361 Capital Weekly Research Briefing

Noise Keeping You Up At Night?

361 Capital Weekly Research Briefing

August 11, 2014

Timely perspectives from the 361 Capital research & portfolio management team

Written by Blaine Rollins, CFA



If you went home on Thursday having gone LONG on risk assets, this is probably how you visualized your tube/subway/train stop that evening. Russia became more intense, Hamas lit up some rockets and broke the cease fire, and the U.S. started dropping bombs in Iraq. Equity futures sold off solidly into the night and we all went to bed a bit unsettled (include me in this camp, given our algorithms & models went VERY long at the close on Thursday). But as we awoke and made our way up the escalators to work, the negative news flow eased and reversed toward the positive. By days end, the long risk positions made money and we were reminded that sometimes the best positions are the ones you’d rather not have on the books.

The current geopolitical issues are creating an incredible amount of noise in the market, which is great for the traders with steel lined stomachs and unbiased algorithms. The rest of the investing world has to either turn off the news and think longer term or set entry prices to take advantage of the depressed prices. So far the geopolitics have not affected the global economic situation, but that could change with the increased Russian v. EU/USA trade sanctions. With that in mind, size up your risk positions so you can sleep at night, and be prepared to visualize more train stops like the one above, with the sounds of Angus Young picking a guitar in the background.

Ukraine threatening to block Russian energy transports was a turning point on Friday…

Ukraine threatened to block Russian oil and gas supplies to Europe in new sanctions against Vladimir Putin’s government, which it blames for a separatist uprising that has ravaged the country’s east. Ukraine, which no longer receives any gas from Russia, but acts as a conduit for its neighbor’s European customers, is considering a “complete or partial ban on the transit of all resources” across its territory, Prime Minister Arseniy Yatsenyuk told reporters today in Kiev… Ukraine transported 86.1 billion cubic meters of Russian natural gas and 15.6 million metric tons of oil last year, according to a February bond prospectus. That’s about half of Russia’s total gas exports, though less than 7 percent of oil shipments.


But the Ukrainian chess game has accelerated to double time…

Despite growing jitters in the West, Ukraine’s military leaders say they are making a well-calculated gamble, betting Mr. Putin feels he has too much to lose by invading, including the possibility of crippling international sanctions. As Western officials view each new Ukrainian artillery barrage in Donetsk drawing the country closer to the brink, the Ukrainians see their unchecked advance as further confirmation that Mr. Putin is mobilizing troops as a scare tactic to keep them from reclaiming territory. The government in Kiev is “calling Putin’s bluff,” said Oleh Voloshyn, a former Ukrainian diplomat, commenting that political leaders dismissed Mr. Putin’s moves as “psychological pressure.”

“If we pause, it would show Putin that any time he puts troops on the border, we will stop,” Mr. Voloshyn said.


As geopolitics dominated the news last week, buyers left the market, contributing to a short term oversold condition…

One indicator we’re watching closely is the S&P 500 10-day advance/decline line. This is a short-term breadth reading measuring the average number of daily advancers minus decliners in the S&P 500 over the last ten trading days. Throughout history, when this reading has become as oversold as it is now, the market typically sees, at a minimum, a short-term bounce.


While the total markets moved to oversold, the riskier assets in the U.S. outperformed by the weekend. It was international stocks, led by Europe, that had significantly underperformed…

Thoughts from one of the biggest trading desks…

JPMorgan Trading Desk adds color – problems over the last few weeks haven’t so much been heavy, aggressive, or panicked selling, but instead a complete lack of buy demand. Longs are staying on the sidelines for the time being, either waiting for clarity (on the Fed, Iraq, or Ukraine) or better prices (even bulls think sub-1900 is more likely before 1950, and many people are beginning to consider 1850 “inevitable”). All that being said, there are signs the selling pressure is growing “tired” (a big factor behind the Friday lift). Meanwhile, sentiment has turned extremely gloomy – in this environment the near-term risks are probably higher (keep in mind, the SPX hit the 100-day moving average Thursday, a level that has been, approximately, a very strong support for many years).

And thoughts from Erik Peters…

“[The] market was looking for an excuse to show some cracks,” said Roadrunner, having somehow sensed this would happen, without knowing why. The WHO declared Ebola an international health emergency, Chinese imports shrank 1.6%, Russian troops amassed on Ukraine’s border as Putin banned US & EU food imports, and Israel and Hamas resumed fighting. Of course, Obama rejoined Islam’s civil war. “But this is a garden variety sell-off, nothing more,” continued the market’s top volatility trader. “Volatility should be around now for a few more months — giving guys who sell it, the chance to continue putting up good numbers.”

(Erik Peters/Wknd Notes)

As we continue to watch High Yield Bonds closely, their week’s outflows slowed meaningfully…

And Barron’s wonders how much of the decline in Junk Bond prices is due to the reduced trading desk liquidity…

I’VE SPILLED PLENTY OF INK in this column in recent months, warning about how a combination of overvaluation, declining market liquidity, and junk bonds’ stock-like susceptibility to shocks, left the high-yield market vulnerable (even if defaults are rare). July’s overdue stock market pullback and resurgent geopolitical risk were finally enough to trigger some selling, which then snowballed. Even so, “This might be the most perplexing selloff we’ve experienced in a while,” Citi strategists wrote in a recent report. “There doesn’t appear to be a clear trigger, causing some consternation among market participants.” That consternation is reflected in an antiquated quirk of high-yield bonds: They’re still mainly traded over the phone rather than on electronic exchanges. Large banks and dealers (the primary buyers) — have the power to set prices they’re willing to pay, for all but the smallest trades. When the selling picked up in late July, they rapidly lowered their quotes. Granted, prices in any market go down when there are more sellers than buyers, but the lack of an exchange creates additional hurdles in terms of efficiency and negotiation.


Meanwhile, Long Treasury Bonds continue to amaze…

Yields have been falling with embarrassing consistency in 2014, despite forecasts to the contrary from most Wall Street analysts at the beginning of the year. “Just about all of us were convinced that yields were rising,” Kathy A. Jones, a fixed-income strategist at Schwab, said in a phone interview this week. “But the bond market didn’t go along with that story.” Instead, the market has been responding to current events: The global economy remains sluggish; central banks continue to push down interest rates in hopes of stimulating their countries’ economies; and, perhaps most important, geopolitical tensions have been rising. President Obama’s decision to resume bombing in Iraq, the violence in Gaza, and the threat of a wider war in Ukraine, are the start of a long and worrisome list.


For the week, Consumer Cyclicals and Staples outperformed, while Health Care was hit by an attack on ‘Inversions’…

More broadly, it was almost anything International that underperformed as the ACWI ex-US lagged by 250 basis points versus the S&P 500…

JPMorgan provided this data, I’ve provided the check marks. If you were looking to place chips around the world right now, it is interesting to see that China and the more resource-based countries stand out (of course, PMI in Russia increased rank but will likely suffer from here).

But if you are interested in buying Russia, add JBDYRU Index to your Bloomberg…

@Pawelmorski: Russian corporate bonds yield 7.2% on average. EM overall: 5.24%. Widest spread yet.

Back in the U.S., the Energy space is about to see more M&A as Kinder Morgan works to simplify its corporate structure so that they can take advantage of the growing assets in North America…

Kinder Morgan, which runs 80,000 miles of oil and gas pipelines in North America, plans to spend $44B to buy out the outside investors in its family of companies; a deal that ranks as the second largest in the energy sector. The decision to simplify its sprawling corporate structure comes amid investor excitement over the prospects for US energy production. Founder Richard Kinder said the combined group would use its shares as a currency for further acquisitions and investments…

Measured by the equity value of the three bids of $44B, the deal announced will be the second-largest in the sector, after Exxon’s $74.5B purchase of Mobil in 1999.

