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Crescat Capital 1Q17 Letter – It is Time to Sell Now. Catalyst is Already in Play. Everything is Set Up to Fail

Crescat Capital 1Q17 Letter, May 1, 2017

  • By keeping interest rates on the world reserve currency too low for too long, the Fed has created speculative asset bubbles in far-reaching areas of the globe:
    • Currency and credit bubbles in China
    • Housing bubbles in Australia and Canada
    • Worldwide gluts in industrial commodities including fossil fuels, iron ore, and steel
    • US passive index and ETF investing bubbles
    • Financial asset and net worth bubbles in the world’s major developed countries
  • Catalyst today to burst these and other asset bubbles is the Fed’s recent interest rate hikes (already raised 3 times since December 2015)
    • Increase in Fed fund rates from 12.5 to 91 bps in the last 16 months equates to 628% increase in the interest cost of borrowing Fed funds
    • It’s the largest Fed funds rate hike in any past US business cycle and it has come late in the economic cycle

The Curse of the Republican First Year

  • Tax cuts should prove bullish but when it comes to political regime change late in the business cycle, there is a much bigger, more imminent problem
  • In prior post-World War II Democratic-to-Republican regime changes, there was a stock market crash and recession in the first year of the new Republican president’s term every time
    • Eisenhower (1953), Nixon (1969), Reagan (1981), Bush (2001)
    • Yes, even under the great Ronald Reagan who ultimately delivered on his income tax cut, the world could not escape the curse of the stock market crash and recession in the first year of a Republican president
  • Stocks were looking great for Reagan at the end of his strong first 100 days but the market faltered in May and then again in June as Paul Volcker pressed the Fed funds rate higher
    • Recession began in July of Reagan’s first year; S&P Index declined 27.1% from its post-election high before the recession ended in November 1982
  • A crisis that happens early in a new president’s term can always be blamed on the prior administration. With the push for tax cuts and deregulation and optimism already baked into the stock market, administration, Congress, and the markets are all goading the Fed to raise rates further, just like under Reagan and Volcker

Why it’s Late in the Business Cycle

  • Current expansion phase of the business cycle is more than 8 years running
  • There have been 11 business cycles in the US from 1945 to 2009 – average length of 5.8 years (expansion phase was 4.8 years and contraction was 0.9 years)
  • The two longest running business cycles next to the current one extended as far as a 9th year
    • These years coincided with the Fed raising interest rates and Nixon and Bush’s first year in the office

Valuations are at Record Highs

  • Aggregate valuation of financial assets (stocks, bonds, cash) relative to after-tax income is more overvalued than it was in both the tech bubble and the housing bubble
  • US household net worth relative to income is also at record valuation levels
  • According to the OECD, similar record imbalances in the valuation of financial assets and net worth to disposable income currently exist in Europe, Canada, Japan, and the UK
  • Across a broad swath of valuation measures for both the S&P 500 and Russell 2000, US stock valuation are either in the same range or in many cases significantly higher than they were at the tech bubble peak and the housing bubble peak
  • Since the time Fed began hiking rates in December 2015, P/E ratio of Russell 2000 moved up from 46 to 115x earnings
    • During the same time, aggregate interest expense has increased by 19% and corporate profits have declined by 33%
  • In Russell 2000, only 68% of the index is made up of profitable companies (at the peak of tech bubble, 76% were profitable and at the peak of housing bubble, 79% of them were profitable)
  • We believe this is as good as it gets. Everything is set up to fail

Bullish Sentiment is a Contrarian Indicator

  • March data from Yale University Stock Market Confidence Indices: only 1% of institutional investors expect the US stock market to be down over the next year
    • Record bullish sentiment from Yale survey that goes back to 1989
  • They know the market is overvalued, but are just waiting for an excuse or a catalyst to bail out
  • Only 9% of big money managers are bearish through year end and only 1% expect a recession in 2017
  • Investors are saying to themselves, “Surely tax cuts and less red tape under Trump are bullish for the stock market. Sure, it might be late in the economic cycle, but there is almost certainly one more significant push higher in stocks. I would be a fool to miss that. That would be like missing out on the tech boom in 1999”
  • It is time to sell now. Catalyst is already in play – the rate of change in the Fed rates

Positioned for the Next Downturn

  • What we see as we have laid out is not “reflation” but rather a significant downturn in the global economic cycle
  • We hold record cash and precious metals in our long-only strategy because we are genuinely bearish right now and care deeply about protecting capital for our clients
  • Fed fund rate hikes usually have major ripple effects through the whole global credit system
  • As a recent example, starting with just the anticipation of the first Fed increase, China and the global oil industry went into crisis mode
    • S&P 500 had a 14% correction from July 15 to February 16
    • Shanghai Composite crashed almost 47% from its high in June 15 to February 16
  • We are not perma-bears by any means. We do not buy into the secular stagnation story. We buy into the idea of an imminent cyclical downturn

Crescat Global Macro Fund Current Positioning by Macro Themes

  • Aging Population: Defensively-oriented long healthcare equities that score well in valuation
  • Asian Contagion: Canadian housing bubble shorts; short Canadian banks and Australian iron ore producer that exports to China
  • Aussie Housing Bubble: Short Australian banks
  • European Disunion: Long the British pound as the short side of this trade became very crowded; short iShare MSCI UK
  • Fed Moderation: Sold US banks as the reflation trade evaporated
  • Global Fiat Debasement: Long Gold futures and have smaller positions in Silver
  • Maturing Expansion: Short semiconductor, auto- and transport-related stocks
  • Millennial Wave: Long homebuilding stocks; homebuilders are either late cycle or possibly counter-cyclical plays
  • Shale Oil Bust: Short crude oil futures and oil-weighted E&P’s
  • Rise of the Machines: AI is for real; own Alphabet and Microsoft
  • Security and Defense: Valuations in defense stocks are reasonable considering future counter-cyclical growth
Image Source: Crestcat 1Q17 Letter, Bloomberg, NY Fed, NBER
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