At a late lunch.

* Pretend and extend?
* Caveat emptor

This morning's opening missive addressed the absence of natural price discovery in equities.

Over the last few months we have had a similar discussion (in our Comments Section) about the same issue in the credit markets.

Indeed, bond and loan price suppression may be even worse.

If you think about it, so much of these assets are held in CLOs or ETFs, both of which are non-mark-to-market vehicles. ETFs do mark-to-market but only about 20% of their holdings are actively traded - the other 80% is grid priced so the prices are not "live" prices. As a result, the prices are not real.

I think this combined with the total lack of covenants will actually delay any credit market collapse because the inability of lenders to force borrowers into default will allow them to "extend and pretend." CLOs will do anything to delay defaults because defaults place their fees and equity distributions at risk.

The structure of credit markets is designed to delay price discovery and flushing of bad credits, and the longer you wait the worse things get and the lower recoveries are going to be.

Tattoo522dougie kass

This statement is far too generic to be valid. How is selling a put on a stock any different than buying 100 shares? Answer: it's safer, because you have the premium/credit you collected as an additional buffer against down moves.

Now, where people definitely get into trouble is the continuing success of this high-probability strategy makes them too confident and they sell too many puts, more than they have cash to cover the short puts at worst or at best that they end up with far too big a position if it's put to them. The strategy itself is just fine, but the application of it can certainly lead to issues.

But "don't sell puts" is not a lesson learned when you're talking about corporate deception. EVERY bullish strategy is flawed in those cases.

dougie kassTattoo522

Respectfully disagree because my experience (and it has been broad in options) is that the average Joe oversells puts or calls, relatively to their normal share position size.
That is why I make the statement TT.
Dougie

Tattoo522dougie kass

I agree with that 100%, but that is execution, not an inherent flaw in the strategy. I personally never sell puts unless I have the cash to cover and I always size the puts as if I were definitely going to be forced to buy the stock.

dougie kassTattoo522

I am not referencing you or any sophisticated trader.
This is my observation when looking at the average retail investor - he/she sells more than a normal position as its seen as "free money."
Dougie

Jefferies upgraded Citigroup (C) this morning.

After an initial jump, C is now in the red in a green market.

This may be supportive of my notion in this morning's bank post that the stocks are going to tread water to move lower over the short term.

That said, I have no plans of disturbing my bank positions.

Twitter (TWTR) was my Trade of the Week at $31.72.
It wasn't a brilliant idea - the birdie laid an egg.

Pressing shorts further this morning.

From Rosie (and I agree 100%):

The data softens, here's Peter Boockvar:

Putting aside the Fed's positive influence on the equity market rally this year, the other of course is the hopes for a substantive deal with China and the elimination of the tariffs. After reading below about more weak economic data overseas and the pretty poor data in the US yesterday, the $64k question from here is whether a deal will reinvigorate economic spirits and activity because if it doesn't, market attention will return to the earnings impact in the US where earnings estimates per share have gone from $172 per share this year to now approaching $167 per share according to Bloomberg. Put a 15x multiple on that $5 per share and that's 75 S&P points. Thus, valuations have only risen.

Japan said its consumer price inflation rate in January was up by .4% ex food and energy and that is a y/o/y number. That is up one tenth from December and is as expected. If we just take out energy which is what the BoJ does, prices rose .8% y/o/y as forecasted. Either way, both are far away from what the BoJ wants and the never ending easing continues. As the figures were in line, the 10 yr JGB yield was unchanged at almost -.04%. Looking at the 40 yr yield which is least influenced by BoJ policy, it is at .65%, down from 1.10% in early October. That is quite a drop.

As if we needed more evidence that global trade has slowed, Thailand, another great proxy, said exports fell 5.7% in January, more than double the estimate of a decline of 2.1%. That's the 3rd month in a row of y/o/y declines.

The important German IFO business confidence index for February fell to 98.5 from 99.3. That was slightly below the estimate of 98.9 and both the Current Assessment and Expectations components were lower m/o/m. This leaves the index at the lowest level since December 2014. The IFO said simply "The economic situation in Germany remains weak." After experiencing q/o/q growth of zero in Q4, the IFO estimates that growth will be just .2% q/o/q in Q1, an annualized rate of below zero. Notwithstanding the continued weakness, the euro is little changed and the 10 yr German bund yield is up by almost 2 bps to back above 10 bps.

