QUARTERLY INVESTMENT OUTLOOK OCTOBER 2021

• Following a V -shaped recovery the global economy appears to be slowing. Manufacturing Purchasing Manager’s Index was at 54.1, a 6-month low. Several major markets recorded weaker readings above 50, including the U.S. and Euro area, with Asia slipping into contraction (below 50To read the report, click here). Noteworthy is that global manufacturing has exceeded pre-covid levels despite widespread supply chain bottlenecks and labor shortages. The advent of the Delta variant is a “wild card” and adds considerable uncertainty to any economic forecast. However, based on 1) the availability of vaccines, 2) changing behavior (wearing masks) and 3) Israel’s recent positive experience with booster shots, we remain optimistic.

• The U.S. Economic Surprise Index at -59 remains in a downtrend, but is close to levels which, since 2009, have signaled a bottom. Until the ESI turns higher bond yields could remain flat to slightly lower. By year-end 2021 we expect the ESI to trend higher along with bond yields. Rising yields would favor the value sector of the stock market and would be negative for growth stocks.

• Our research shows that durable inflation cycles are accompanied by an expansion in credit demand. This usually happens following the end of recessions. There is already early evidence that loan demand in the U.S. commercial banking system is turning higher.

• Asian growth is slowing led by China’s zero covid policy. We believe China’s policymakers will soon begin another round of both fiscal and monetary stimulus. The major negative for investors is their zero covid policy. This means that they will lockdown an entire factory/city in order to prevent the spreading of the virus.

• Equity investors are paying an estimated 21x 2022 earnings. This valuation is at the high end of the 20-year range. Meanwhile, Fed Chairman Powell indicated that, assuming employment conditions continue to show improvement, and inflation flattens, then tapering their $120 billion asset purchase program could begin by year-end 2021. Analysts have long pointed to the high correlation between the size of the Fed balance sheet and the level of stock prices. Caveat emptor!

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QUARTERLY INVESTMENT OUTLOOK: JULY 2021

At this juncture we would welcome a correction in risk assets i.e., equities, commodities, bitcoin etc. Momentum and sentiment are stretched. Risk assets need a reset in order to pave the way for a continuing cyclical advance in prices, which is our base case looking out twelve months.

• Equity valuations are also extended. Stock prices are far ahead of corporate earnings trends. A digestion phase would be beneficial. The cyclical advance in bond yields has raised investment risk! A slowdown in real growth (ISM manufacturing) could flatten bond yields over the intermediate term.

• Corporate bond spreads, both Baa and Junk, are trading near historic lows. Tight corporate spreads vis a vis treasuries are supportive of risk assets. Our macro strategists MRB Partners caution investors not to become too complacent regarding low corporate yields. As treasury yields gradually trend higher this is bound to exert upward pressure on corporate yields, having a potentially negative effect on equity valuations. On a positive note, this is unlikely to happen until central banks finally shift gears.

• We expect both real growth and real yields to remain low in the post-pandemic period. Inflation should gradually trend higher with both fiscal and monetary policies remaining accommodative. Our inflation barometer is trending higher. Avoid intermediate/longer dated Government bonds.

• Gradually increase exposure to global ex-U.S. equities. Foreign markets offer better value and should benefit from dollar weakness.

• StuyvesanTrends Dividend Growth Payers: Introducing a value strategy with growth attributes.

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QUARTERLY INVESTMENT OUTLOOK: APRIL 2021

• The U.S. dollar is in a bear market. This should lead to higher commodity prices and ultimately benefit Global ex-U.S. equities. We expect global to outperform U.S. equities in 2021. The rapid rise in U.S. bond yields could temper the advance in equities, thereby dampening the rise in yields.

• The U.S. growth outlook favors a continuing cyclical recovery as shown by the trend in both the Conference Board’s Leading and Coincident Economic Indicators. We follow a ratio of the LEI to the CEI which leads both recessions and recovery phases of the business cycle.

• China’s credit impulse at +9.06% suggests that the uptrend in industrial metal prices should continue.

• A monetary regime change is a necessary condition for higher inflation. This happened in the early 1920s and 1970s. In our opinion the U.S. Government’s willingness to run twin deficits, which are likely to be funded by the Fed (buying $80 billion of treasuries every month) is a regime change. Higher inflation/bond yields are inevitable.

• Gold prices have been consolidating since August 2020. Gold miners have corrected by 25% and trade at historically low levels relative to the bullion price. We anticipate significantly higher gold prices and are bullish on the miners.

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QUARTERLY INVESTMENT OUTLOOK: JANUARY 2021

• We view the recent release of Pfizer's (core holding) COVID-19 vaccine as a potential "game changer" for equity investors. Our analysis considers the fact that widespread public availability of the treatment will probably not occur until the Spring 2021 at earliest. Health care workers are already receiving the vaccine.

• The pandemic has weighed heavily on several value sectors including Financials, Energy, Industrials and Materials. Despite the general level of market overvaluation as shown by our analysis of the Buffett Indicator, the markets uptrend is intact. Other positive market factors are the steep yield curve, tight credit spreads, low yields, a weak dollar and global recovery. The recent breakout of Emerging Markets to a 10-year high validates our cautious optimism for a continuation of this bull market into 2021.

• Rising yields in 2021 should contribute to an increase in money velocity and ultimately assure a sustained economic recovery. While the pace of recovery will likely remain tepid, due to both sluggish gains in both the labor force and productivity, inflation should rise and may exceed the Fed's 2% price target. Rising oil prices should gradually feed into the headline data for consumer prices.

• According to a recent Horizon Kinetics 3rd Quarter Summary, the transition from fossil fuels to renewables will likely take longer and cost more than is generally believed. In order to achieve net zero emissions by 2050 liquid fuels consumption is projected to decline by roughly 10 mil. bbl/d by 2030. Under a business-as-usual assumption global liquids consumption will likely flatten out at 100 mil. bbl/d over the next 10 years.

• A 65% decline in oil rigs ytd all but guarantees oil production will decline well into 2021. With oil demand expected to recover to pre-pandemic levels by 2H 2021, the market should be in a supply deficit throughout next year according to Goehring & Rozencwajg's latest forecast.

• As shown in the chart to follow our weekly momentum studies show the S&P 500 is challenging the upper trend line which has served as major resistance over the past 5 years. Meanwhile, price momentum appears to be turning higher which is bullish for equities over the intermediate horizon. Global ex-U.S., not shown, has a much more constructive price/momentum profile.

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QUARTERLY INVESTMENT OUTLOOK: SEPTEMBER 2020

SUMMARY

• The next bull market phase should feature new leadership. We expect value to take over from growth in the U.S., with foreign equities the new leaders in the global space.

• The revised U.S. budget outlook 2020-2030 shows Federal debt increasing to 107% of GDP by 2023, the highest level since 1946.

• The Fed has adopted a new monetary policy framework favoring average price level targeting. Interest rates are likely to remain low for an extended period. The Fed has officially abandoned the Phillips Curve which defined a relationship between low levels of unemployment and higher inflation.

• Gold is rising in multiple currencies, a sign of a sustained bull market.

• What's ahead for the dollar? An update on Ray Dalio's book Changing World Order.

• Investment Strategy for a stagflation cycle; a three pronged approach.

• Energy prices could be at a multi-year low.

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QUARTERLY INVESTMENT OUTLOOK: July 2020

• Central bank balance sheet expansion has been the main driving force behind the cyclical bull market in stock prices. The fading of pandemic stimulus should slow asset purchases allowing stock prices to consolidate. Bear markets almost always end with a change in leadership.

• History shows pandemics, although exogenous events, can change economic behavior and ultimately have inflationary consequences.

• Rapid growth in M2 money supply will result in increasing inflation expectations, rising credit demands and higher inflation.

• China policy is turning pro-growth. Combined with recently announced stimulus measures from the Eurozone should foster a global industrial led recovery.

• Any attempt by the Fed to peg its policy rate will only exacerbate underlying inflation trends.

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QUARTERLY INVESTMENT OUTLOOK: APRIL 2020

APRIL 2020

• The sharp correction in equities featured nine 90% downside volume days within eighteen trading days. This intense capitulation selling is indicative of a bottoming process.

• The Fed should remain accommodative, and is starting a new form of liquidity expansion deemed QE infinity. This is positive for risk assets including equities and commodities, notwithstanding the current equity meltdown. It is confirmed by a steepening of the yield curve.

• Industrial commodities have historically followed gold prices higher. Having lagged in the current cycle due to the China trade dispute and coronavirus, a period of catch up is overdue.

• An inflation warning signal is flashing. The ratio of gold to treasury prices is favoring inflation.

• The global economy is stable and should survive the COVID-19 episode with one perhaps two quarters of negative growth. We would not rule out the use of fiscal stimulus to offset demand weakness created by the COVID-19. This could include direct money transfers and relief for small businesses.

• We view a peak oil price of $80/bbl. as our target despite the recent Saudi move to increase output by 2 million bbl./day. Our research indicates the Saudis have a present capability to increase their oil output by perhaps 200K-300K bbl./day to 10.3 million bbl./day. According to Ghoering & Rozencwajg they don't have the capability of producing 12 million bbl./day.

• Dollar weakness is the missing link to the reflation trade. The dollar is forming a major top.

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Quarterly Investment Outlook: January 2020

SUMMARY

• The Fed, ECB and PBOC are all following easy money policies. This is finally contributing to an increase in global liquidity, a condition needed for stocks to outperform bonds into 2020.

• M2 money supply is growing at 7% yoy, accelerating to a 13% annual rate since September. This could cause general price level inflation to move above 3% in 2020.

• Both oil and gas prices should move higher. Oil is benefiting from both an increase in the base decline rate coupled with slowing productivity, despite a 10% increase in well completions.

• A solid expansion in the Leading Economic Indicators along with a steepening in the Treasury yield curve, suggest a U.S. recession is not probable next year. Weakness in manufacturing is being offset by firm consumer/services sector. Consumer confidence at high level

• A weak dollar is the key to our stagflation thesis. U.S./German yield spreads are already trending lower, a necessary condition for a dollar bear market.

• China is poised to lead the global recovery. We expect an S&P earnings recovery into 2020, but stretched valuations could limit gains in the S&P 500, a growth dominant index.

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Quarterly Investment Outlook: September 2019

SUMMARY

• In an article entitled “Paradigm Shifts”, Ray Dalio, founder of Bridgewater Associates, anticipates the formation of a new monetary regime (featuring money printing) in the next decade. It will likely be driven by unorthodox fiscal policy aimed at bolstering consumer spending, featuring guaranteed incomes, wealth tax and “helicopter money”.

• Federal deficits could rise by $12.2 trillion over the next decade, and that assumes no recession. Debt could approximate 140% of GDP according to Deutsche Bank Global Research. Higher deficits over the past two years is causing the government to ramp up borrowing, which is running at the annual rate of $1 trillion per annum.

• The combination of both loose monetary and fiscal policies will drive a new inflation cycle. Commodity prices should enter a new bull market. Gold prices, having broken out of a 6-year base, are the “canary in the coal mine”.

• The Conference Board Leading Index, which measured as a 12-month moving average of a 12- month roc, is at +3.65%. This is signaling continuing economic expansion. The IHS Eurozone Markit PMI Manufacturing Index has leveled off (slightly below 50) over the past six months, while the euro at 110 has cheapened, potentially giving European auto makers a reprieve. China’ Caixin Manufacturing PMI, taken from a sample of 500 firms, also ticked up in June. Business confidence was at a 3-month high.

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Quarterly Investment Outlook: June 2019

SUMMARY

• Geopolitical risks have intensified since our last communiqué and will represent a material risk to the economic expansion should the trade war intensify. We still maintain that risks are likely to dissipate as President Trump is forced to focus on his reelection campaign.

• Over the last year-and-a-half the dollar was bought as a risk-averse investment, despite its deteriorating fundamentals. Two catalysts may cause the dollar to depreciate: converging global growth and interest rates.

• The yield curve has taken on a sinusoidal shape, indicating that growth is likely to slow over the next couple of years. We maintain that the steepening of the long-end may be forecasting a period of structural inflation.  We believe that this inflation will be driven by a debasement of the dollar.

• The Fed will begin purchasing Treasuries by yearend. Shoddy forecasting and poor policy decisions have significantly impaired the institution's credibility. It is increasingly likely that their policy tools will be ineffective at stimulating the real economy during the next recession and may only serve to inflate asset prices further.

• The healthcare sector experienced a statistically significant selloff in 2Q19. We initiated a position in Allergan PLC(AGN) to take advantage of sector's weakness. The company is a restructuring play and represents a deep value investment.

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Quarterly Investment Outlook: March 2019

SUMMARY

• The December 2018 selloff provided buying opportunities in stocks relative to bonds, and cyclicals (energy, basic materials, technology, and industrial sectors) relative to defensives (utilities, consumer staples, and healthcare sectors). The last time that a selloff of this magnitude occurred was at the beginning 2016, a period that warrants further examination due to the many historic parallels that can be drawn between then and now.

• The selloff was dramatic in volume. The ensuing rally has been strong and broadly-based. However the average active manager did not re-enter the market and has excessive holdings of cash.

• Leading economic indicators that we track signal a continuing domestic economic expansion. Given that ninety-five percent of bear markets occur during a recession, we have a high degree of confidence in forecasting the continuation of the current bull market over the next twelve months.

• Technical and fundamental analysis, however, indicates that we are in the late stages of both the investment and business cycles. Historic trends support overweight positions in stocks and commodities and underweight positions in fixed income securities.

• The Federal Reserve has changed their outlook for the future level of the Fed Funds rate and their balance sheet runoff. The dramatic scaling back of expectations for Quantitative Tightening supports our thesis that the Fed will be forced to monetize the federal debt. Past episodes of debt monetization have resulted in an periods of higher inflation.

• The airline industry has undergone a significant consolidation that has provided the big four with immense pricing power. We initiated a position in Delta Air Lines, Inc. (DAL) to take advantage of this trend.

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Quarterly Investment Outlook: January 2019

SUMMARY

· The US recession indicators that we monitor show no imminent signs of danger, although domestic economic growth is likely to decelerate to 2.5% as we enter 2019. We believe that the selloff since September is a sharp and violent correction, not the beginning of a bear market.

· Fears of a yield curve inversion have been overhyped by the financial media, exacerbating Wall Street's sense of despair.  Inversions since 1978 have been accurate forecasters of recessions, however economic contractions typically occur with a lag of almost two years.  Moreover, since the late 1970s inversions have never marked a peak in the bull market, but instead signal the beginning of the final risk-on phase that has generated average equity returns of 25.2%.

·  Investor sentiment is washed out.  The current reading from the State Street Investor Confidence Index is at a low that has only been matched twice in the last decade.  From a contrarian perspective this level of fear may indicate that the market's path of least resistance is higher.

· The Congressional Budget Office's (CBO) projection of deficit spending continues to deteriorate.  Moreover, an analysis performed by Hoisington Management highlighted the CBO's estimates have significantly underestimated the rate at which the federal government's debt balance has grown.  Our analysis indicates that a recession by yearend 2023 could increase the level of Federal debt to GDP from 107% currently to 129% by 2024.

· This issue marks the introduction of the Portfolio Additions section, which highlights the investment rationale behind Stuyvesant's recently added core holdings.  In this issue we discuss Las Vegas Sands Corp., Paccar Inc., and The Chemours Company.

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Quarterly Investment Outlook: September 2018

SUMMARY

• The rate of domestic economic growth is likely to peak in either 2Q18 or 3Q18 based on the leading economic indicators that we monitor.  Growth should subsequently trend towards the Fed's projection of long-term growth at approximately 2.0%.  If this is true then a continuation of the Fed's rate hiking program may result in an overly restrictive monetary policy within the next twelve months.  We will not be surprised if President Trump attempts to influence the Fed in order to appease his constituency by promoting a policy that will allow for the continuation of the economic expansion.

• Quantitative tightening is causing the Fed's balance sheet to shrink at an accelerating rate.  The Fed's balance sheet has been positively correlated with the decade-long equity bull market.  It is disconcerting that the balance sheet is now beginning to shrink since this correlation is backed by a fundamental causation.  We ultimately believe the long-term path of least resistance for the Fed will be to decrease the rate of tightening. 

• The Federal Reserve's Underlying Inflation Gauge is forecasting that inflation is likely to accelerate to above 3.00% within the next six months.  Rising wages, fiscal stimulus and higher oil prices should cause inflation expectations to trend higher.  Our fixed income allocation towards Treasury Inflation Protection Securities will benefit if the rate of inflation accelerates.

• · We continue to forecast a recovery in G-10 ex-US economic growth in the closing months of 2018, where G-10 includes European countries plus Canada and Japan.  The current period of dollar strength is serving to reallocate growth away from the U.S. towards the G-10.  Chinese stimulus in the form of lower rates, a pickup in credit growth, and higher infrastructure spending should benefit growth in Asia ex-Japan.  Cyclical stocks have dramatically underperformed defensives over the last quarter.  Green shoots in the global economy relative to the US economy should serve as a catalyst in revaluing our cyclical and international holdings.

• Oil production in the continental US is beginning to undershoot expectations.We believe this is due to insufficient investment in midstream assets, a lack of qualified laborers, and shortages of key drilling materials such as frack sands and water.These shortages are likely to continue into at least 2H19. A significant supply deficit is likely to materialize in oil as we enter 2019 due to continued OPEC production shortfalls, coupled with the re-implementation of Iranian sanctions.Oil stocks are cheap and remain a core holding.

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Quarterly Investment Outlook: June 2018

SUMMARY

• In the May 16th FOMC policy statement, the Fed implied it will foster monetary policy that allows inflation to rise modestly above 2%, consistent with its symmetric objective.  This policy is equivalent to price-level targeting, which has been advocated in recent years by former Federal Reserve Chairman Dr. Bernanke.
• The U.S. administration's recent announcement that it would be investigating tariffs on auto imports, as well as the lack of the clear trade policy with China, raises the risk of a "trade war".
• 1Q18 earnings were strong, supported by an 8% yoy revenue gain.  While earnings growth is forecasted to slow into 2019, profits should continue to support equity prices, which should lead to another increase in the stock market into 2H18.  Normally the best gains in a mid-term election year occur in Q4.
• Global growth is diverging.  The U.S. is strong while the Eurozone and China have lost momentum.  The recent decline in the euro should benefit European growth/equity markets in the second half of the year.  It should be particularly helpful to the weaker members.  China should be aided by a lower bank reserve requirement (with the release of additional reserves), coupled with the potential for more fiscal stimulus, which we are anticipating. 
• We believe the dollar has entered a multi-year bear market driven by long-term deterioration in both our fiscal and current accounts.  Gold miners should be an excellent hedge against future dollar weakness and the growing possibility of monetizing the expected increase in Federal debt.             
• We expect bond yields to resume their upward climb later in the year after a brief consolidation, driven by an increase in inflation.  This is supported by the trend in the Fed's Underlying Inflation Gauge, a leading indicator that is currently at 3.2% yoy.  BCA Research recently noted that for the first time in the 17 year history of the BLS JOLTS Survey, job openings exceeded the number of unemployed workers.  A surge in the proportion of workers willing to leave their jobs, at a time when it is getting more difficult for employers to find skilled labor, should also foster higher wages leading to increased inflation.
• Our favored domestic sectors include Energy, Financials, Materials, and Healthcare.  Following a 16% gain in oil prices, the Saudi oil minister stated that OPEC was likely to increase production quotas at their June meeting, which has led to profit-taking.  We believe that OPEC production will increase by several hundred thousand barrels in the second half of the year in an effort to offset the expected loss of equivalent Venezuelan production.  With strong demand, oil prices should rise above $80/bbl with risk to the upside.  There has been insufficient investment in ex-shale energy producing assets, causing an increase in the fragility of the oil production system. 

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Quarterly Investment Outlook: January 2018

SUMMARY

• The 2-10 year Treasury spread has flattened by more than 50% since yearend 2016 to approximately 60 basis points (bps).  Core personal consumption expenditure inflation (PCE) at 1.45% is struggling to trend higher and inflation expectations remain soft, despite wage inflation increasing 2.6% yoy.  The Fed could make a policy error by raising the Fed funds rate once in December (probability currently > 90%) and once more in March (probability currently > 60%), reinforcing market sentiment that inflation is unlikely to return to 2.0%.
• We ultimately expect lower business taxes and expensing of capital equipment to survive a resolution of the House and Senate.  With the US economy operating at full employment, additional fiscal stimulus is likely to be inflationary to the extent that it is funded by increased deficit spending.  There may be some productivity benefits, but most businesses will use the increased cash flow to pay down debt or to increase shareholder returns via share buybacks and dividends.
• In Germany, the 10-year bund yields a paltry 35 bps, which coupled with the strength of the economy and headline inflation at 1.80%, leaves financial conditions excessively easy.  Effectively, the real 10-year bund yields -145 bps.  The average spread between the US and German 10-year yield is historically 40 bps.  The current spread of 200 bps is unsustainable and should narrow in 2018, leaving the US dollar with further room to decline.
• Our analysis of recession risk indicators (the rate of change in the Leading Indicator Series) continues to support the notion that the business cycle is unlikely to turn down over the next six months.  However, other measures of growth such as the ISM Manufacturing Index and the U.S. Economic Surprise Index are at elevated levels.  This is typically followed by a decrease, which may signal a slowdown in economic momentum.  This does not indicate a recession, but rather a decrease in the rate of growth over the next six months.
• The US equity market is significantly overvalued.  The CAPE-10 P/E Ratio stands at twice its historic mean and median levels.  While valuation metrics are not good market-timing tools, they do suggest that real forward returns are likely to be nominal when viewed over a 10-year period. Market leverage is excessive and could exacerbate selling should prices drift significantly lower.
• Preservation of capital is now paramount and value securities still trade at a significant discount to their intrinsic value and to the market. Our domestic equity holdings are geared towards late-cycle value plays, such as energy, financials, industrials, and miners.  Select foreign markets continue to offer relative-value and are better positioned to benefit from the global synchronized recovery.

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Stuyvesant Insight: The Market Is Broadly Overvalued

The S&P500 returned over 20% since the November 8, 2016 Presidential election.  The investment community attributes the increase to strong and synchronized global growth, earnings growth, and business optimism due to the possibility of corporate tax cuts and reduced regulation.

