Good Morning,

Significant movement for U.S. stocks last Friday closing mixed due to pressure from this year's best-performing sector: technology.

The Nasdaq composite hit a record high at the open before closing 1.8 percent lower. Shares of Apple, Facebook, Amazon, Netflix and Google-parent Alphabet all fell more than 3 percent.

The tech-heavy index also posted its worst weekly performance of the year. The S&P 500 closed 0.1 percent lower, erasing earlier gains, with information technology dropping more than 2.5 percent. Big tech was slammed as investors took profits from the group, which some fear has become a massive market bubble.

These concerns were bolstered by a report released by Goldman Sachs on the top five outperforming mega-cap names in tech with some warnings on valuations and concerns that their volatility has become extraordinarily low. In fact, the stocks had become closely correlated to safe haven plays, like bonds and utilities.

Meanwhile, the Dow Jones industrial average rose about 90 points, notching a record close as out of favor financials and industrials led.

Also this week we saw another unfortunate chapter of Donald Trump’s Presidency unfold. Hiding in plain sight in former FBI Director James Comey’s testimony Thursday before the Senate Intelligence Committee was a potentially major new avenue for special counsel Robert Mueller’s investigation of Russia-related crimes: the possibility that President Donald Trump committed a federal crime by lying to Comey about his connections to Russia and activities on his 2013 visit there.

Our Take

“Big tech” could be vulnerable in the near term as investors rotate into other groups that have lagged such as financials and energy yet the long-term earnings growth story remains intact. If anything this rotation is evidence of a healthy market alive to the issue of valuations supported by sound fundamentals (almost 40 percent of fund managers think that global equity markets are overvalued, the highest level since January of 2000. And 80 percent see U.S. markets as the most overvalued in the world).

Interestingly, looking back at the year 2000, all five companies have eight times more cash than the big tech stocks had in the bubble.

As for the Trump show, this week what became more clear is that the self-inflicted wounds of what appears to be an undisciplined presidency are increasingly likely to blow its chances of passing any of the anticipated economic stimulus measures. The trifecta of tax reform, repatriation and infrastructure investment could put the U.S. on very strong footing for the next several decades but this opportunity seems to be slipping away.

Barry Ritholtz in an interesting piece for Bloomberg, suggests that the president is becoming radioactive. He is having problems hiring outside counsel: four top law firms have reportedly turned him down. Resignations are mounting. Diplomats are revolting. Hundreds of key positions have gone unfilled as people increasingly perceive working for Trump as a career killer.

What now appears increasingly likely is not a dismantling of the Trump administration from the outside. But an implosion from within. Furthermore, although there may be no serious collusion with the Russians, there is now certain to be a wide-ranging independent investigation into all things Trump. This investigation will likely make governing even more difficult than it already is...

But, some may say, stocks are up, so how bad can it be? It’s true that while Wall Street has lost some of its initial excitement about Trumponomics the market is still sitting close to all time record highs as investors and businesses don’t seem to be pricing in the risk of disastrous policy.

Or aren’t they? Interestingly, in a recent research note put out by FactSet the initial excitement does not appear to be translating into stronger performance for most measures of the real economy so far in the first half of 2017. Even the initial surveys suggesting optimism have retreated somewhat as the equity markets have flattened out as progress on reforms has stalled in Washington D.C.

Business and consumer surveys initially reflected optimism, but we have seen small retreats in sentiment measures for both in the second quarter. *Note that the sentiment indicators may have pulled back recently, but they still remain elevated and near longer-term highs.

Perhaps the big money, which classically tends to equate wealth with virtue, is beginning to consider (even Ray Dalio is starting to break a sweat as Trump consistently chooses conflict over cooperation) the potential risks posed by this increasingly self-destructive Presidency….

Musings

On a not so unrelated topic, I came across two notable bearish "expert" perspectives on the American economy this week. Good old gurus Bill Gross, manager of the Janus Henderson Global Unconstrained Bond Fund, and Paul Singer, founder of hedge fund Elliott Management Corp. Speaking last week at the Bloomberg Invest New York summit on Wednesday.

They’re message: a crash is coming. Their argument: The Federal Reserve flooded the U.S. economy with cheap money after the 2008 financial crisis by holding interest rates near zero and beefing up its balance sheet. Corporations and individuals responded by bingeing on debt and risk assets -- as the Fed encouraged them to do so.

Now we’ve heard this argument many times before. In fact we’ve basically heard it every year since 2013. Should we be worried as these two investors are considered by many to be two of the greats having both superbly navigated the 2008 financial crisis?

There is no doubt that debt levels should be watched closely yet what is the data telling us?

As shown in the chart above, after over eight years, the nominal outstanding amount of U.S. consumer debt which includes mortgages eclipsed its $12.6 trillion peak from Q4 2008. While the $12.7 trillion current outstanding amount of consumer debt has made a new high, consumer debt has seen zero growth in the last nine years compared to a near doubling of debt in the five or so years that preceded the prior peak.

The consumer loan delinquency rate is at a 30 year low.

And this chart paints a positive picture of where the consumer stands regarding paying off their loans:

Nir Kaissar for Bloomberg reminds us that Gross's and Singer’s investment realms -- high-grade bonds and multistrategy hedge funds, respectively -- have been two the biggest laggards since the financial crisis. The S&P 500 has returned 18 percent annually from March 2009 through May, including dividends. By contrast, the HFRI Fund Weighted Composite Index -- a collection of various hedge fund strategies -- has returned 6.2 percent annually, and the Bloomberg Barclays U.S. Aggregate Bond Index has returned 4.2 percent annually.