“This transaction dramatically simplifies the Kinder Morgan story,” Mr Kinder said in a statement on Sunday, adding that the combined group would be able to raise dividends, cut its cost of capital, and use its shares as an acquisition currency. He promised to raise Kinder Morgan’s dividend by 16 percent next year and by 10 percent per annum for the rest of the decade. “In the opportunity-rich environment of today’s energy infrastructure sector, we believe this transaction gives us the ability to grow for years to come,” he added.


In residential lending, the Federal Reserve is seeing a notable loosening of standards…

Nearly one in four U.S. banks said they had eased mortgage-lending standards for borrowers with strong credit during the second quarter, the largest movement of its kind by lenders since the housing bust hit nearly eight years ago… Banks said they had eased standards on commercial and industrial loans primarily because of more aggressive competition from other lenders amid growing competition between banks in a slow-growth, low-interest-rate environment. Some also said an improving economic outlook had contributed somewhat. The survey showed that lenders continued to ease standards on loans to businesses “amid a broad-based pickup in loan demand.” It also showed more banks signaled easier standards for commercial real-estate loans than had been the norm since 2005. Though bank lending to businesses has accelerated throughout the five-year recovery, banks have, until now, remained more cautious about lending to households. Lending standards for mortgages are easing amid sustained increases in U.S. home prices and a plunge in refinancing activity over the past year.


Not to be left out, Commercial Real Estate demand is also seeing a notable uptick…


If you know a riveter, send them to a Boeing factory because the 787 is crushing it for U.S. GDP…

Boeing has pushed some factory work on the 787 Dreamliner to the uncovered tarmac outside its assembly plant in Washington state, in an effort to keep churning out the popular plane at a rate of one every three days, according to people with knowledge of the situation… The 787, an innovative, fuel-saving long-range jet (the most popular version of which carries a list price of $257 million), has garnered 1,057 orders since it hit the market in 2004. Most are made at Boeing’s factory in Everett, Washington, with a smaller line in North Charleston, South Carolina… Employees at the plant in Everett are working mandatory 10-hour days and weekends to keep up, said the people, who were not authorized to speak publicly about the company. One source said several hundred workers are assigned to teams doing final assembly after planes have left the factory. “We’ve had hundreds of those guys coming to the flight line almost on a round-the-clock basis to perform all the traveled work,” said one of the sources.


Meanwhile, Airbus’ $25 billion bet on a Super-Sized Plane has not paid off for Eurozone GDP…

Airbus has struggled to sell the planes. Orders have been slow, and not a single buyer has been found in the United States, South America, Africa, or India. Only one airline in China has ordered it, and its only customer in Japan has canceled. Even existing customers are paring down orders. The A380 has a list price of $400 million, but the pressure has forced Airbus to cut prices by as much as 50 percent, according to industry analysts. So far, Airbus has received 318 orders and delivered 138 planes to just 11 airlines — a disappointing tally given forecasts that the plane would be a flagship aircraft for carriers worldwide…

The A380 hasn’t done so well for a number of reasons, some merely cyclical. The plane was introduced amid a deep downturn in the airline business. Airline executives were wary of expanding their fleets aggressively, especially for a costly, four-engine fuel hog. But critics like Richard Aboulafia, an aerospace analyst at the Teal Group, an aviation consulting firm in Fairfax, Va., say the main problem is more fundamental: Airbus made the wrong prediction about travel preferences. People would rather take direct flights on smaller airplanes, he said, than get on big airplanes — no matter their feats of engineering — that make connections through huge hubs. “It’s a commercial disaster,” Mr. Aboulafia says. “Every conceivably bad idea that anyone’s ever had about the aviation industry is embodied in this airplane.”


For anyone having a tough year in the stock market, you have some good company…


If you are looking for some rolling 10 year data on how dividend stocks outperform the market, here you go…


It is difficult to be a long-time active investor in the markets while remaining free of bias. Turnaround investors are digging through the rubbish looking for the next great stock, while the rest of the investment world is looking to use the garbage can for a different reason, regarding those same stocks. While Pitney Bowes was a name that made most of Wall Street sick for the past 15 years, my hat is off to this team that looks to be quite successful reaching into the rubbish can…

Last spring, Pitney Bowes was anathema to most portfolios. The once-titan of snail mail saw its stock peak at $70 a share in 1999, before starting its steady slide. By 2013, the company was suffering through its fifth straight year of revenue losses. Short-sellers were circling, accounting for roughly 30% of public shares outstanding.
“The world had left it for dead,” says Harold Levy, co-manager of the $3.1 billion First Eagle Fund of America fund (ticker: FEFAX). Yet, where short-sellers saw an easy target, Levy and his team saw an opportunity for new management—led by IBM alumnus Marc Lautenbach—to turn things around. And with the stock (PBI) trading at $15 a share—or a 20% recurring free-cash-flow yield, based on their projections–even small improvements could lead to sizable returns… Over the 15 years through Aug. 7, it’s up an average of 8.69% a year—versus 4.54% for the Standard & Poor’s 500. More impressive, perhaps, is the fund’s relative performance in down markets; since inception, its losses have been about three-fourths that of its peers, according to Morningstar.


For my several Multi-Family Residential Housing and Private Equity readers, take a look at this disruptive company that would make Howard Roark proud…

Prescient’s building system distributes the weight of the structure into the columns, allowing for the use of standardized and lighter panels, saving on material costs. Such standardization means panels and trusses can be mass produced at precise tolerances, eliminating the need for cutoffs and other time-consuming modifications now made on the fly. Because steel is used rather than wood or concrete, curing times are eliminated, and the follow-on work can start sooner.

Three Denver-area buildings have gone up using the company’s system, including the B Street LoHi in Highland and University Station. In April, the company won a contract for a dormitory at Lackland U.S. Air Force Base in San Antonio, one of eight buildings it expects to help complete this year. Prescient’s system at University Station, a senior affordable-housing development near the University of Denver, allowed for quicker construction times at a lower cost, said George Thorn, CEO of Mile High Development. The lower costs allowed Mile High and its partner Koelbel and Co. to build six floors, rather than the usual limit of four floors on wood-frame designs, he said. “We wouldn’t hesitate to use the Prescient again in similar circumstances for a similar-sized building,” Thorn said.



Geek Quote of the week…

“I’m not sure there is a secret. It’s just a matter of learning the words.” Nigel Richards, the best Scrabble player on Earth.


Hopefully your kids will have a programming class on their fall schedule. If not, it’s time to send the Principal a strong suggestion…

Starting this September, every single K-12 student in Great Britain will start taking classes in computer programming. That is, kids at the age of five will take programming, and they won’t stop until they’re at least 16. A majority of these children will be using the free online learning platform Codecademy, says co-founder Zach Sims. Also true in France, Estonia, and Buenos Aires. In China, Codecademy, which has programming lessons contributed by more than 100,000 people from around the world, has been cloned multiple times. Meanwhile in the U.S., where education is controlled by the states, fewer than 20 recognize computer science as a science; the rest consider it an elective.


Geek Read of the Week = The Rosie Project. Hat Tip to Melinda and Bill Gates for this find; a hilarious quick end of summer read…

MEET DON TILLMAN, a brilliant yet socially challenged professor of genetics, who’s decided it’s time he found a wife. And so, in the orderly, evidence-based manner with which Don approaches all things, he designs the Wife Project to find his perfect partner: a sixteen-page, scientifically valid survey to filter out the drinkers, the smokers, and the late arrivers.


And finally, the most tweeted and commented on picture of the week…

@NBCNewsPictures: Kim Jong Un amused by lubricant at North Korea factory, worker beside him not so much



If you like the ideas Blaine Rollins shares each week in the 361 Capital Research Briefing…

Then you should learn more about how he incorporates these ideas in the new mutual fund he is managing, the 361 Global Macro Opportunity Fund. Contact 361 Capital or your advisor for additional information.

In the event that you missed a past Research Briefing, here is the archive…

361 Capital Research Briefing Archive

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