“The stock market has just finished one of its least volatile six months in its history. A 5% market correction has not occurred in over 250 days. This won’t last. A normal, 10% correction might happen very fast, and be very scary.” Trend Management report July 1, 2017.
We were eight months early in predicting when the return of volatility would occur. The market just had a scary 12% correction in February that brought some fear back into investors’ minds. Volatility is back and it’s going to be with us for a while. Buckle up. We will outline in this letter how we plan to deal with what is a more normal market now.
On February 6, the Dow Jones was down about 1000 points before the market opened. We took that opportunity to buy a 2% position in Goldman Sachs at the open. We filled at $242 and it closed that day at $258 (it’s now $252). Our confidence in buying Goldman that day was based on two things. The first was that it hit our buy price. The second was that we didn’t think the decline in the market that week was based on fundamentals. Wall Street had been gambling again, and they got caught on the wrong side of a bet.
Wall Street loves to place bets on just about anything. The latest rage is betting on how volatile the markets are going to be. Wall Street created a product called the CBOE Volatility Index (VIX) that allows you to bet on the implied volatility of the market for the next 30 days. Starting in late 2016, this bet became a one-way street. Most of the money was betting on no volatility. For a while they were right. We figured this out in April of 2017 and wrote the above quote in July. We knew that when the first signs of volatility picked up, it would cause a total market rout as these positions unwound. We weren’t disappointed. To throw gas on the fire, academia has been writing white papers about how stocks that show low volatility, and smooth path dependency (don’t ask) will outperform the S&P 500. Money started flooding into these smart beta, low volatility funds in 2017. It was destined to end badly, and it did.
There was a fund created called the Inverse Volatility Index Exchange Traded note. On February 1, it was trading at $125. On February 6, it was trading at $7.35. In four market trading days it lost 95% of its value. There was close to a billion dollars “invested” in this fund. The fund was set up to bet on market volatility. If the market wasn’t volatile you made money and it went up. If it became very volatile they would wipe you out and close the fund. On February 5, the market volatility that day caused a stop order to be filled and the fund was closed. By closing the fund, investors could not recoup the 95% loss they just took.
This fund wasn’t the only one doing volatility trading. It was simply the most public. We will soon find out who owns this stuff when Wall Street gives their report. We have a theory who it is, and it’s not our U.S. financial companies this time.
The chart above is an index we created of four of the largest derivative bank dealers in Europe. We think somebody in this group is going to fess up to experiencing some problems. We think the most likely suspect is Deutsche Bank (DB). It just so happens they reported terrible earnings on February 2, and the market blew up later that day. They also warned again about their business on March 22. The market lost 5% right after that talk. We think there is a correlation between the two events. DB is over 20 times leveraged which is twice the leverage of a U.S. bank. Over half of their $1.7 trillion balance sheet is in something that is not a loan. A gamble so to speak. We think when they warned on February 2, it started “a run” on their positions that hasn’t ended yet. We have been looking to buy market breaks from “bad European bank” news for the last few months. The economy is good worldwide. Earnings for our stocks have been good. We think the recent volatility reflects gamblers getting caught on stupid trades. This isn’t new, but it usually takes time to work its way out. At some point, Europe will have to address this issue, and not kick the can down the road. We think that time is within months as opposed to years.
We have owned US Gypsum (USG) as a way to play the housing recovery. Our average cost is below $10. In the last week of March, Knauf made an offer to buy the entire company at $42 per share. Knauf owns 10% of USG. Warren Buffett owns another 30% of USG. Mr. Buffett agreed to sell his stock to Knauf if the USG board said that was a fair offer. We think Knauf will have to raise their price to seal the deal and we aren’t sure what that price will be. When one of our stocks is involved in a takeover bid we usually sell half to decrease our risk. In this case, we sold half of USG at $40 per share. We will ride the other half and hope for a higher offer. We think the biggest risk we face in the midst of this deal is that the U.S. government may not allow a foreign company to buy a U.S. company. We think they will allow it, but it’s not a slam dunk.
Two of our better performing stocks this quarter have been Maxwell Technologies and American Public. Maxwell was up 4% and American Public 72%. These two stocks have been a drag on our performance for the last few years. We have mentioned in our letters that American Public is the cheapest stock we own. The biggest problems for them have been a poor regulatory environment and the budget sequester. Both of those are getting better. Once Wall Street saw that and believed it, they bid the stock up a lot this quarter. American Public is no longer the cheapest stock we own. There are a few mergers going on in this area. This has helped drive the stock up. We are watching this one closely to decide what to do next.
