August 15, 2017
Martello Investments
Please read the important disclaimers at the bottom of this post. Past performance is not indicative of future results. Not a recommendation to buy or sell securities. Nothing in this presentation is intended to be construed as investment advice.

Market Mystery Team: Each year, July 31st marks the non-waiver trade deadline for Major League Baseball. For weeks, fans are overwhelmed with rumors about players on the move and teams’ strategies as the deadline approaches. In this commentary, we examine the use of the rumor mill in baseball (including the proverbial “Mystery Team”) and capital markets, particularly in their ability to drive increased value for the holder of the asset (players or stocks). We also discuss two “Market Mystery Teams” that have been prevalent in the headlines over the last few years: OPEC and global central banks.

Markets: After a strong first half of 2017, headline equity market indices rallied across the board in July, led by continued strength in the Emerging Market Index, which has gained over 25% this year. Technology stocks continue to lead domestic markets higher, and after a significant move in recent months, implied volatility in the tech sector fell in July. Dissention in the Fed over the pace of rate hikes sent the US Dollar lower and steepened the US Treasury yield curve. Oil, after struggling for several months, rallied sharply on cooperation within OPEC, including export cuts by Saudi Arabia.

The Market Mystery Team

The end of July marks one of my favorite times of year, the non-waiver trade deadline for Major League Baseball. When I was a teenager, my dream job was to be a baseball general manager, the front office executive that basically controls the team’s roster, transactions, and minor league player development. The non-waiver trade deadline generally brings a flurry of activity, where contenders stock up for the playoff push while weaker teams look to stock their farm system with prospects for the future. For the weeks leading up to the deadline, I check the league news more often than I’d care to admit, awaiting news of a pending blockbuster that changes the shape of the league for years.

As I’m sure many of you can imagine, news around the trade deadline is dominated by the rumor mill. Each day brings reports of players that will certainly be traded or that a team is prepared to deplete their minor league system of all prospect talent in search of a player to help the team to a playoff berth this year. In many cases, not only does the rumor not come to fruition, but team executives claim there was no basis to the claims at all. In recent years, the rumors have taken on a more interesting shape with the creation of the “Mystery Team.” The “Mystery Team” is exactly what it sounds like, a team that is in on a trade or player that is unidentifiable for some reason. An example headline, unbelievable as it might be, would be “An unidentified team joins the Orioles and Pirates in pursuit of Charlie Culver, Pitcher for the Green Sox.” This obviously fake headline does highlight the winner in the Mystery Team report, though, as the Green Sox. Logically, the presence of a Mystery Team in this case only helps the Green Sox, who are seeking to drive up interest in their pitcher to improve their return. This incentive has led many baseball pundits to suggest that the concept of a Mystery Team has been invented by teams seeking to start a bidding war in trade discussions, or by agents looking to drive up the value of their players.

Markets seem to have their own Mystery Teams these days, and more and more market action seems to be dominated by the rumor mill. We have seen several clear examples of this over the last few years, particularly in stories surrounding central bank activity, OPEC’s plans, and the machinations of activist “investors.” Much like the Mystery Team in baseball, the nature of the rumors makes clear who stands to gain. Take the oil market, for example, which has taken some painful losses since the start of its most recent drawdown in 2014. Many factors have contributed to the collapse in crude prices: low global inflation, the strength of the U.S. dollar, the new dynamics of shale and hydraulic fracturing technologies, and significant production growth in the United States. Furthermore, the Organization of the Petroleum Exporting Countries (OPEC) has shown itself unable to stabilize oil prices, and splinters are forming in the cartel. With each jog lower, the rumor mill begins to spin, primarily around OPEC’s production and whether the cartel will further curtail output in effort to stabilize prices. It is clear that these types of rumors have a primary motivation: to change investor attitudes about oil, which might drive the price up in the short term. Who may have started the rumors, the ones that benefit OPEC member nations above anyone else? Analyzing it in the same incentive framework as the baseball Mystery Team above leads to only one conclusion: OPEC is the Mystery Team.

Like the crafty general manager using a Mystery Team to bid up the price of a trade, rumors in the market have a similar motivation. The greatest Mystery Team of them all is the global central banks. As the developed world continues to battle structural deflation caused by over-indebtedness, aging populations, the diminishing impact of stimulus, and the falling productivity of credit, leading global central banks continue to fight back with accommodative policies. Over the last few years, suggestions that the central banks (the Federal Reserve, particularly) might reduce their accommodative activity has been met with episodic bouts of volatility and modest sell-offs in the equity market. Even worse, for several years the US market was stuck in the “good news is bad news” paradigm, whereby good news about the economy was interpreted as poor news for the market, if only because it would encourage the Fed to taper. Inevitably, the Mystery Team stood ready to greet the market in the midst of these tantrums; each benign move lower was met with a rumor (or outright comment by a Fed official) that accommodative policies might persist.

In baseball, the ultimate consequence of the Mystery Team rumor is at least a partial disregard of it; as I stated earlier, it is generally accepted that at least some of the Mystery Team reporting is caused by the interested agent or team trying to create additional value in its player. In the market, however, the consequence of these rumors is a phenomenon known as the “central bank put”, the idea that central banks will intercede in any negative market event to stabilize investor sentiment and ultimately prices. This causes investors to bid up the price of equities and implied volatility to plummet (see our May commentary titled “Markets in a Post-Volatility World”). Recent months, however, have seen the Federal Reserve signal its intent to unwind its bond portfolio. How global markets might respond to this unwinding is unclear; on one hand, it signals at least some level of confidence in the economy, even though recent Fed minutes show tension about rate hikes given the benign level of inflation. On the other hand, the “central bank put” has at least somewhat helped support the market, meaning recent Fed actions could call that support into question. Put another way, when the Mystery Team is removed from the equation, what happens to the value its existence helped create?

