The View from Bannerstone Capital
Chlorophyll, Aeolus, and George A. Stephen, Sr.
“The foresight of financial experts was, as so often, a poor guide to the future."
–John Kenneth Galbraith
Ah, summer. It’s the time of infinite chloroplasts and shimmering cicadas, enthusiastic mornings of birdsongs and stubborn evenings of tiny brown bats flitting overhead as daylight fades a gauzy blue gray. Mother Nature is furiously creating biomass all around us, like some magnificent life factory running three shifts, sucking carbon dioxide from the rich atmosphere, plucking the magic quanta from the yellow summer sun, phosphorylating adenosine and hatching baby turtles along a sunny sandy path. The unmistakable scent of a nearby Weber grill wafts on a warm breeze. I like summer.
In juxtaposition to the Eden under my watering can is the third calendar quarter on my computer screen. While the world outside is in the season of abundance, July, August and September is often winter for the stock markets. For investors, it’s hunkering down time. You may have to rely on the bounty of past growing seasons. Sure, some winters are downright hospitable, at least nicer than others. Winter sports are kind of fun in a glad-when-it’s-over sorta way. You have to be careful, though, the winter weather can kill you, and that brings me to stocks.
This danger of Q3 is very much on my mind as I watch so many signs of autumn, not summer, on the tape. The Dow Transports are off over 10 percent year to date, its last all-time high was November. As the Dow Industrial Average has managed to claim new highs twice since then, albeit tepid ones to be sure, the Transports just head south. This is a condition Dow Theory advocates watch for: non-confirmation. It gives bulls the heebie-jeebies. Me, too.
Greece is in the news. Again. I first read The Odyssey one summer long, long ago as a teenager. I found a serious-looking grown-up paperback lying around the house and, to my astonishment, it was pretty good! I was anxious to show my dad I had read something “smart,” and I was sure he had read it too, of course. Sometimes the road to smart means not smart first. During an impromptu, and utterly unrequested, book report over Sunday Night Dinner, I happen to, of course, describe the main characters. My thoroughly disinterested brothers and sisters politely listened to the particular emphasis on the long-suffering wife of Odysseus (phonetically now): “Pen-uh-lōp”. Three syllables. My father’s delicate, er, correction was not lost on the sibling audience, to say the least: merely 12,110 lines later, at least I now had her name right. And hot glowing cheeks.
Have we really gotten nowhere on Greece and Euro? Odysseus is on my mind as Greece advances and retreats on its modern economic Odyssey. Odysseus, you might recall, thinks he finally has it made. After 10 long years under a curse of Poseidon (payback for blinding the Cyclops), Odysseus can at last see his homeland Ithaca from the deck of his ship. Secure in his future, he falls sound asleep. He leaves a mysterious bag, forbidden by Aeolus to be opened by anyone but Odysseus, unattended. Given to him, its contents must be kept secret. The secret bag is a gift from Aeolus: only favorable winds, invaluable for reaching Ithaca. His curious crew opens the bag (did the crew vote while Odysseus slept—a referendum perhaps, voted upon by his misguided crew?) and the favorable winds escape. Now they must deal with the capricious winds unaided by the gods, and as luck would have it, only unfavorable winds prevail. History does not know the first thing Odysseus said upon awakening, but there are many good guesses. Incredibly, they are blown all the way back to the very start of their long journey. Sometimes you just have to start over.
Investor sentiment can utter prophesy, especially at extremes, but it’s currently mum. Sentiment is the cruelest of market indicators: it works because we’re usually so wrong. The weird thing about recent American Association of Individual Investors survey results is the extreme readings have all been in the Neutral responses. Extremely Neutral? On July 15th, the AAII reported Bulls at 30.8 percent, Bears at 23.2 percent and Neutrals 45.9 percent, up 3 percent. Bulls increased 2.9 percent in the past week, but they are still well below an average reading of 38.83 percent. Bears dropped 5.9 percent for the second week in a row and are now well below the long-term average of 30.28 percent. Both are moving toward more optimism. Neutral is running almost 50 percent above the long term average. Extreme optimism would bolster the case for a Q3 stock market upset. It seems plausible that a Neutral voter is easier to get to convert to Bullish than a Bearish voter and vice versa: It’s half the psychological distance to an extreme. So perhaps some blast of news somewhere will suddenly convert the fence-sitters with unusual force, and we get an extreme number of Bulls or Bears. If, for example, we get good news from say Greece or China or Iran or ISIL, I expect a possible rapid balloon in the percent Bulls, or a further drop in Bears, and maybe trouble soon after. Comfort is thine enemy. A blast of bad news and a sharp rise in bearishness would be more bullish for stocks. How much worse can the news get? Yikes. Forget I said that.
Maybe China is the way this market cycle ends and a correction is ushered in. Or maybe the correction just crashes the party. While the crowd obsessed about Greece, China was bubbling over the top. Best case for global Bulls: Chinese government intervention is perceived to stabilize the domestic stock market and there is almost no knock on negative wealth effect. Worst case for the Bulls: Shares ignore the Communist Party and China erupts in civil unrest. I mean isn’t “a communist country stock market” an oxymoron? Someday, something has to give. The Tiananmen Square protests of June 1989 came out of nowhere. The Chinese call this the “June Fourth” incident, by the way. Chinese civil disobedience seems to have a habit of seeming to come out of nowhere. A massive loss of wealth has occurred in China and may get much worse. The coming weeks will be telling.
