WHYTECLIFF FINANCIAL CORP.
By Bradley Parkes
Markets – Trades
Investment ideas for Q1/16
Note: Distribution dates have been changed to the following:
First week of January, April, July and October.
Quarter 4/2015 Investment Ideas
German DAX (EWG.N)
Japanese Stocks (EWJ.N)
US Consumer Discretionary (XLY.N)
Long DOW - With AAPL a new component in the DOW and with capital flows to the US from (Africa, Asia, Europe...) the S&P500 and DJIA are likely going to peak at a level considered obscene...DJIA = 22,000. This trade is the break down of European socialism and will violate cheap/expensive market metrics as money flees to where it seems “safe”. It may not seem rational. Capital tends to flee the battlefield.
The above chart shows the return on $1 Canadian invested since inception vs. various benchmarks. All foreign benchmarks have been converted to Canadian Dollars. The portfolio returns represent investing and reallocation of assets to new ideas only at the beginning of the quarter. This is the buy and hold return.
“Your best work involves timing. If someone wrote the best hip hop song of all time in the Middle Ages, he had bad timing.”
The way I want to do this is we will act as if we closed out each position at the end of the quarter. However each position has a maximum 15% loss and that position should be closed if a position goes 15% against us. My discount broker charges me $9.99/trade so transaction costs should not alter the returns too much. The reason we close out each quarter is that I never want to be able to claim that “I sold that six weeks ago before it declined”. Each one of my ideas should be good for at least a quarter and likely longer. Should the idea still have merit we will re-enter the idea at the beginning of the next quarter.
The portfolio returned 4.9% in Q4, following a 9.35% return for Q3/2015. For the half year (plus one month) since the portfolio was initiated the return has been 14.7%. If you had hit the highs, you could have returned more, but that is a fool’s lie. Nobody does that. This is a quarterly hold idea generator. If I were trading this portfolio it might have been different. This portfolio is a real return portfolio and so allocating assets to maximize returns requires catching tailwinds. A strong tailwind this quarter was the Canadian Dollar. This tail wind may subside in the coming quarters, however, when adjusting the US benchmarks to Canadian Dollars the portfolio has outperformed from inception.
We plan on closing the SHORT Euro trade. This trade to me seems like a one sided bet. I once read a great parable (I think from the great Dennis Gartman) about how crowded trades are like boats with everyone on one side eventually causing it to tip. There may be more downside to the Euro short trade but my gut says the easy money has been made for now. I think the contrarian idea of the year could be a rally in the EUR/USD cross.
We also plan to close the LONG Consumer Discretionary. This trade performed well, however, I believe the seasonality of trade has worked through. It seems the US economy is weakening a little and sentiment may become a little more defensive over Q1/2016. This should benefit the consumer staple sector. It is likely we rotate back into the discretionary trade, after sentiment stabilizes and we approach the fat phase of the rally (phase 3).
We also plan to close the LONG DAX. This is trade has been a loser over the past two quarters, even with the currency tailwind. If the EUR has any sort of bounce over the first quarter of 2016, the DAX should struggle to rally. A stronger EURO would likely cause the peripheral markets (further out on the risk spectrum) to rally vs. the German DAX, which is the hiding place for money, for if the EURO disappeared you would be given Marks. This trade may be revisited should there be evidence that the potential contrary trade of 2016 does not appear likely.
The trades we will be entering or re-entering, will be SHORT gold, LONG oil, LONG DJIA, LONG China and LONG US Consumer Staples. Please see the charts below for each trade.
New Ideas (in Orange) and Re-entered (in purple) trades:
1). Short Gold
The head and shoulders pattern identified in the last edition resulted in our price target being hit ($1075) and more, however, gold finished the year on a bounce higher. The chart is still pointing down although there may be a rally in to 2016. Since we do not try to pick tops and the investment policy is to buy and sell only at quarter beginning/ends, one should not worry about a short term rally as we expect in April the price of gold to be lower. I still maintain that until we see sub $1000, one gold bug newsletter writer committing suicide and half the TSXV becoming biotech companies gold cannot bottom. Gold is the effeminate metal, it has emotions and until it cries you cannot buy.
2). Long WTI Oil
There are a number of reasons I want to attempt to pursue WTI oil from the long side. The above chart I found in a fantastic report by Matthew Frailey of Breakpoint Trades. It appears to show WTI oil creating a descending triangle. This technical pattern tends to be bullish and it is further confirmed with a rising RSI and MACD, while new lows are being made. The apex of the triangle is in the low $30’s suggesting this trade could be close to turning higher and reversing the second half of 2015’s weakness.
The second reason I feel oil could be bought here is the seasonality of oil prices. The below chart shows that WTI oil has a tendency to bottom in mid-December and rally into the spring.
The third reason crude may be putting in a short term bottom is that the global PMI (Purchasing managers Index) has appeared to bottom and this has been beneficial for oil in the past.
The final reason I plan to discuss here has to do with sentiment. Earlier in the report I mentioned the boat analogy to describe a crowded trade. Sentiment is very negative towards oil. Any positive piece of news could cause a short squeeze.
3). Long DJIA
The two charts below were included in the Q3/2015 report. In that report I wrote:
“That until the orange line is broken, which is the 2014 low – YES the 2014 low, are things that bad? On the weekly chart you have a huge hammer in the Japanese Candlestick lexicon. Those tend to happen at bottoms.”
So far that is how the DJIA has traded. I continue to believe the DJIA will be the beneficiary of global capital flight. Until Europe stabilizes, Asia enters a new upcycle and commodities put in a long term bottom, the DJIA is where large money will hide. One concern I do have is that a series of lower highs have been made.
However, historically the fourth year of the presidential cycle has been the second best performing year of the four year cycle. The below chart from CitiGroup shows the average and median gains of the fourth year only trail the third year. However, the third year did not perform as expected in this cycle, and that gives me some pause on expecting the pattern to repeat.
4). Long China
China had some big news last quarter. The IMF has decided to include the Renminbi into the basket that makes up the Special Drawing Rights (an accounting currency used by the IMF and the Panama Canal). This is a small vote of confidence in the reforms China is making to become more transparent and open.
The sentiment on China is quite negative. Partially this is rational. China will never grow for an extended period of time above 7% EVER AGAIN! China has a debt problem, China has a demographic problem and many other well-advertised problems. But who cares? A big tree growing at a slower rate, still blocks more sun than a small tree growing fast (that is my attempt at a Sun Tzu type metaphor). However, America had many difficulties in becoming the globe’s largest economy. A civil war, multiple depressions, two World Wars however, this did not derail the long term trend and a slowing China and its problem has not derailed the long term trend.
The excellent free newsletter Daily Wealth, written by one of the smartest guys in the room, Steve Sjuggerud, has written repeatedly how as China is included in the MSCI International Indexes hundreds of billions of dollars will flow into China to create the passive indexes, followed by managers chasing the index and will increase the allocation, as most managers are under allocated towards the Chinese market. The Renminbi has been devalued since we sold out of our Chinese position and it is likely to get weaker before getting stronger, adding a tailwind to our position.
The Chinese have likely been overstating their GDP numbers. If one makes the assumption China has been growing at 3-4% over the past 12 months, it could be the trough has been reached and the devaluation, tax cuts and stimulus announced over the second half of the year will benefit the Chinese market.
Looking at the weekly chart of FXI we can see that the first bounce after the large sell off was repelled at the 38.2 Fibonacci retracement level. There also has been a series of higher lows recorded. I expect this market to test the 50% retracement level over the next quarter before either breaking out or breaking down. To be revisited in three months.
5). Long Consumer Staples
The fat phase of the rally (stage 3 in Dow Theory parlance) is likely still ahead, however, I feel that Q1/16 could be a little subdued and that sentiment may become a little defensive. The fat phase will kick in when everyone decides they need to be in the market and sets the public up for a top. The market’s job is to frustrate the most people all at once. It rallies when the masses are underinvested and tops when everyone is in. However, that is still in the future, as not everyone is in. In Q1, the market will continue to digest the first rate hike, while the DJIA ends its consolidation pattern, after a volatile 2015. During this period I think staples will outperform.
Economic data over the past quarter has been volatile, maybe weakening a little, but this should probably keep the FED conservative. The last issue discussed a weak NY Empire Index, this month it was a weak ISM index, with the ISM index showing lower highs since the recession.
Light truck sales, an indicator I believe is an excellent warning signal for recessions, has continued to trend higher, however, the chart may be rolling over. This indicator has peaked approximately 6-12 months prior to recessions.
On the positive side, wage growth has continued to be above trend, the spike last quarter has moderated, but the growth rate is still higher than at any time since before the Great Recession.
This suggest to me the FED still has a bias towards raising rates, but will likely be on hold in March. The USD tends to peak on the first rate hike, but ends higher 12 months later. This is classic “buy the rumour, sell the news” type action.
So far the DXY Index has had difficulty crossing ~101. If this level holds, some reprieve will be given to the commodity complex.
2016 is going to be a year of transition and extremes. There are so many political, geopolitical and economic events colliding.