Maxwell is our green play on the electrification of cars. The years 2018 and 2019 will be pivotal years for them (their words, not ours). If they execute, we should have fun. If they don’t, we will sell this stock. We hope they get it right.
Our growth stock system has three stocks in it, Data I/O, Skyworks and Profire Energy. All three reported good earnings, and we continue to hold them. As a reminder, our system is not reliant on the price of the stock, but the operations of the company. Skyworks and Profire went up after their earnings and Data IO did not. They each still have our highest ranking and we will wait and see how they do on the next earnings report.
We started writing about a coming trade war with China in 2010 and 11. We think it’s safe to say we are in one now. President Trump wants to put 60 billion dollars’ worth of tariffs on a long list of Chinese products. You can learn a lot about the president’s views by reading what his advisors have written about trade. President Trump’s lead advisor on trade is Peter Navarro. We suggest reading his books on trade to get a feel for where this is headed. Here are two of the titles of books he has written, The Coming China Wars (2008) and Death by China (2011). We sure don’t see a middle ground for negotiations in those titles. This is going to be a long ugly fight. We don’t think this will be going away anytime soon.
Our trade deficit with China is pushing $400 billion or 4% of their GDP. This is not sustainable. When we started talking about this years ago, we thought this imbalance would be corrected in one of two ways. Either the U.S. would place a tariff on any import coming into the U.S., or our currency would decline to make our exports more competitive. We thought the most likely outcome would be a decline in currency. When we came to that conclusion two years ago, we bought gold, commodities, and Latin American stocks in your account. So far, this has worked out. We still see more upside to those trades. The Trump administration will continue to use tariffs or some form of border adjustment taxes (Vat tax) as a way to even the trade flows out. We don’t see either of these two trends slowing down soon.
We are going to introduce a third way to stop trade imbalances. It’s one we think is becoming increasingly likely in the next five years. Capital controls. What are capital controls? They occur when the government places restrictions on what you can do with your money. For 40 years, ANYONE has been able to take money in and out of the U.S. without restrictions. By anyone, we mean foreign governments, their citizens, or U.S. citizens. We are now thinking there is a 25% chance (up from 0) this ends within the next five years.
When we ran trade deficits over the last 30 years, those countries took that trade money and sent it back to the United States as an investment. For the most part, they have bought our government bonds with that excess cash. China has over $3 trillion of foreign exchange, and Japan has over $1 trillion. Most of that money is invested in the United States bond market. There is a growing school of thought (Michael Pettis, Richard Koo) that if you limit a foreigner’s ability to send the money back, you stop the actual PHYSICAL trade deficit. If you are thinking this is never going to happen, consider the following: The Trump administration has blocked four transactions in which a Chinese company wanted to buy a U.S. company. The dollar amount of those busted acquisitions is over $100 billion. That’s a form of capital controls in our opinion. The U.S. is dictating what people can and cannot do with their excess dollars. The United States is exerting control. That’s a form of capital control.
China is an example of a country that has capital controls on its people. You can’t legally take $50,000 out of China if you are resident. In the 1960’s and 1970’s, the United States had restrictions on where U.S. citizens could invest their money outside the U.S. That ended with the demise of Bretton Woods in 1973. In 2012, the Brazilian government tried to limit the amount of money that could come into their country to stop “hot money.” An example within the U.S. that a real old timer will remember occurred in 1933. When Roosevelt became president, he took over all of the gold in the U.S. He made it illegal to own gold. If you owned gold as a citizen, you were forced to sell it back to the government. There is precedent for capital controls in this country and others.
If we went to full blown capital controls in the U.S., we think studying the Argentine economy this decade might help. They instituted capital controls when their currency was four pesos to the dollar in 2011. When it ended, it was 20 pesos to the dollar. Inflation in Argentina was around 10% in 2011, and four years later, it was around 40%. They blocked their citizens from freely using their credit cards in foreign countries. That helped keep dollars in the country. We don’t think something that extreme would happen here, but we think the trend would be correct. Our currency goes lower, and our inflation goes up. In that environment you don’t want to be a bond holder or own your currency. It is this scenario we are trying to figure out how to deal with if the probability goes from 25% to over 50%.
If you have any thoughts on this, or questions about your account, feel free to call us at (417-882-5746).
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR