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How To Survive The Coming Market Crash

If we have an atom that is in an excited state and so is going to emit a photon, we cannot say when it will emit the photon. It has a certain amplitude to emit the photon at any time, and we can predict only a probability for emission; we cannot predict the future exactly. —Richard Feynman This week, the S&P 500 finally broke through its 2,100 level, despite a huge influx of negative earnings reports . Though it failed to hold, the resistance has been tested. We ask whether the fundamentals of the stocks in this index could justify a true breakthrough of this resistance level. Much of this 7-year rally has been bolstered by central bank stimuli and stock buybacks. Both of these catalysts are coming to their ends. Most notably, as pointed out by Seeking Alpha contributor Gary Gordon, corporations are abandoning their buyback programs as a result of debt concerns. The next market crash will inevitably be labeled a “debt” or “balance sheet” market crash – allow me to explain: The Japanese market crash of the 1990s was caused by companies selling their assets to pay off debt. Individually, each company was doing the logical thing: Cleaning its balance sheets. However, when the majority of corporations engage in this action at once, you have a situation in which no companies are borrowing – despite ZIRP. The quiet liquidation of assets to pay off debt leads to a market crash that is stealthy at first but quickly turns into a landslide. The problem in the current market is investors’ ignorance of such an activity in favor of the go-to data, such as strong nonfarm payroll reports and interest rates. When we see such positive data, we feel the equity prices are justified. The problem is that if the economy really does look good, the Federal Reserve (the Fed) will have no choice but to “slow things down” by raising interest rates; and we all know what happened last time the Fed raised rates. That is, we are in trouble either way. On the one hand, if the fundamentals as per company activities and earnings look bad, the market should react negatively. On the other hand, if economy data supports a strong economy, the “data-driven” Fed must raise rates, which will cause a market correction. It seems that in either case, the 2,100 level of the S&P 500 should not hold for long. From a technical standpoint, the S&P 500 is stuck between 1,810 and 2,134. If this condition holds, we have much more downside at the 2,100 level than upside; i.e., a downward movement can bring us down 300 points but an upward movement is unlikely to bring us up more than 30 points. One problem with earnings being so poor is that the drop in earnings necessarily raises the P/E of stocks in the S&P 500. We are looking at an average P/E of 25. Falling earnings should be seen as a warning sign that the P/E is on the rise – that stocks are becoming increasingly expensive. The natural – logical – reaction would be to sell stocks and instead short stocks or buy bonds and other non-correlated investments, such as gold . Still, the market could continue to rise, as a result of short squeezes and algorithmic trading, which makes up 50% of the market’s trades. A new all-time high could be on the horizon, but it would be historical: The first all-time high created by a short squeeze, not by fundamentals. The question we must ask now is whether a reversal is also on the horizon. Thesis Corporate debt will be the catalyst for the next market crash. This market crash will be the result of balance sheet recession, which was the same type of recession that caused the Japanese market crash. This type of crash is fueled by debt: Corporate debt reaches all-time highs Companies begin to default Other companies begin paying off their debt out of fear To pay off this debt, assets are sold (this is where the crash begins) Borrowing slows The government lowers interest rates to attract borrowers Monetary policy fails because it relies on the assumption that borrowers always exist The economy grinds to a halt Investors move their capital into savings and precious metals, as bonds and equities no longer pay off Food for Thought Balance sheet recessions are basically invisible because only two groups of people look at balance sheets: fundamental investors and creditors (banks). The latter group only wants to know the probability that a company will default. The former group only sees the trees – not the forest. To put it more clearly, think of it this way. If you’re an investor looking at company ABC and you notice ABC paying off debt, you’ll think of this as a bullish indicator. After all, paying off debt is the responsible thing, especially when the company’s debt is at record-high levels. However, the point of a company is to invest your money better than you can. If that company is not investing but paying off debt, it is ignoring its main duty. In addition, paying off debt is not part of the growth cycle of a business, and a company spending its money to reduce debt is therefore not a