-Will Trump stay strong in the pools?
-Will the far right in Europe continue to gain strength?
-Will Iranian and Saudi relations continue to deteriorate?
-Will Saudi Arabia alienate the rest of OPEC?
-Will Russia retaliate on Turkey and will Article 5 in NATO be invoked?
These are just some of the possibilities.
Markets will be volatile.
America is the likely to remain the destination for capital. This should push markets higher, well past fair valuations as this is capital fleeing the battlefield.
Europe is recovering, but will flare up. I believe by the second half of the year the periphery will begin to outperform the core nations.
Asian markets are maturing. China’s inclusion to the SDR and the MSCI, in combination with the devaluation of the Renminbi will drive money into Chinese equities. The rest of the region will likely remain lackluster, other than some smaller markets.
Inflation may be the surprise of 2015. I think we are at an inflection point. Wages are rising in the US, while Europe is stabilizing. Core inflation is at the FEDs 2%, and any increase in the price of oil will pull headline inflation higher. War is heating up and war and inflation are connected.
Oil has been testing 2008 and 2004 lows. I believe oil drifts higher, but the largest price effect will be the renewal of the terror premium.
Gold should bottom below $1000 sometime in mid-2016 and finish somewhere north of $1200. A new gold bull is on the horizon.
Copper will make a new low in early 2016 .This cycle is bottoming. The green revolution will need a lot of copper to wire all those solar installations.
Surprises and Contrary Bets
A new year is upon us. Even the least jovial of us can enjoy the rebalancing of their portfolio. For myself I like to think of what could surprise me in the New Year and three topics come to mind.
Geopolitical risk and a new risk premium in the price of oil
Creeping headline inflation
A rally in the Euro
1) The price of oil appears to trade in utopia. Supply will never disappear and the glut is permanent. This glut is measured as high as 2-3 million barrels per day. Global demand is just north of 93 million barrels per day, making this an oversupply of 3-5%. Global stockpiles are 10-15% higher than they historically are in this calendar month. Below is a chart of OECD Total Oil Stockpiles. The 2015 number is certainly higher than the 2010-2014 range, but when you review the numbers (3000-2750/2750 = ~10%), the current level is only 10% higher than the top of the range over the past 5 years. 10% does not seem like as large of glut as the headline “Unprecedented Oil Stockpile”.
There are a number of geopolitical risks that could quickly destroy this margin.
-Venezuela Supreme Court rejecting opposition party Super Majority...is there a coup in the works?
-Iran testing missiles near US carriers.
-New Iranian sanctions on ballistic missile program, Iran not deterred...does the nuclear deal fall through?
-Iraq threatening war against Turkey, if Turkey does not remove their troops.
-Russia accusing Turkey of aiding ISIS.
-Kuwait sending troops to Saudi to protect border.
-Rebels in Yemen firing missiles at refineries in Saudi...what if the next Patriot missile is not as successful?
The roll of a risk premium is to make marginal production ready to come online due to a shutdown of cheaper but geopolitically riskier supplies. With the negative sentiment and lower for longer thesis, there appears to be either no, or even a negative risk premium in oil. If any of the potential geopolitical risks accelerate, there could be a huge short covering in oil.
2) Core inflation has been trending around the FED’s 2% target, yet headline inflation has been subdued due to declining energy prices. However, as year over year energy price comparisons become less of a boat anchor, any surprise to the upside will pull the headline number higher.
In the past El Nino events have affected odd parts of the supply chain causing input inflation that passes through the production process. Will any of the potential geopolitical risks amplify this possibility?
3) What if everybody who wants to own the dollar does and everyone who plans to short the EURO already short? Earlier in this document the crowded trade analogy of a capsizing boat was used and the Charles Schwab “sell the news” dollar and rate hike chart shown. On the CS chart, the dollar tends to sell off for 3-6 months following the first rate hike. But what if there is only one rate hike and traders got a little too excited? Any positive news in the EU area and negative news in America could cause a strong short covering rally, as long USD is a crowded trade.
None of these Contrary Bets are certain, but they are something that is worth watching…as you never know.
Investors should carefully consider the investment objectives, risks, charges and expenses of any investment. The above does not constitute investment advice or recommendations, just crazy ideas I have when I cannot sleep. There is no guarantee that any investment (or this investment) will achieve its objectives, goals, generate positive returns, or avoid losses. The information provided should probably be disregarded and potentially treated as a contrarian advice, with the expectations that I am 100% wrong on everything. Please consult someone with a higher level of intelligence than the author with respect to investing money.