate to the 4% promised by the new administration, when the daily sentiment indicators are pointing the opposite direction?

I can't wait to see how this one plays out.

It's May!

Trading the U.S. Steel Fiasco

Diary, Newsletter, Research

Talk about unintended consequences. Tamper with the free market and it will usually blow up in your face.

You would have thought that U.S. Steel was going to announce blockbuster earnings in the wake of the new 25% steel tariff imposed by the administration, right?

Wrong.

Instead, it has triggered a disaster of epic proportions. The reasons why provide a crash course on how fast the modern economy is evolving.

Of course, the stock market didn't like it, the shares crashing some 17.1% since the announcement. U.S. Steel, far and away the biggest beneficiary of administration policies, is now down on the year.

You may recall that we made a fortune when we bought U.S. Steel last summer at $21 a share, well before the run up into the passage of the tax package. The shares gained a mind-blowing 127%.

Not only did the company deliver a shocking disappointment on Q1 earnings, bringing in net profits of only 10 cents a share, it guided lower for Q2. Expectations had been far higher. Still, that is far better than the $180 million loss it brought in a year ago.

The CEO, David Burritt, cited unexpected "operational volatility." Take that to mean the chaos created by the steel tariffs. There is also trouble with its Great Lakes factory.

Flat rolled steel used to manufacture cars swung from an $88 million loss to a $23 million profit. But tubular steel used for pipelines incurred a $23 million loss.

What is really amazing is that the company made only a dime per share off an increase in total steel shipments YOY of 15.6%. Clearly, there is trouble in Pittsburgh.

And here is what U.S. Steel didn't expect. Instead of paying the extra 25% for imported steel, many customers are simply designing steel out of their products to cut costs rather than shifting to (X).

Three decades ago, this might have taken years to achieve. Thanks to advanced software applications this can now be accomplished in weeks. Companies are vastly more sensitive to costs than they were only a few years ago, and mere pennies can make all the difference.

It's only a matter of time before the entire auto industry shifts to carbon fiber, which has four times the strength of steel at one fifth the weight. That gives you a 20X improvement in performance and safety. Cost and mass manufacturing are the only issues.

Tesla (TSLA) is planning to make the jump in a couple of years. Boeing (BA) and the U.S. Air Force already have.

Where is U.S. Steel in a carbon fiber world? Try Chapter 11.

In the meantime, U.S. Steel consumers are scrambling to get exemptions from the punitive tariffs, creating a bureaucratic nightmare for all involved.

Wilber Ross's Commerce Department has been flooded with some 3,500 requests, each one of which takes months to review. The agency has boosted staff, but it is still overwhelmed. It looks like the only new American jobs the tariff will create will be government ones.

It turns out that many types of high grade steel, such as for razor blades and specialized carbon steel parts, aren't made in the U.S.

To prove that I learn something new every day, I discovered that even France is an important steel supplier. And I thought it was all about wine, cheese, and those cute black berets.

The net result for consumers has been uncertainty in the extreme. That purgatory has just been extended with the government's 30-day postponement of the tariffs announced yesterday.

If companies wait long enough the tariffs will simply disappear. They will certainly be declared illegal by the World Trade Organization.

The national security rationale for the steel tariffs was always completely bogus and will be laughed out of court. If steel really were a national security issue the Defense Department would have its own steel mill, as it already does with semiconductors.

The chips in U.S. weapons systems are 100% made in the USA to keep foreign back doors out of the design process.

Wars of the future will be bought with software, not M1 Abrams tanks or battleships. If fact, they already are.

As for the shares of U.S. Steel, I'm not touching them here. If the economic data continues to weaken as it has, you don't want to be anywhere near this sector.

The stock market already has reached that conclusion.

On the USS Missouri; Made in the USA

Anatomy of a Great Trade

Diary, Newsletter, Research

So, I'm sitting here agonizing over whether I should sell short the US Treasury bond market (TLT) once again.

Thanks to the bombshell Israel announced today alleging the existence of a secret Iranian nuclear missile program, oil has rallied by 2%, the US dollar has soared, and stocks have been crushed.

The (TLT) has popped smartly, some $2.5 points off of last week's low, taking yields down from a four-year high at 3.03% down to 2.93%.

The report is probably based on false intelligence, which is becoming a regular thing in the Middle East. Suffice it to say that the presenter, Prime Minister Benjamin "Bibi" Netanyahu, may soon be indicted on corruption charges. Clearly, they are going "American" in the Holy Land.

But for today, the market believes it.

You can understand me chomping at the bit, as selling short US government bonds has been my new rich uncle since the market last peaked in July 2017.

I just ran my Trade Alert history over the past nine months and here is what I found.

I sent you 38 Trade Alerts to sell short bonds generating 18 round trips, AND EVERY SINGLE ONE WAS PROFITABLE! In total these Alerts generated a trading profit of 216%, or 21.62% of my total portfolio return.