So what up with the Transportation Average? Why the funk? Maybe this time is different: The slow death of coal in the United States has depressed railroad profits. Is that all that is happening? Natural gas is cheap and clean. It’s politically popular. Coal is heavy and dirty and politically radioactive, as if sulphur and CO2 aren’t enough. I am concerned about the various “explanations” for why Dow Theory isn’t applicable to the current divergence between the Industrials and the Transports. Frankly, it reminds me of the explanations for why the inverted yield curve in 2007 didn’t matter. Inverted yield curves are like Great White Sharks (OK, it has been Shark Week): not every Great White kills you, but to stay in the water with one is a bad bet. No upside, lots of downside, and he decides how it turns out. See Figure 1.
Fig. 1 Industrials (Gray) vs. Transports (Red): Dissonance YTD
As a nod to Charles Dow, the venerable creator of the eponymous theory, I have reduced exposure here early in the third quarter. I don’t like the weak Transports. Thales (“Thay-leez,” as in the philosopher of antiquity) is our all-capitalization, high-conviction equity strategy. I have sold some stocks and have not replaced them yet. We don’t typically take our exposure up and down based on market forecasts. Very few important market rallies have begun in the third quarter (although August of 1982 comes to mind—a powerful counterfactual—but 1982 was at the end of a recession), so I am betting the conventional seasonality reduces my opportunity costs. Meanwhile, I have above average-reserves, about 20 percent, to reduce the effect of any downturn and, far more important, provide cash to invest during a bout of panic.
I guess the Great Bond Bull Market, born in 1981 will die in a coma, not a final spine-chilling roar as most of us anticipated (uh, see Galbraith’s quote). But it has occurred to me almost nothing makes longer-dated bonds rally these days. On goods days they sort of go down and on bad days they sort of go down. I think the markets are taking matters in to their own hands. This has implications for the equity markets. It’s tough for me to be bullish after reviewing the nearby charts of longer-dated bond ETFs. Treasuries have been the last to give up the ghost, but judging by investment grade corporate bond ETF LQD, that ghost has one foot out the door. I think Treasuries are close behind. See Figure 2.
Fig.2 ETF LQD Year to Date: Corporate Bonds are Anticipating Higher Rates Ahead
We have made changes to our strategies in the second quarter. Alloy, our oldest stand-alone strategy, has sold Apple down to its natural weighting in the NYSE Arca Tech 100 Index; it has been much higher for years. Unable to break 135, AAPL looks like a double top me on the daily chart, and the 14-Day RSI is no longer in a bull-market band. Everyone owns this one. I think the potential for future civil unrest in China is a remote but potentially significant factor.
Alloy also sold Legg Mason, the Baltimore-based asset manager. This was a sector adjustment, not a referendum on Legg Mason. We still own Janus, where Bill Gross now works, but I think if we get the Q3 market action I anticipate, we can buy Legg Mason back or a name like it lower, later. Both positions are escrowed as cash, and I am considering increasing the Berkshire allocation, as well as a regional bank position. I like CUBI, Customers Bancorp Inc. for example.
In our high-conviction strategy Thales, we made many changes in the second quarter. Thales is having its best first half relative to the S & P 500 in many years. We sold Apple, Cabot Oil & Gas, Cheniere Energy (LNG), GlobalStar Inc., and Noah Holdings. We bought names like Luxoft Holdings, Kate Spade and Lannett Company. We have about 20 percent in cash.
We intend to begin publishing select composites’ performance this year, including Thales and Alloy. My confidence in our ability to conform to GIPS (Global Investment Performance Standard) is high enough to finally give it a shot. We’ll start at the website and then include it The Coteau. With a little luck, we can include Broad Creek Partners, a hedge fund we manage, too. Watch for this.
A plausible sequence this summer may be rapidly improving optimism after China’s speculative A share markets stop falling, Greece is sort of stabilized, Congress accepts the Iran Nuke deal, Puerto Rico kicks the can down the road (they strike oil?) and we all get a copy of Go Set a Watchman for our beach time.
Investing is important. The third quarter is a tricky one for investors, and I am nervous about it again this year. But July, August and September isn’t tricky when it comes to some other important things in life: like living, for example. To wit, reflect on George Stephen, an American who, in the long run, may mean more to all of us than Prime Minister Tsipras, Angela Merkel or the Shanghai A shares combined. Tonight, summer twilight will again descend softly on America. Garage doors will close behind workers returning home after a long day. Families will reconvene on decks and back porches as Venus burns in the indigo west. Tiki torches may be lit while sprinklers hiss and pop. Backyards will fill with the aroma of sizzling something on the ubiquitous Weber kettle grill, a device George Stephen first crafted from a steel navigational buoy manufactured in Chicago in 1952. I don’t know if Americans will be sharing Homer’s Odyssey in summers hence, with or without embarrassing pronunciation, but I am sure they’ll be celebrating life in the cathedral of summer with a Weber grill.
Are we out of ketchup?
This publication does not constitute, in any way, investment advice. The views described may have changed by the time you read this, anyway. Use your head, for crying out loud. Craig Cox is our editor. Thank you, Craig. Bannerstone Capital Management, LLC is a registered investment advisor. We are on the web at bannerstonecapital.com