worthwhile investment. As for how this relates to a market crash, investors look at companies individually. Rarely would an investor note that the result of a massive number of companies engaging in debt reduction equates to a lack of borrowing, which equates to the government engaging in new fiscal and monetary policies – the latter of which fails during the beginning stages of a balance sheet recession, and the former only softens the blow, delaying the inevitable. When we step back and look at company behavior as a whole, we begin to see the forest: Paying debt when interest rates are near-zero is the sign of a recession. What spurs debt reduction? Defaults, exposure to debtors at risk of default, and heightened overall default risk. Food for thought: Click to enlarge The Contrarian Strategy We should always be hedged against a Japan-like market crash. But going short on the S&P 500, such as via the SPDR ETF (NYSEARCA: SPY ) could be dangerous during a phase in which government intervention and short squeezes could bring us to new highs. Instead, I recommend a ratio back spread: Click to enlarge Here, we short an out of the money (OTM) put option with a near strike price and buy two OTM put options with a far strike price and long expiration date. This position is taken when we think a large downward movement will happen in the future for SPY but simply cannot pinpoint when. Here, we are delta neutral and theta positive, which means that the small, daily fluctuations of the SPY will only help us profit via time decay. However, once a large downward move takes place, we will see the profit of the above option strategy skyrocket, as the delta for the bought put will increase much more quickly than that of the sold put (note how gamma is negative). Vega is high, implying that any volatility change in the SPY will lead to an increase in the above spread. With market volatility at a relative low, now is a good time to open such a spread. We only need to do one thing to manage the spread: Roll over the front-end put every month. That is, every month, sell a monthly put option that is roughly $10 out of the money. In this way, we keep the strategy delta-neutral and theta positive. Happy trading. Learn More about Earnings My Exploiting Earnings premium subscription is now live, here on Seeking Alpha. In this newsletter, we will be employing both fundamental and pattern analyses to predict price movements of specific companies after specific earnings. I will also be offering specific strategies for playing those earnings reports. In our last four newsletters, have accurately predicted earnings beats 100% of the time. In the most recent newsletter, we predicting how Microsoft (NASDAQ: MSFT ) will react after its upcoming earnings report. Request an Article Because my articles occasionally get 500+ comments, if you have a request for an analysis on a specific stock, ETF, or commodity, please use @damon in the comments section below to leave your request. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Navigating Shifting Risk Sentiment In A Low-Growth Environment

Andrew A. Johnson, Head of Global Investment Grade Fixed Income The global fixed income market is increasingly complex and erratic. We live in an overly indebted, overly obligated world, with a growth rate that is slower than we are used to. Central bank activism, very low or negative rates, the threat (even if remote) of deflation and increased regulation have contributed to violent market responses – exacerbated by yield-seeking investors who have been forced out on the risk spectrum and away from their natural habitat. Andrew Johnson shared factors he and his team are focused on in this unique market environment, as well as their potential investment implications. What do you make of the pace of growth, and its effect on investment opportunities? On balance, we believe the most likely economic scenario is one of positive albeit lower-than-pre-crisis growth in the U.S., and more of a struggle for growth in Europe and Japan. We expect significant continued help from central banks. The ECB remains extremely accommodative, as we recently witnessed in the latest round of easing. Japan also is maintaining a very aggressive easing stance, deciding a few months ago to join the world of negative policy rates. And, the Fed still is accommodative, just moving toward “less so.” In aggregate, global growth is low, but still positive. This is not the world of 10 years ago, however, when U.S. growth was running over 3%, helped by the excessive use of leverage. Today, growth is simply lower. Economists generally put potential growth (the rate the economy can grow without stimulating inflation) at 1.5%-2.0%, while the Federal Reserve is expecting slightly above 2%. Europe’s growth potential is probably about 1% and Japan’s is 0%-0.5%. The contrast with pre-financial crisis expectations is a key reason for market volatility – but I think investors should “get real.” A more moderate pace close to 2% is more likely the case going forward. Given this reality, incremental sources of