That means 35% of my profits over the past year came from selling short Treasuries.

You should do the same.

Falling Treasury prices have been one of the few sustainable trends in financial markets during the past year.

Stock rallied, then gave up a chunk. Gold (GLD) has gone nowhere. Only oil has surpassed as a sustainable trade, thanks to successful OPEC production quotas, which have been extended multiple times.

Texas tea is up an admirable 67% since the June $42 low. And who was loading up on crude way down there?

Absolutely no one.

Of course, I have an unfair advantage as a bond trader, as I have been doing this for nearly 50 years.

I caught the big inflation driven fixed income collapse during the 1970s, which had a major assist then from a rapidly devaluing US dollar.

That's when they brought out zero-coupon bonds, effectively increasing our leverage by 500% for virtually no cost. Principal only strips followed, another license to bring money on the short side.

The big lesson from trading this market for a half century is that trends last for a really long time. The bull market in bonds that started in 1982, when 10-year yields hit 14%, lasted for 33 years.

As we are less than three years into the current bear market the opportunities are rife. We are very early into the new game. This one could last for the rest of my life.

The reasons are quite simple. The fundamentals demand it.

1) The Global Synchronized Recovery is accelerating.

2) The Fed will start dropping on the bond market in the very near future $6 billion a month, or $200 million a day, worth of paper in its QE unwind.

3) Tax cuts will provide further stimulus for the US economy.

4) With the foreign exchange markets now laser-focused on America's exploding deficits, a weak US dollar has triggered a capital flight out of the US.

5) We also now have evidence that China has started to dump its massive $1 trillion in US Treasury bond holdings.

All are HUGELY bond negative.

All of this should take bonds down to new 2018 lows. What we could be seeing here is the setting up for the perfect head and shoulders top of the (TLT) for 2018.

As for that next Trade Alert, I think I'll hold out for a better price to sell again. What's the point in spoiling a perforce record?

Time to Stick to Your Guns

Why It's a "Sell the News" Market

Diary, Newsletter, Research

It could have been the 3.0% print on the yield for the US 10-year Treasury bond yield (TLT).

It could have been the president's warlike comments on Iran.

It could even have been rocketing commodity prices that are driving consumer staple stocks out of business.

No, none of these are the reason why the stock market melted down 700 points intraday yesterday.

The real reason is that we have had too much fun for too long.

Some nine years and 400% into this bull market, investors are starting to take some money off the table.

Not a lot mind you, but enough to make a big difference on a single day.

The Fed was seen carrying off the punch bowl, and the neighbors have called the police. Clearly, the party is over. At least for now.

If you had to point to a single cause of the Tuesday rout in share prices it had to be Caterpillar's (CAT) rather incautious prediction that its earning peaked for this business cycle in Q1, and it was downward from here.

Traders, being the Einstein's that they are, extrapolated that to mean that ALL companies saw earnings peak in Q1, and you get an instant 700-point collapse.

I think they're wrong, but I have never been one to argue with Mr. Market. You might as well argue with the tides not to rise.

In a heartbeat, investors shifted from a "sell earnings on the news" to "sell NOW, earnings be damned."

All of this vindicates my call that markets would remained trapped in a wide trading range until the November congressional elections.

This has been further confirmed by the three-year chart of my Mad Hedge Market Timing Index.

For the second time this year, the Index peaked in the 40s, instead of the 80s, which is what you normally get in a bull market. The new trading strategy for the Index is to buy in the single digits and sell in the low 40s.

This is why I have been aggressively taking profits on long positions and slapping on short positions as hedges for the remaining longs. The Global Trading Dispatch model portfolio went into this week net short.

My Mad Hedge Technology Letter has only one 10% position left, in Microsoft (MSFT).

While a 3% 10-year is neither here nor there, the rapidly inverting yield curve is. The two-year/10-year spread is now a miniscule 53 basis points.

The 10-year/30-year spread is at a paper thin 18 basis points. To show you how insane this is, it means investors are accepting only an 18-basis point premium for lending money to the US government for an extra 20 years!

This is a function of the US Treasury focusing its new gargantuan trillion dollar borrowing requirements at the short end of the curve. This is the exact opposite of what they should be doing with yields still close to generational lows.

What this does is create a small short-term budgetary advantage at a very high long-term cost. This is constant with the government's other backward-looking Alice in Wonderland economic policies.

When the yield curve inverts, watch out below, because it means a recession is near.

If the stock market continues to trade like this, as I expect it will, you can expect the next stock market rally to start in two months when we ramp up into the Q2 earnings reports.

Until then, we will probably just chop around. Enjoy your summer.

