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May 26, 2016

Reading the Signals

Bill Miller

“I think we have been forming a significant market top and a downside break at some point in next 6 to 12 months will be ugly”

I received this comment this week from a friend who did well enough investing that he retired in his early 50's. He has always invested conservatively, mainly utilities and staples and other low vol, predictable businesses. Just about the perfect thing to do since 2000, although it has actually worked well since 1981. I would say his view is pretty much consensus, given that Nasdaq short interest is back at 2008 highs and the news outlets keep talking about the next crash. The data from Michael Goldstein at Empirical Research Partners is also consistent with extreme risk aversion, as are the continuing outflows from equity funds.

What is quite surprising about this is that the data point in the opposite direction, toward a near term (next few months) breakout to new all time highs, which would be confounding to the consensus. But GDP and corporate profits are hovering at or near all-time highs, as is the stock market. Stocks have gone nowhere for over a year, which the Bears see as a topping formation, but which will be seen as a new base in the event of a breakout. Commodity prices continue to be firm, which is hardly bearish. The dollar is no longer rising and will be a tailwind in the second half of this year. Housing numbers are also solid and the stocks are now catching a bid. Financials likewise are acting a lot better, and the market is adjusting to the prospect of a rate hike, probably after the Fed’s July meeting. The Atlanta Fed's model is showing GDP accelerating this quarter to 2.9%.1

If we are on the cusp of a breakout, then the weakness recently showing up in utilities and staples, both expensive historically, should persist and even accelerate. The benign bear market in risk free treasuries that began when rates bottomed in 2012 under 1.40 should become less benign.

If people come to believe they can actually lose money in risk free treasuries, the environment for stocks will get a whole lot better.

Let's stipulate that nobody knows what the future will bring or what stocks and bonds will do, but the evidence seems to point in a different direction from my friend's concerns.

Or maybe not. He could very well be right, but not about the market: the "ugly break" just might be coming in "safe" assets.

1Using the Atlanta Fed's GDPNow model. 5/26/16 forecast: 2.9%

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee dividends will be paid or continued.

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