yield become an important portfolio contributor, especially over the long run. We believe there are a number of areas that provide opportunities to capture such yield, including credit, non-agency mortgages, senior floating rate loans and select emerging markets bonds. On the other hand, low yielding government bonds in countries such as Germany and Japan are less appealing. In the U.S., given the level and trajectory of yields, there is little compensation from government bonds currently for the possibility of better economic conditions that could lead to a quicker pace of rate increases. There’s a lot of talk about deflation these days. How likely is it? Deflation is a fear, but a remote one. The problem is that deflation could be highly damaging for the markets, especially those that are overly indebted. A move into deflation potentially sets up the kind of spiral that economist Irving Fisher talked about in the Great Depression of the 1930s. That’s why central banks, from the Fed to the ECB to the Bank of Japan, are doing everything in their power to make certain it doesn’t happen. I believe there are strong arguments against the likelihood of deflation. Although there is considerable debt outstanding, it has been trimmed since the financial crisis, and the debt that has been issued has been well dispersed across the financial system. Moreover, the amount of leverage in the system is down, so there is less risk that asset declines will force sales, and then trigger further asset declines, and sales, and so on. Core inflation has been strong, but somewhat veiled by the sharp decline in energy prices – which we believe is transitory. Then why is the threat of deflation having so much of an impact on markets? Are investors overly worried? However remote the possibility of deflation, the implications are so feared that markets are responding aggressively to the possibility. In our investment approach, we consider various potential economic scenarios or states, in what we call States-Space Analysis. Within this framework, we believe the most likely state is one of low, but positive and stable inflation. In contrast, we assign a state of sustained deflation as a low probability, given the strength of the U.S. economy, the commitment of central banks, and generally constructive financial conditions. Not all investors see it that way. Recent asset price declines due to a sharp fall in energy prices have helped frame investors’ expectations, so relative to the probability of deflation, we believe inflation is underpriced in the market. All this comes with a caveat: Other developed regions may be more vulnerable to deflation than the U.S., given their lower inflation rates, slower growth and the general trend of increased indebtedness. To some degree, Japan is a special case given its long-term bout with deflation and demographic challenges. Europe bears close watching as it seeks to move past recent weakness. Banks securities have recently been in the headlines. What are the concerns, and what’s your take? Credit issued by financial companies suffered earlier this year, in line with equities. Earning concerns arose due to expectations of reduced net interest margins if the Fed departed from its current rate hike path, and revenue reductions from an unfavorable trading and investment banking environment. Loan losses were also a concern given deterioration in commodity prices. The specter of systematic contagion captured the markets’ attention, as Deutsche Bank, after a full year of losses, was feared to delay payment of one of its hybrid loss-absorbing instruments. While some of these factors may impact profitability, credit fundamentals of financials, especially in the U.S. remain strong. Banks are well capitalized with quality assets, liquidity has improved and regulators have curtailed risky activity. European banks are also better capitalized, although many (for example in Italy) have yet to deal with loan vulnerabilities. With that in mind, we favor senior and subordinated debt of large U.S. banks, with more muted enthusiasm for subordinated debt of banks outside the U.S. Names matter though, and we believe that diligence as to issuer and part of the capital structure remains crucial. Of all the economic factors you’re considering, what are you most focused on right now? We are watching consumer behavior, and think it is a major factor in the future economic path. Confidence, retail sales, personal consumption expenditures (PCE), income expectations, the savings rate and credit growth are all indicators we are watching closely. Confidence is fairly high – higher than it was in the middle of the last decade. The confidence of the middle third (by income) of the U.S. population recently hit its highest level since the mid-2000s. So, outside of Wall Street, people are pretty confident; they have de-levered and believe that their incomes are going to go up. However, if confidence rolls over, we have a real problem, because the other contributors to economic activity are not growing enough. In fact, capital expenditures and