The UK CBI retail sales index was zero for a 2nd straight month. The estimate was +5. CBI said "The High Street has seen a slow start to the year, with y/o/y sales volume unchanged again this month. Although real earnings growth is higher, consumer confidence has been ebbing away, keeping a lid on demand...Until politicians can agree to a deal that commands a majority in parliament, is acceptable to the EU and protects our economy, business despair will deepen." That's for sure. The pound is slightly lower but still above the $1.30 level. I still like the pound on expectations of some resolution soon. Along with the rise in German bond yields, the 10 yr Gilt yield is higher by 3.5 bps to 1.17% which is about 1 bp higher on the week.

*It's a non trivial possibility!

Overnight I reflected upon the abysmal news at Kraft Heinz (KHC) :

* SEC accounting probe
* EPS miss (based principally on rising costs as top line growth was, more or less, in line)
* Lower profit guidance (see above, coupled with increased spending to support in place brands)
* $15 billion write off of goodwill
* A reduction in the cash dividend down to $1.60 per year (with the "savings" dedicated to reducing leverage)

The competitive landscape for consumer packaged goods has been deteriorating over the last several years - a position I introduced back in 2017 with "Buyer Beware of Consumer Staples Sellers Amid the Emerging Retail Monopsony" (though my thesis hasn't helped me not to lose money in (CPB) and KHC - while making a lot of money in (PG) ).

The above adverse events have historically been a call to investment arms by Warren Buffett.

Consider GEICO and American Express (AXP) - in the former case the investment was made under fundamental business duress, the later during the salad oil crisis.

Other investments, in (GE) , (BAC) , (GS) , etc. were made during economic and specific business crises - when, like Kraft, their "moats" were being challenged.

Warren "knows" Kraft Heinz well (he had been on the Board for several years) and is capable of making a quick decision (remember the decision to invest in Bank of America in the bath tub?).

He certainly is emboldened with a (record) large and burgeoning cash horde.

Given the fundamental company uncertainty, a call play might make sense and I plan to ask Tim "Not Judy or Phil" Collins for some options ideas.

Note: CNBC's Becky Quick will be interviewing Warren Buffett on Squawk Box on Monday (following the publication of his letter to Berkshire Hathaway shareholders on Saturday) - and will certainly ask about his Kraft investment. Stay tuned.

* The 1Q is tracking in line with expectations

With almost two thirds of the 1Q complete, let's take a fast dive into the emerging fundamentals of the banking industry.
Here are the quick takeaways:
* Capital markets activity and risk appetites are improving - that's the swing opportunity for an immediate improvement in EPS reports relative to consensus expectations.
* Over the last 15 years, trading revenues typically increase about +65% from 4Q to 1Q.
* With equity prices and credit trends recovering, coupled with lower volatility, I expect this to approximate this year's gain.
* Non U.S. banks continue to falter and provide the basis for further market share gains by U.S. banks along several important product lines.
* Trading volumes are slowly improving.
* Little sequential movement in net interest spreads are expected.
* Credit costs should be in line.
* A reduction in operating costs should continue.
Full year bank profits in 2019 and 2020 are not expected to vary materially from consensus - with steady improvement in returns (on invested capital) and, on average about +6% to +9% compounded EPS growth (aided by continued large buybacks and return of capital).Bottom Line
While consistent with lower interest rates (and slowing global economic growth), the Democratic party's move to the left (with some fears of a regulatory give back) and my equity market concerns, bank stocks may tread water in the months ahead after a spirited rally from Christmas Eve.
But the long term prospects for this overcapitalized industry remains very much in place and bank stocks remain my single largest industry bet for the long term.

* A changing market structure has annihilated natural price discovery* Resultingly, I am more skeptical of the reliability of the charts that form the basis of technical analysis

"Although I did a little flipping today to lock in some gains, I continue to like the way individual charts are developing. The weakness is actually a positive from a technical standpoint but there is no rush to act at this point."
- Rev Shark, I Like the Way Individual Charts Are Developing

I get what Rev Shark wrote last night - that individual charts are improving.

I can see what Rev sees.

But where I respectfully disagree with the right Reverend, is that it is my strongly held view that (1) owing to the popularity and proliferation of ETFs (which rebalance daily) and (2) the dominance of machines and algos (that feed Quant Trading strategies and products and worship at the altar of price momentum) have produced artificial prices by exaggerating short term moves (that may extend for days and even weeks).