In fact, as determined by FactSet, analysts estimate that S&P500 earnings will grow by 11% in 2017 and 10% in 2018.  A back of the envelope calculation shows that an increase in earnings has already been discounted by the market (1.10*1.11=1.22 or 22%) through 2018.  This is also evident via the 12-month forward P/E multiple (below).  This multiple is calculated by taking a weighted monthly average of the Wall Street analyst's earnings estimates for the current and next year.  It then divides the price of the market by the 12-month forward estimate.  This year the multiple has expanded from 16.94 to 18.00, indicating that 6.3% out of the 17% advance YTD is attributed to multiple expansion.  This indicates that almost 40% of this year's advance is due to multiple expansion, not to a fundamental improvement in earnings.

Source:  www.stuyvesantcapital.com and FactSet

The Stuyvesant Earnings and Dividend Discount Model uses a cyclical P/E ratio, 5 year earnings forecast, and 5 year dividend growth to calculate present value.  Since 2015, the price-to-present value metric trended upwards for the Dow30 (below).  Currently it stands at 104% of present-value.  Usually we avoid adding a stock to our core list unless it trades at 90% of present value.  As such, the Dow30 would have to decline by 14% before it qualified as a buy.    This indicates that the price of the Dow30 largely discounts Wall Street's 5-year earnings growth at the prevailing discount rate.

source: www.stuyvesantcapital.com

Moreover, the breadth of the Dow30 (below) confirms the overvaluation.  The percentage of constituents that are fully valued (PV > 100%) stands at  60%.  This indicates the overvaluation is not confined to a few outliers, but a majority of securities. Moreover, 24 stocks or 80% of the Dow30 trade at a premium to our 90% investment threshold.  

source: www.stuyvesantcapital.com

In a market that is broadly overvalued, it is pertinent to selectively take profits in order to reduce risk.

Quarterly Investment Outlook: September 2017

SUMMARY
 
• According to market strategist Tom Lee of Fundstrat, stripping out the 10 largest weighted S&P 500 stocks, would result in a gain of 4% ytd.  This is evidence of how narrow and selective the market advance has been.  A tech S&P 500 weighting of 25% has bolstered the returns of these 10 top gainers, and propelled growth returns of +17.7% over value at +4.7% thus far.  With growth overvalued, we believe we are close to an inflection point where value will likely outperform, perhaps for the next several years.  This will negatively impact the returns of passive investment strategies, similar to what happened in l999 when  the dotcom stocks peaked. 
 
• The Fed should shortly announce its scheduled balance sheet reduction plan.  Initially, they will let $10 billion of treasuries and mortgage backed securities mature without reinvestment.  This will gradually rise to $50 billion monthly by yearend 2018.  The runoff of investments will cause a decline in excess reserves, but is unlikely to negatively impact risk taking.  For many years these reserves have been sitting dormant, earning interest but not used by commercial banks to increase lending.   
 
• Nevertheless this policy may have unintended  consequences.  A smooth running exit may engender "animal spirits," and lead to increase in risk taking.  An increase in borrowing would drive interest rates higher, causing the Fed to respond with its usual lag, by pushing up the Fed funds to perhaps 2% (FOMC dot target for 2018).  Under this scenario, Treasury yields on 10year maturities could hit 3%, a level that would increase volatility in risk assets. 
 
• Oil prices should rise over the months ahead, benefitting from declining inventories and flat production, which are offsetting seasonal demand weakness.  Meanwhile, geopolitical risks are elevated.  These include possible curbs on Venezuelan imports, a termination of the Iranian nuclear deal, and a possibility the Saudis will be forced to act alone, before their scheduled November 30th OPEC meeting, by cutting production to stabilize cartel compliance at 70%. 
 
• Ninety-five percent of equity bear markets are caused by U.S. recessions. While valuations are stretched, and the Fed is gradually removing liquidity, we see few signs of a recession beginning in the next six to twelve months. 
 
 
• As such, equities should outperform bonds, at least through the first half of 2018.  Foreign markets offer more attractive value, and should continue outperforming their domestic counterparts.  We prefer Europe, Japan (removed currency hedge), China "H" shares, and are looking to purchase South Korea on any weakness.  While U.S. tech/telecom are fairly priced, SK offers above average exposure to these sectors at more reasonable valuations.

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Stuyvesant Insight: High Yield Bond ETFs Provide a False Sense of Liquidity

Exchange traded funds (ETFs)  securitize stocks, bonds, commodities, or currencies into funds that are subdivided into shares, which are tradable on exchanges.  They are often promoted for providing diversified exposure to an index at nominal cost.  I believe that investors are overlooking the inherent risk in securitizing certain assets into ETFs.  High yield bond ETFs might be at risk of significant underperformance during the next bear market due to the illiquidity of the underlying securities.