inventory replenishments are probably going to worsen. Confidence of Middle Third of U.S. Population Near Highest Level Since Mid-2000s Source: Bloomberg. Represents middle third of consumers by income. Fortunately, the energy “tax cut” likely provides a floor for consumer conditions. The wage pie (the number of hours worked times earnings) has been expanding, and as long as that happens, the consumer will probably be fairly optimistic. The savings rate is high – higher than most economists expected – and trending upward somewhat. You would think that, given the repair of the consumer balance sheet, they would “let go” a bit, but that has not been the case yet. Where does all this leave you from an investment perspective? Given the improvement in the U.S. economy and the low probability of deflation, coupled with such low yields, we see limited benefit to holding Treasuries. This is especially true at the short end of the curve, where even though the Fed talks about moving rates higher, the markets still are not convinced. However, we see real opportunity in credit and particularly in the high yield market, where spreads recently widened to a level of historical opportunity. We also believe it makes sense to be somewhat short on duration, given the probability of further, staggered U.S. rate increases. And, we prefer TIPS (Treasury Inflation Protected Securities) to Treasuries given the low inflation expectations priced into the TIPS market today. This is an environment of intensified risk. How can investors account for that in portfolios? Because of low potential growth around the globe, I believe that shocks have become much more dangerous to economies and markets. There is far less of a buffer, as growth and inflation are a lot closer to zero, and the risk of a GDP slipping for a quarter or so below zero is more likely given the low initial rate of growth. Investor psychology also creates market hazards. As investors seek yield and move further along the risk spectrum, they go to places that are less comfortable for them; they’re not in their usual habitat. So, they are more likely to overreact at the first hint of volatility. We saw this in emerging markets, the oil and gas industry, and more recently across the credit markets. Coupled with significantly less liquidity, these jittery investors can trigger sharp market responses, and we believe should be considered when sizing positions, assessing liquidity, and in choosing securities that have a better chance of withstanding short-term volatility. Because we live in a less forgiving economic environment, with jumpier investors, I believe riskier assets should have a higher risk premium attached to them today. This means that spreads on riskier assets may not get to historical levels, and investors could be compensated in portfolios for the higher expected risk. With significant bouts of heightened correlation of riskier assets, it is important to pick through the securities to see where price declines have been warranted, and where securities have just been swept up in the tide of sentiment. 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JPMorgan Alerian MLP Index ETN: The Time Has Come To Buy

AMJ – The Basics The JPMorgan Alerian MLP Index ETN (NYSEARCA: AMJ ) is an exchange-traded note issued by JPMorgan Chase & Co. (NYSE: JPM ). Its net asset value and cash distributions are based upon the Alerian MLP Index, by far the most widely recognized index of MLPs. Alerian MLP Index is made up of the 50 largest MLPs and constitutes over 75% of the available MLP market capitalization. At $3.3 billion, AMJ is by far the largest and most liquid MLP ETN (An ETN is an “exchange-traded note” and unlike an ETF does not hold any actual securities). Its expense ratio is a rather high .85%, but then, nearly all MLP ETFs and ETNs have a similar expense ratio. It has an extremely tight bid/ask spread of about .05%. Master Limited Partnerships (MLPs) are companies that are organized as partnerships rather than corporations, and as such, avoid paying corporate income tax. To qualify as an MLP, a business must generate at least 90% of its income from what the IRS deems “qualifying” sources, including the processing, storage, and transport of energy commodities. Most MLPs are oil and gas pipeline companies. They earn money by charging fees on the oil and gas moving through their pipelines. They generate a lot of stable cash flow and tend to pay out most of it in the form of cash distributions to their investors (although they aren’t legally required to do so). One advantage of the ETN structure is that as a note or debt security tied to an index, the fund issues a 1099. The MLPs themselves issue K-1s, which are more complex tax forms, often arriving late in the tax season, and sometimes requiring large investors to file returns in multiple states. In addition, MLPs may generate Unrelated Business Taxable Income (UBTI) that could be a nightmare for IRAs and tax-exempt institutions. Most investors prefer to avoid receiving K-1s. The major disadvantage of the ETN structure is that an