Markets

Domestic stock indices rallied again in July, shaking off a jog lower at the end of June to continue this year’s strong run. US Large Cap stocks, as measured by the S&P 500 Index, gained 2.1% for the month, while the Russell 2000 small-cap index rallied 0.7%. Small cap has lagged large cap so far this year, with the Russell 2000 gaining 5.8% year-to-date compared to a 11.6% gain for the S&P 500. Emerging Markets led the way, with the MSCI Emerging Markets Index gaining 6.0% in July to bring year-to-date gains to 25.8%. At the sector level, each S&P 500 sector index posted gains for the month, though Technology continued to lead the market with a 4.3% gain in July. After rallying sharply in May and June, the NASDAQ 100 Volatility Index (VXN) fell nearly 10% in July, as recent fears of forthcoming volatility in the technology sector appears to have abated for now. Similarly, headline market volatility, as measured by the CBOE Volatility Index (VIX), fell 8.2% to close July at 10.26, near record lows.

Fixed Income markets rebounded from a weak June to post gains in July, with the Bloomberg Barclays US Aggregate Index rallying 0.4% for the month. The US Treasury yield curve steepened in July, with the 2-year Treasury yield falling 2 bps to 1.35%, the 10-year Treasury yield rising 2 bps to 2.29%, and the 30-year Treasury yield rising 9 bps to 2.90%. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, tightened 16 bps to close July at 3.61%, though the Index tested its 52-week low during the month. Bond yields in Europe were mixed, as June’s sharp rise in German yields continued in July, though yields in the UK fell modestly.

The S&P GSCI Total Return Index gained 4.6% in July, as a rebound in energy prices bolstered in the commodity index. The GSCI Energy sub-index gained 8.1% on strong rallies in Gasoline [+12.4%], Heating Oil [+12.2%], Gasoil [+11.8%], and Crude Oil [+8.6%]. WTI Crude Oil, which has fallen 14% year-to-date through June, gained nearly 9% in July to close the month at $50.17/bbl. The main driver of July’s crude bullishness were reports surrounding the OPEC meeting at the end of July. At the meeting, Saudi Arabia pledged to limit exports while Nigeria planned to cap production at 1.8 million barrels per day. Saudi Arabia’s export cuts are seen mostly as an attempt to offset increased production from Libya and Nigeria, which continue to ramp output after years of war and terrorism. Still, US crude production continues to trend higher, and several countries including Iraq, OPEC’s second largest producer, continue to violate the cartel’s agreement to reduce overall output. After a pause in June, the Precious Metals sub-index gained 1.9% in July, as investors flock to gold as a safe-haven asset. NYM Gold rallied $34/oz. in July to close the month at $1,275.40, nearly 11% higher on a year-to-date basis.

The US Dollar faced continued pressure in July, as the US Dollar Index fell 2.9% on the month. The Index, which measures the US Dollar’s value against a basket of 6 foreign currencies, has fallen over 9% year-to-date after posting gains in each of the previous 4 years. The USD has trended lower on continued political turmoil in Washington, with the GOP’s latest failure to pass healthcare reform sending the greenback lower. In addition, the most recent Fed minutes show dissention on the pace of rate hikes, as growth and inflation remain sluggish, which put further pressure on the currency.

We’re thankful for the continued interest and feedback. Please feel free to contact us with questions or comments.

Sincerely,

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

important disclaimers

The information contained in this presentation is qualified in its entirety by the following disclosures which must be read in conjunction with the presentation. The presentation is intended for sophisticated investors for informational purposes only and is not intended to constitute investment advice or recommendations by any party. Unless otherwise indicated, information, data, strategies and opinions included in the presentation are provided as of 02/26/2020 and are subject to change without notice. In accordance with relevant SEC advertising regulations, a full list of trades and investment recommendations is available upon request. Past performance is not a guarantee or a reliable indicator of future results. The views and strategies described herein may not be suitable for all investors. You should consult your financial advisor regarding such matters. The material contains the current opinions of the author, and such opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based on proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. This material contains information that has been prepared from original sources and data believed to be reliable. However, no representations are made to the accuracy or completeness thereof. Investing involves a variety of risks and may be only appropriate for sophisticated persons who can afford a loss of all or a substantial portion of their investment. No part of this material may, without advance written consent, be copied or duplicated in any form by any means. There can be no assurance that any client’s investment objective will be achieved or that a client will not lose a portion or all of its investment account. The investment return and principal value of any investment will fluctuate over time. No chart, graph, or other figure provided should be used to determine which investment strategies to use or which securities to buy or sell. No figure above should be taken as a recommendation or endorsement of a specific security, sector, or strategy. References to market or composite indexes, benchmarks or other measures of relative market performance over a specified period of time are provided for information only and do not imply that any client account will achieve similar returns, volatility or other results. The composition of an index may not reflect the manner in which a client’s portfolio is constructed in relation to expected or achieved returns, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of which may change over time. An index’s performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. You cannot invest directly in an index.