I would liken the risk that I see in high yield bonds to that of the securitization of mortgages into mortgage-backed securities (MBS) leading up to the Great Financial Crisis.  Those securities were championed for their diversification of the underlying issues and assigned investment grade ratings by credit rating agencies.  However, diversification did not address the fact that probabilities of default for all of the underlying issues would increase during a housing crisis (probability of default was conditional as opposed to independent).  Similarly, high yield bond funds are promoted as a liquid means to invest in illiquid high yield bonds.  However, I expect these securities will suffer steep declines if a liquidity event occurs in the event of a bear market.

I decided to examine the relative liquidity of high yield securities versus purported liquidity based on the inclusion of the same security in an ETF to determine if the ETFs provide a false sense of liquidity.

I began the study by assigning numbers to the 1,032 individual high yield issues that were held in the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) on August 15, 2017.  Using a random number generator, I selected ten of the issues for further analysis.  I then followed a two step process to determine the relative liquidity between the individual issue and the ETF.

The first process was used to determine the actual average daily trade volume of each issue:

1.      Collect the daily volume per issue over the previous month (July 15, 2017 through August 15, 2017) from Bloomberg Finance LP.

2.      Aggregate the daily volume to determine the monthly volume and divide the monthly volume by the number of days that the exchange was open (22).  This produced the average daily volume per issue over the period.

3.      Count the number of days that each issue was traded and divide that number by the number of days in which the exchange was open.  This produced the percentage of days that the security was traded.

The second process was used to determine the effective trading volume of each issue as a constituent of HYG:

1.      HYG's net asset value (NAV) was recorded for August 15, 2017 at approximately $18.6 billion.

2.      Determine the dollar value of the issue as a percentage of HYG by multiplying the percent of the fund comprised of the issue by the NAV of the fund (data obtainable on iShares website).

3.      Divide the dollar value of the bond by the average price of the bond for the analytic period to determine the approximate quantity of bonds held per issue.

4.      Calculate HYG's average daily volume over the period and divide that number by the outstanding shares of HYG on August 15, 2017.  This approximately produces the daily turnover of the fund.

5.      Multiply the daily turnover of the fund by the quantity of bonds held per issue to determine the effective quantity of bonds traded per day.

I proceeded to divide the effective quantity of bonds traded in HYG by the actual number of bonds traded on the open market to determine the "Fund Liquidity Magnification Factor".  The results of this analysis are provided below:

The Fund Liquidity Magnification Factor  averaged 8.2x with a median of 6.4x.  Moreover, the individual issues only traded an average 67% of days that the exchange was open and a median 73% of days that the exchange was open.  I believe that this analysis indicates that ETFs for high yield bonds provide a false sense of liquidity for the underlying issue, which has given holders of the unit trusts a false sense of security. 

Thus far, the securitization of illiquid high yield bonds into liquid ETFs has not resulted in a market event.  Moreover, I admit that I am unable to identify at what point a problem might emerge, especially as the funds continue to benefit from ETF arbitragers.  ETF arbitragers are individuals or algorithms that, in times of great supply or demand for ETFs, will take advantage of the fund mispricing by buying (selling) the constituencies of said fund in order to create (break down) the ETF units and drive the price to the intrinsic value.  This arbitrage process has worked incredibly well over the last market cycle, which has reduced the volatility of ETFs the majority of the time (outside of flash crashes).

I expect that a problem will arise when volatility increases.  An increase in volatility decreases the certainty in calculating the intrinsic value of securities, which will negatively impact the price of high yield bonds.  It will similarly impact the certainty that arbitragers use in calculating the present value of securities to arbitrage.  Though spurts of volatility can emerge from geopolitical threats, such asa potential continuation of the Korean War, I believe that a prolonged increase in volatility will be caused by the next recession / bear market.  This will be the ultimate cause of a liquidity event in high yield bond ETFs.

In a period where the intrinsic value becomes more difficult to calculate, arbitragers will remove themselves from the market.  Heightened volatility will decrease their ability to forecast the intrinsic value of the bond, negatively impacting their ability to arbitrage.  At the same time, investor's will generally tend to become risk-averse.  As a result, I expect market for high yield bond funds to be dominated by sellers.  If there is a lack of buyers, the unit trusts may be broken down into their constituencies: high yield bond issues.  As depicted in our study, these securities are even less liquid, which should result in bids decreasing at a faster rate than for the ETFs.  Thus, breaking down the fund into the underlying securities in an attempt to realize the intrinsic value of securities will exacerbate the decrease in high yield bond prices.  HYG currently has approximately 1.5% of its assets held in cash that could be redeemed if the unit trusts experienced a sudden burst of selling.  After this cushion, the trusts will be broken down and sold on the open market.  HYG is only one example of a high yield ETF.  When you consider that there are more high yield ETFs and mutual funds that hold non-investment grade issues, the scope of a potential selloff magnifies.  Buyer beware.