ETN is a general obligation of the issuer and exposes investors to the credit of the issuer, in this case, JPMorgan. That is, if JPMorgan goes under, investors in its ETNs could lose all of their money just like other bondholders. The 2008 experience with Lehman Brothers made many investors leery of taking on this exposure. However, like all major banks, in the wake of the 2008 experience, JPMorgan is much more stringently regulated and has been forced to hold more capital and manage its risks more conservatively. The risk of default can be monitored and measured in real time using credit default swap rates. Currently, the CDS market charges about .4% to insure default on JPMorgan bonds for a one year term. JPMorgan’s credit default swap rate is among the lowest of all major global banks. The Strategic Case for AMJ – Why Ever Own It? I prefer to invest in assets that are likely to be systematically underpriced relative to their economic benefits. MLPs are definitely in that category. The primary driver is the fact that, unlike C-corporations, MLP investors are taxed only once, not twice. The MLP itself pays no income tax – taxation occurs only when investors receive distributions. That is a major economic benefit. MLPs are also likely to be systematically underpriced because few investors are willing to deal with the tax complexities of K-1s, particularly institutional investors. Fear of UBTI is another impediment. Fewer buyers usually mean lower prices. Finally, the Alerian Index has historically had a relatively low correlation with stock market risk and bond market risk. These are the two major risks prevalent in most portfolios. Adding an investment that has a low level of sensitivity to these risk factors may help to reduce overall portfolio volatility. AMJ tracks the returns of its benchmark index, the Alerian MLP Index, very closely. The inception date for AMJ is April 1, 2009, but I have returns for the Alerian MLP Index going back much further. This additional historical data provides a longer-term look at the historical risk sensitivities of the index (and consequently, the ETN). I measure the sensitivity of its returns to four risk factors that capture much of the risk common to most ETFs: Stock market risk (MKT), as measured by the S&P 500 Index Interest rate risk (LTB), as measured by the 10-Year Treasury Benchmark Index Currency risk (DLR), as measured by the U.S. Dollar Index Commodity risk (OIL), as measured by the West Texas Intermediate Crude Oil Index Click to enlarge Based upon the history of its index, while AMJ’s risk sensitivities to stocks (MKT) and interest rates (LTB) have both moved up recently, this may be related to the unusual interplay of oil prices, economic outlook, and Fed policy that has affected capital markets in the recent past. Some reversion back towards more normal, and lower, levels of sensitivity to these risk factors over time is a reasonable expectation for AMJ. Click to enlarge The graph above tracks the cumulative return of the Alerian Index (in black), and disaggregates it into return due to each of the four risk factor sensitivities and residual return, or what is left over after accounting for the risk effects. The Alerian Index is unusual for the very high proportion of its return being residual of risk effects, and also in the fact that three of the four risk factors play a noticeable (but not dominant) role in explaining its returns. For most ETFs, a single factor dominates. For example, the return of most equity ETFs is largely explained by its MKT sensitivity. For most debt ETFs, LTB is the dominant explanatory factor. But AMJ’s overall return (black line) is largely determined by its residual return (orange line). This makes it a very good diversifier from a portfolio standpoint. The Tactical Case for AMJ – Why Now? Using the Alerian Index as a proxy for AMJ, from 2008 to 2014, investors would have been quite happy to have AMJ in their portfolios – it was generating very strong returns that were largely uncorrelated to broad risk factors (The orange line was going up). However, since 2014, AMJ has been in a steep decline, again most of it residual return not explained by risk factors, even as its sensitivity to those risk factors, and their power in explaining its returns, has been rising. Residual return remains unusually large, but risk factors are currently contributing a lot to AMJ’s volatility. I do not like to try to catch a falling knife, and AMJ (launched April 1, 2009) has certainly been falling precipitously since 2014. It has suffered from a “triple whammy” of concerns: 1) the prospect of a slowing economy, which may reduce demand for energy, 2) falling oil prices, which may reduce the demand for energy infrastructure, and 3) fear of interest rate increases, which could increase interest expense on debt. AMJ peaked at the end of August 2014 at about $54, and is now under $27, a decline of more than 50%. The fall in price has coincided with a 65% decline in the price of crude oil over the same time period, as shown below: Click to enlarge Clearly, the