As I noted recently in Hey, SEC, Limit Leveraged ETFs and Quants Before They Kill Our Markets, I don't trust the charts that technicians pour over relative to a decade or more ago when there was less counterfeit (imbedded in stock prices). Today's charts, more than ever based on artificial influences, have been rendered less valuable/dependable within the context of technical analysis:

* SEC, listen up...
* The new regime of volatility is to a large degree a function of the proliferation of leveraged ETFs and the dominance of quant strategies and products
* As monetary policy pivots, liquidity is reduced and the role of these "financial weapons of mass destruction" is increased
* If they are not limited and are left unregulated, more and more investors will be turned off to the investing game as volatility expands

"Houston, we have a problem."
- Jack Swigert

We are clearly now in a new regime of volatility. As evidence, the Dow Jones Industrial Average has experienced a daily change of greater than 100 points in 14 out of the last 15 trading sessions.

There is little doubt that the reduced level of liquidity in direct response to the Federal Reserve's tightening pivot has contributed to this new bout of volatility. And, arguably, so have some other factors, such as an untethered president's hastily crafted policy, conflated with politics and delivered over Twitter.

As liquidity evaporates, leveraged ETFs and quant strategies, governed by machines and algorithms, take on an even greater role in impacting our markets.

Everyone knows that the risks associated with the proliferation of leveraged ETFs, which tend to exacerbate short-term swings in stock prices, and the trading dominance of quant strategies (e.g., risk parity) possess the potential for another Flash Crash.

I increasingly can imagine a spin-out into a disaster that would be difficult to recover from.

The frequency of wild, unpredictable and precipitous market swings and moves that are divorced from fundamentals -- other than explanations in search of problems after the fact -- are unarguable. They produce an unnerving artificiality and lack of natural price discovery and precipitate more bouts of volatility.

The business media generally have ignored the causality between levered ETFs and quant products, preferring instead to rejoice in 500-point rallies in the Dow Industrials and to hold "Markets in Turmoil" specials when the DJIA falls by 400 points. The enormous swings in both directions impact confidence in the markets and cause retail investors to buy when they should not be buying and to sell when they should not be selling. (See this Jim Cramer column from last Friday.)

In its extreme, it erodes the ability of companies to raise capital and create jobs.

ETFs were supposed to be a low-cost democratizing vehicle that brought cheap tax-efficient diversification. Over the years, ETFs have expanded to double and triple leverage (short and long), representing with quant strategies the largest portion of the volume on exchanges and have become vehicles for everyone other than Main Street. They're used by macro strategists whose algorithms correlate away and are only sometimes correct.

Meanwhile, exchanges that used to be self-policing institutions dedicated to clean and transparent markets are now public. They make their money on the volume generated by high-frequency and quant strategies and products, selling special data feeds to the perpetrators of this mess.

The Securities and Exchange Commission (SEC) is all over Elon Musk's ranting, but nowhere for years on a matter that is fundamental to health of American markets. (The ultimate irony, as discussed in this Wall Street Journal column, is quant king D.E. Shaw's human-being traders are losing money.)

In The Great Recession of 2008-2009, Warren Buffett famously called derivatives "financial weapons of mass destruction." The newest financial weapons of mass destruction -- leveraged ETFs and quant products and strategies -- are destabilizing, sabotage natural price discovery and corrode investor confidence.

A Computer Lesson From 1987 Is Still Unlearned

Today's "financial weapons of mass destruction," though not as venomous as the last cycle's contrivance, represent a structural threat to the capital markets not seen since Portfolio Insurance devastated the U.S. stock market in October 1987.

As a first step I would recommend that CNBC, Bloomberg and Fox Business immediately invite SEC Commissioner Jay Clayton on their networks to discuss why the SEC removed the "uptick rule" and why they allow the New York Stock Exchange to rent space to the High-Frequency Trading crowd in order to get closer to exchange computers (and to get a split- second advantage over the public).

It is imperative that the SEC evaluate the harmful impact of leveraged ETFs and quant strategies and products for the purpose of creating needed regulations before our markets are further undermined.

I have been writing about the vulnerability and "Peak Housing" over the last year, as affordability is challenged by rising home prices and rising mortgage rates (from resets).

Here is confirmation from the January housing data:

Source: NAR

This drop is occurring with only 4.5% mortgage rates .

Can you imagine what happens to the U.S. Residential Real Estate market when interest rates really rise?

As is the case at every housing top, the National Association of Realtors economist, Lawrence Yun (much like their economist David Lereah did back in 2007) remains optimistic and "lost in the woods'":

Existing home sales in January were weak compared to historical norms; however they are likely to have reached a cyclical low. Moderating home prices combined in gains of household incomes will boost housing affordability, bringing in more buyers in the months to come.

Caveat and investor emptor.