Stuyvesant Insight: The CAD/USD Cross to Lead Oil Prices Higher

In a previous insight I highlighted the positive correlation between oil prices and inflation expectations. I asserted that oil prices would trend towards $55.00-60.00 by yearend due to decreased productivity in the Permian Basin, coupled with global restrained energy-related capital expenditures and OPEC's output cut.  I further asserted that this would drive the 10-yr Treasury yield higher due to an increase in the yield's inflation component.  This week we go to the foreign exchange market, which may be signaling that the recent advance in oil prices is sustainable.

The Canadian Dollar (priced in US Dollars) has been tightly correlated with price of West Texas Intermediate Crude Oil since 1999:

Source:  www.stuyvesantcapital.com

This relationship is derived from the fact that Canada is endowed with copious natural resources and is a net exporter of oil. Its economy is highly dependent on the natural resource sector and tends to outperform when the oil price is strong, supporting its currency.

From a technical perspective, the CAD/USD cross just violated a multiyear downtrend:

Source: www.stuyvesantcapital.com

Currency traders typically have a high degree of leverage assigned to their trades.  Most long-term downtrend lines have large blocks of available securities on the ask-side.  Breaking this would require significant volume from buyers.  The fact that the trend has been violated indicates that forex traders wagered vast sums that the Canadian Dollar would continue to appreciate relative to the US Dollar.  Based on the strong positive correlation between CAD/USD and WTIC that has existed since at least 1999, I expect oil prices will trend higher.  This should lend support to the 10-yr Treasury yield based on my past analysis.

Stuyvesant Insight: The Copper-Gold Ratio

An announcement that China is looking to ban copper scrap imports, coupled with higher than expected mine depletion, strong demand, and decreased mine productivity (strikes at world-class mines) caused copper to increase 5.7% this week through Thursday's close.

This week's roll-out of an affordable Tesla may have  also caused analysts to begin increasing their projections for the global demand of copper.  The average American car has approximately 55 pounds of copper wiring, while electric cars require closer to 150 pounds. As a result, the International Copper Association increased copper demand for cars and buses from 185,000 tons in 2017 to 1.74 million tons in 2027. The near ten-fold increase would represent 7% of today's global copper production.  Moreover, years of depressed copper prices caused copper miners to defer green field projects.  They, instead, increased output via smaller brown field expansion projects, which have already come on the market.  Freeport McMoRan's CEO, Richard Adkerson, highlighted on a recent conference call that the market would require prices to remain north of $3.00 per pound in order to incentivize new mine investment.  From there a new mine would take between five and ten years to start producing copper ore.  These projected changes in supply and demand fundamentals are beginning to have a material impact on both the absolute price of copper and price ofcopper relative to that of gold.

The copper-gold ratio is calculated by dividing the market price of copper by the market price of gold.  Copper is an industrial metal.  It is used in plumbing, electric wiring, and its anti-bacterial properties coupled with its malleability lend the metal to be used in medical equipment.  Demand increases during periods when economic output is rising.  Gold is a store of value.  It is molded into ingots, bullion, or displayed as jewelry.  Its actual industrial applications are limited.  The differing uses of the metals has allowed the copper-gold ratio to act as an accurate barometer of global growth.

The ratio began the year on the weak side, but recently trended upwards and made a new high as of July 27, 2017: 

Source: www.stockcharts.com

This indicates that growth is strong, which is supported by global PMIs and today's second quarter US GDP print at 2.6%.

In his 2017 outlook, Jeffrey Gundlach of DoubleLine highlighted that the copper-gold ratio is a powerful coincident indicator of the 10-yr Treasury yield.  This is due to the fact that the copper-gold ratio and the real yield and inflation components of the 10-yr Treasury are highly correlated with global growth.  As you can see (below) the 10-yr Treasury yield has exhibited a trend similar to the copper-gold ratio this year:

Source: www.stockcharts.com

However, the most recent upleg in the copper-gold ratio has been unmatched by an increase in Treasury yields.  We expect that the real yield will move higher given improving economic prospects.  We similarly expect that the inflation component will move higher given continued dovishness from the Federal Reserve coupled with higher oil prices.  This should continue to benefit value stocks relative to their growth counterparts.