cumulative total return of AMJ (blue line above) has been very negative since 2014. Most MLPs have stable cash flows under long-term contracts that make their cash flow somewhat insensitive to the price of oil, yet investors have treated MLPs almost like they are in the exploration and production business. A very depressed level of cumulative total return is certainly one indication that AMJ may be attractively priced. If an ETF is significantly below its recent levels, there is reason to assume that it may be undervalued and will eventually revert back towards its historical norms. However, my research indicates that an even better indication of the likelihood of near-term mean-reversion is the degree to which an ETF has deviated from its five-year trendline. Because this trendline is sensitive to recent twists and turns in cumulative return, significant deviations from the trendline are rare. When they occur, it is because of dramatic price swings over a fairly short time period. These patterns are often indications of a market over-reaction. Click to enlarge As illustrated in the graph above, AMJ is currently at a level that is significantly below trendline. While further declines are certainly possible, the value gap that has opened up the last six months is the widest it has ever been in the history of the Alerian Index. There are fundamental reasons to believe that the risk of further declines has somewhat abated. Recall the three concerns that seem to have driven AMJ’s decline: 1) slowing economy, 2) falling oil prices, and 3) rising interest rates. While the rate of economic growth remains a concern, crude oil has rallied nearly 50% off its lows in the past month and the Fed recently announced a slower pace regarding future rate hikes. These developments help allay two of the concerns that have been plaguing AMJ and may portend a positive turn in market sentiment towards MLPs. Click to enlarge Dividend yield is another indication of value. Since 2014, AMJ’s dividend yield (concatenated in the line above with the Alerian Index dividend yield) has climbed from 4.3% to 8.2%. This dramatic increase in dividend yield is reminiscent of the Crash of 2008, and provides another indication that the selling may have been overdone. Click to enlarge To be sure, the per share dollar amount of AMJ’s dividend has declined by a little over 10% since its 2014 peak, as shown above. This reflects the fact that some of the MLPs in the Alerian Index have cut their cash distributions. And there may be some further cuts to come. Most of those reducing their distributions are “upstream” MLPs in the business of buying oil and gas fields, optimizing them, and selling their production to the market. However, upstream MLPs constitute only about 3% of the Alerian Index. While a few MLPs are “downstream” companies in the business of distributing energy products to the end customer, the vast majority of MLPs are “midstream.” They store and transport energy products, mainly through pipelines. Their basic business has fairly steady cash flows that are not terribly exposed to energy prices. The 50% drop in price may well be an over-reaction. However, there is some fear among some MLP analysts that even midstream MLPs may start to reduce their cash distributions, forcing AMJ to further reduce its dividend. Most MLP managements have traditionally considered maintaining and growing their cash distributions as somewhat sacrosanct. But MLPs rely on continued capital expenditures to grow, and most are finding their access to capital markets limited at this point: their equity prices are too low to issue stock and their debt coverage ratios are too low to get new debt financing. Some MLPs may sell off non-core assets, but that will only go so far. The big cash savings would come from reducing cash distributions. Arguably, MLPs that reduce their distributions to invest that cash in high-return capital expenditure projects would be doing the right thing for their investors. However, the initial reaction would likely be a wave of selling out of a combination of panic and frustration since most MLP investors are very yield-oriented and may interpret the move as a signal of lack of confidence on the part of management. For this reason, I expect further cuts to be limited. While not without its risks, AMJ seems a compelling value. There may be more volatility ahead, but with its generous dividend yield, AMJ pays investors handsomely to be patient. Disclosure: I am/we are long AMJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: My long and short positions change frequently, so I make no assurances about my future positions, long or short. The information contained in this article has been prepared with reasonable care using sources that are assumed to be reliable, but I make no representation or warranty regarding accuracy. This article is provided for informational purposes only and is not intended to constitute legal, tax, securities, or investment advice. You should discuss your individual legal, tax, and investment situation with professional advisors.