Thus, a market meltdown would perhaps be the best thing that could happen to Gross and Singer. Should we therefore brush off such warnings?

The answer is no. Although the consumer’s balance sheet appears to be healthy, vigilance is necessary as signs are now emerging in the credit markets that leverage is on the rise with a surge in corporate debt issuance that has steadily pushed investment-grade corporate leverage to a new peak for this cycle, as measured by debt-to-equity ratios. The ratio for companies in investment-grade indexes is around 2.8 times and 4.2 times for those on high-yield indexes.

Even though the ratios are near historic highs, market volatility as measured by the VIX is near a record low. Yes, the VIX is often criticized as a good measure of stock market volatility, but the divergence between leverage and VIX isn’t sustainable. We may be looking at a reversion to the mean as volatility is bound to pick up as investors and markets come to realize that low volatility and rising leverage may no longer be a suitable marriage.

Nevertheless, none of this suggests a 2008 style meltdown. What is likely is simply for the market to hang around its current level for years, waiting for earnings to catch up with stock prices as there are compelling reasons that companies will remain incredibly profitable for the foreseeable future. Thus, what vigilance in the face of such warnings should mean is what it has always meant to the prudent long term investor: buy right and hold on. You’re never going to get a perfect all-clear or get-out-now signal from the markets and this time is no different.

Logos LP Updates

May 2017 Return: 3.68%

2017 YTD (May) Return: 23.36%

Trailing Twelve Month Return: 31.01%

Annualized Returns Since Inception March 26, 2014: 28.471%

Cumulative Return Since Inception March 26, 2014: 92.53%

*All returns are reported unlevered

Thought of the Week

"Simplicity is not the goal. It is the by-product of a good idea and modest expectations.” -Paul Rand

Articles and Ideas of Interest

6 Long-Term Economic and Investment Themes. Good list from Gary Shilling. 1) Huge fiscal stimulus, primarily infrastructure and military related 2) Globalization that shifted manufacturing from West to Asia is largely completed 3) Worldwide aging of populations 4) The long-promised Asian Century of global leadership is unlikely to come to pass due to the completion of globalization, the slow shift from export led domestic spending driven economies, government and cultural restraints, aging and falling populations 5) Disinflation with chronic deflation likely, especially as services follow goods in price retreats 6) The bond rally of a lifetime continues

Stop being positive and just cultivate neutrality for existential cool. Do we believe in the superiority of optimism? Culturally, we’re obsessed with positivity—our corporations measure worker glee, nations create happiness indices, and the media daily touts the health and social benefits of optimism. Thus, the good answer is to see the glass half full. Otherwise, you risk revealing a bad attitude. But are things so mutually exclusive? Is the glass not in a state of perpetual change? Can neutrality set us free? Can it help us see something more like the truth, what’s happening, instead of experiencing circumstances in relation to expectations and desires? The pressure to succeed—or to define success conventionally—can be subverted with neutrality. Things can go just so or totally awry once you understand that all things are fine, their upsides and downsides to be determined.

Mary Meeker’s 2017 internet trends report. In the most anticipated slide deck of the year Kleiner Perkins Caufield & Byers partner Mary Meeker looks at trends in digital and beyond. Of great interest is her coverage of interactive games as the motherlode of tech product innovation + modern learning (slides 113-150). Interesting concepts as we debate whether machines will replace most roles performed by humans. Such research supports that rising engagement in digital games is preparing us for the merger of man with machine.

Leverage: Gaining disproportionate strength. Wonderful explanation of the concept of leverage. Anyone who has ever haggled at a market or with a salesperson will understand the principle of using leverage in a negotiation. The trick is to declare their product or service to be so flawed and worthless that you are doing them a favor by buying it. Subsequently, the next step is usually to offer a low price which they counter with a slightly higher one that is still much lower than the asking price.

Passive investing is worse than...the misuse of antibiotics. The FT argues that the passive investment industry has become an oligopoly, with three large managers “drawing on seemingly limitless economies of scale” and amassing assets “simply by slashing costs” — both things, surely, that a blue-blooded capitalist would think is a sign of progress. Passive investing erodes competitive forces, because companies in the same sector end up with the same investor base and thus could pricing mechanisms break down?

Is the Canadian economy finally smooth sailing? Canada’s labor market continued surprising in May, with a greater-than-expected 54,500 jobs gain that also finally came with signs of a pick-up in wages. The employment gain -- the third biggest one-month increase in the past five years -- was driven by the addition of 77,000 new full-time jobs, which offset falling part-time employment. Economists had forecast a 15,000 increase in employment. The employment gains bode well for the continuation of the country’s expansion, which is the fastest among the Group of Seven, as Canada emerges from the oil price collapse and benefits from a soaring real estate market. It also could raise pressure on the Bank of Canada, which has been citing worries about slack in the economy for being cautious, to increase rates sooner. Certain funds are even becoming bullish on Canadian stocks seeing oil prices recovering. Nevertheless, it is doubtful that the bank of Canada will raise interest rates any time soon. Vulnerabilities remain. What should be watched closely is the impressive growth of Home Equity Lines Of Credit (HELOCs). A recent report from the Financial Consumer Agency of Canada explored this growth and found that “HELOCs offer relatively low interest rates and convenient access to large amounts of revolving credit, which may encourage some consumers to use their home equity to fund a lifestyle they cannot afford.” Keep an eye on the temperature of the market...

Our best wishes for a fulfilling week,

Logos LP