Why Indexers Are Toast

Diary, Newsletter, Research

Hardly a day goes by without some market expert predicting that it's only a matter of time before machines completely take over the stock market.

Humans are about to be tossed into the dustbin of history.

Recently, money management giant BlackRock, with a staggering $5.4 trillion in assets under management, announced that algorithms would take over a much larger share of the investment decision-making process.

Exchange Traded Funds (ETFs) are adding fuel to the fire.

By moving capital out of single stocks and into baskets, you are also sucking the volatility, and the vitality out of the market.

This is true whether money is moving into the $237 billion S&P 500 (SPY), or the miniscule $1 billion PureFunds ISE Cyber Security ETF (HACK), which holds only 30 individual names.

The problem is being greatly exacerbated by the recent explosive growth of the ETF industry.

In the past five years, the total amount of capital committed to ETFs has doubled to more than $3 trillion, while the number of ETFs has soared to well over 2,000.

In fact, there is now more money committed to ETFs than publicly listed single stocks!

While many individual investors say they are moving into ETFs to save on commissions and expenses, in fact, the opposite is true.

You just don't see them.

They are buried away in wide-dealing spreads and operating expenses buried deeply in prospectuses.

The net effect of the ETF industry is to greatly enhance Wall Street's take from their brokerage business, i.e., from YOU.

Every wonder why the shares of the big banks are REALLY trading at new multi-year highs?

I hate to say this, but I've seen this movie before.

Whenever a strategy becomes popular, it carries with it the seeds of its own destruction.

The most famous scare was the "Portfolio Insurance" of the 1980s, a proprietary formula sold to institutional investors that allegedly protected them by automatically selling in down markets.

Of course, once everyone was in the boat, the end result was the 1987 crash, which saw the Dow Average plunge 20% in one day.

The net effect was to maximize everyone's short positions at absolute market bottoms.

A lot of former portfolio managers started driving Yellow Cabs after that one!

I'll give you another example.

Until 2007, every computer model in the financial industry said that real estate prices only went up.

Trillions of dollars of derivative securities were sold based on this assumption.

However, all of these models relied on only 50 years' worth of data dating back to the immediate postwar era.

Hello subprime crisis!

If their data had gone back 70 years, it would have included the Great Depression.

The superior models would have added one extra proviso - that real estate can collapse by 90% at any time, without warning, and then stay down for a decade.

The derivate securities based on THIS more accurate assumption would have been priced much, much more expensively.

And here is the basic problem.

As soon as money enters a strategy, it changes the behavior of that strategy.

The more money that enters, the more that strategy changes, to the point where it produces the opposite of the promised outcome.

Strategies that attract only $10 million market-wide can make 50% a year returns or better.

But try and execute with $1 billion, and the identical strategies lose money. Guess what happens at $1 trillion?

This is why high frequency traders can't grow beyond their current small size on a capitalized basis, even though they account for 70% of all trading.

I speak from experience.

During the 1980s I used a strategy called "Japanese Equity Warrant Arbitrage," which generated a risk-free return of 30% a year or more.

This was back when overnight Japanese yen interest rates were at 6%, and you could buy Japanese equity warrants at parity with 5:1 leverage (5 X 6 = 30).

When there were only a tiny handful of us trading these arcane securities, we all made fortunes. Every other East End London kid was driving a new Ferrari (yes, David, that's you!).

At its peak in 1989, the strategy probably employed 10,000 people to execute and clear in London, Tokyo, and New York.

However, once the Japanese stock market crash began in earnest, liquidity in the necessary instruments vaporized, and the strategy became a huge loser.

The entire business shut down within two years. Enter several thousand new Yellow Cab drivers.

All of this means that the current indexing fad is setting up for a giant fall.

Except that this time, many managers are going to have to become Uber drivers instead.

Computers are great at purely quantitative analysis based on historical data.

Throw emotion in there anywhere, and the quants are toast.

And, at the end of the day, markets are made up of high emotional human beings who want to get rich, brag to their friends, and argue with their spouses.

In fact, the demise has already started.

Look no further than investment performance so far in 2018.

The (SPY) is up a scant 0% this year.

Amazon (AAPL), on the other hand, one of the most widely owned stocks in the world, is up an eye-popping 30%.

If you DON'T own Amazon, you basically don't HAVE any performance to report for 2017.

I'll tell you my conclusion to all of this.

Use a combination of algorithms AND personal judgment, and you will come out a winner, as I do. It also helps to have 50 years of trading experience.

You have to know when to tell your algorithm a firm "NO."

While your algo may be telling you to "BUY" ahead of a monthly Nonfarm Payroll Report or a presidential election, you may not sleep at night if you do so.

This is how I have been able to triple my own trading performance since 2015, taking my 2017 year-to-date to an enviable 20%.

It's not as good as being 30% invested in Amazon.

But it beats the pants off of any passive index all day long.