Many U.S. asset classes have diverged from the U.S. growth-slowing reality, which continues to be corroborated by the data, writes Landon Whaley.
After ending last year on a historic note, 2019 is attempting to make its own mark on the annals of history. The Nasdaq 100 index is up 10 weeks in a row, the longest streak since December 1999. The S&P 500 is off to the best start in more than 30 years (1987) and Chinese equities (Shanghai Composite Index) are off to their best start since 2000.
What do all three of these markets (and many more) have in common? Their 2019 price action has been historic and has dramatically diverged from the underlying Fundamental Gravities of the economies where they trade.
Divergence
Many U.S. asset classes have diverged from the U.S. growth-slowing reality, which continues to be corroborated by the data. Last week’s release of the February Markit U.S. manufacturing Purchasing Managers Index (PMI) was the lowest reading since August 2017, and February’s ISM Manufacturing PMI (which is one of the most accurate predictors of GDP growth) fell back to the lowest level since December 2016, after a one-off bounce in January.
Similarly, Chinese equities’ massive rally to start the year took place despite a slew of data confirming the Fundamental Gravity environment. The Service PMI slowed from December to January, while the Manufacturing PMI experienced a one-off bump but remains in contraction. Even the “official” non-manufacturing PMI is confirming this FG4 environment, slowing in three of the last five months.
nd it’s not just growth that’s slowing in China. Consumer inflation has now slowed in three consecutive months and producer prices have slowed for seven straight months, taking the producer price index (PPI) to an anemic +0.1% pace.
Outside a few economies, the data is painting a vivid picture of both global growth and inflation slowing. The last thing you want to do against that backdrop is to get all bulled up on equities or other risk assets.
History Lesson
Remember what happened when those markets mentioned in my first paragraph re-aligned with their Fundamental Gravities?
Just two short months after the Nasdaq’s December 1999 winning streak, the Nasdaq Bubble burst and it lost 83% of its value over the next two years. The S&P 500’s historical start to 1987 was abruptly reversed by Black Monday when the S&P 500 fell -20.4% in one day. Similarly, the Shanghai Composite peaked in early 2001, then entered a four-year bear market, losing over 50% of its value in the process.
I’ve learned the hard way that no matter what financial markets do in terms of price action, you must remain data dependent, process driven and risk conscious. This approach doesn’t get you paid every day (which is why we are down 1.3% for the year), but it positions you to get paid when everyone else is losing and, most importantly, it positions you for outsized annual returns you simply can’t earn by evaluating markets and behaving the same way as everyone else.
On the short side of the Gravitational 15, we’ve done just four trades this year, all of which have gone against us. Fortunately, the Mongoose sniffed out the diverging market environment, which kept us from doing more trades and made sure our short positions were sized correctly. In this kind of market, minimizing activity and short-related losses is as good as it gets for those of us who (almost) always have active short positions.
On the flipside, our longs worked just fine until the last three trading days. The U.S. 10-year Treasury note yield had declined in 12 of the prior 16 weeks, so last week’s countertrend bounce was inevitable, but it gave our long positions the woodshed treatment. Being wrong for three trading days isn’t going to force us to scrap our macro themes or shake us out of those positions. We purposefully determine position sizes and risk prices to account for the distinct possibility that trades may not go immediately in our favor. Not one of our current positions breached a critical Abyss line, and nor have the Quantitative Gravities deteriorated to a point of concern.
The Bottom Line
After two decades of professionally managing money, I refuse to trade assets in a manner that runs counter to the prevailing Fundamental Gravity. This continual eye on the developments in the Fundamental Gravity is how we called for Q4 2018’s carnage just three days before the S&P 500 hit a brand new all-time high in September. Those investors chasing charts never saw reality coming, and they got smoked when the S&P 500 declined in nine of the following 13 weeks, crashing -20.7% in the process.
I haven’t seen one economic data point or central bank-related item that is causing me to rethink how we are currently positioned or the validity of the macro themes we are trading. In short, we are right where we need to be.
That said, we’ll remain vigilant with our risk management (as we also do when the profits are stacking up), because most of our returns come in just four or five months of each year. In the remaining months (like January and February) when markets aren’t aligned with our macro themes, we try not to give back too much. While I prefer to start the year with gains before going through a drawdown, they are a part of trading, and a -1.3% drawdown is more than palatable given the kind of annual returns we earn.
