October 1, 2015

Greetings,

We’ve hit a macro news vacuum that should last for the next week and a half. The September jobs

report hits tomorrow morning, but labor conditions aren’t holding the Fed back from a hike. The BoJ

releases its decision next Wednesday, yet officials have already started lowering expectations. Minutes

from the Fed’s September meeting will be released next Thursday, but Yellen spoiled the surprise with

her hour long speech in Amherst. The combination of a nervous stock market and little news typically

doesn’t result in rallies.

The present angst can be distilled down to concern over two particular issues: 1) economic

activity in China and 2) the Fed. China will be shut down for “National Day” all of next week, so we won’t

see any data or price signals. Meanwhile, the Fed will be digesting the spate of manufacturing indicators

that hit this week. Chicago PMI contracted to 48.7 in September, the fifth time it’s been below 50 in 2015.

The ISM index, which looks at the whole country, was also a disappointment at 50.2. The Citi surprise

index is inherently mean reverting, but if August marked this cycle’s peak it would be the lowest high

since the index started in 2003. Meaning expectations are low and headed lower.

While the macro market goes dark, earnings season gets underway next Thursday with Alcoa (AA)

batting leadoff. Third quarter results could be the most important in recent memory as the S&P 500 sits

at precarious levels. Analysts are bracing for the third consecutive quarter of Y/Y declines in earnings.

Looking at earnings momentum reveals a similarly bleak picture. 2016 forecasts for the highly cyclical

semiconductor sector in the US have been written down -8.3% over the past three months. In other

words, there’s not much momentum at all.

Much of this is already priced into the market, but fundamentals could get much uglier if share

buybacks slow down. In the second quarter, S&P companies bought back a net $104bn in shares, up +7%

Y/Y. But if you look over a longer period, buybacks have essentially flat-lined after three years of huge

increases. The sector by sector breakdown reveals this trend. The energy sector bought more than $10bn

per quarter last year, now it’s less than $2bn. The materials sector saw a similar drop, and media

buybacks are down over 30%. It’s no coincidence that these three sectors have performed poorly this

year, and there are concerns this trend will spread to the broader market.

Over the last six quarters, at least 20% of S&P 500 companies have reduced their share count by at

least 4% - boosting EPS by 4% as a result. It stands to reason that if earnings (especially forecasted

earnings) are declining, there will be less capital to fund buybacks. Keep an eye on the PowerShares

Buyback ETF (PKW). If those shares roll-over, it’s safe to say we’re entering a bear market.

The Cup & Handle Fund is up around 6.0% YTD, and +19.0% Y/Y. This week we closed some

positions that have been in the portfolio for many months. They all made money and probably have

further to go, but realizing profits is never a bad thing. We’re now sitting on a little bit of cash, which I

expect to be deployed shortly. The October investor letter went out this morning, and it’s a bet I feel good

about. If you’d like to start receiving these letters click here.

As always, if you have any questions or comments or just want to vent, please send me an email at

mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld Managing Editor – Cup & Handle Macro

Looking for a Corpse in Commodities

Not all commodities are created equal, oil is by far the most important. It’s a major input cost,

often the largest, in the production of every commodity. When oil prices are cut in half over 12 months

the cost to produce everything from corn to platinum declines, boosting supply and weighing on prices.

Commodities have been in a bear market since 2011. The oil collapse wasn’t the cause of this bear

market, it was the nail in the coffin.

Commodities have been in a rut because of the immense overcapacity built up following China’s

infrastructure spending in 2009-2010. In retrospect, oil held up extremely well relative to other bulk

commodities until it finally succumbed to USD strength in late 2014. The question investors are asking

now is: where’s the bottom? Bear markets typically end in some form of capitulation after over-leveraged

players are wiped out. In other words, we need to see a casualty before the bottom is found.

Almost every bear market is the result of deleveraging. They typically start with banks restricting

loans, which hurts prices, which shrinks collateral, causing banks to restrict loans even more. This nasty

cycle continues until there’s some form of disorderly liquidation. The most obvious candidate for default

at the moment is Glencore, where shares prices are down 90% from the IPO in 2011.

The company has a vast trading arm funded by nearly $18 billion in short-term debt—often

revolving lines that roll over roughly every 30 days. Aware that investors were nervous, Glencore took

action three weeks ago, announcing plans for $10 billion in debt reduction through a stock sale, a

dividend cut, asset sales and cost reductions. They’re also seeking to raise more than $1 billion by selling

future production of gold and silver.

The casualty does have to be a public company. A default on sovereign debt from a major

commodity producer would send a similar signal. Brazil would seem to be a contender, but even though

its 5Y CDS is up 115% since May, the B in BRIC is probably too big to fail. Chile, a huge copper supplier to

China, is another candidate. Venezuela is the most likely to default, but that economy has been broken for

years.

If you need further evidence why the market is not ready to re-leverage in the commodity space,

take a look at the M&A market. On Monday, billionaire Kelcy L. Warren’s Energy Transfer Equity (ETE)

agreed to a $37.7 billion takeover of competitor The Williams Companies (WMB) that will instantly

transform into one of the largest pipeline operators in the US only to be rivaled by Kinder Morgan.

Following the announcement, both stocks dropped 10%. When the market so emphatically rejects

transactions like this, there’s still some excess left to purge.

Don’t Sleep on Palladium

Palladium has great fundamentals no matter how you look at it. More than 80% of supply comes

from two unstable countries, South Africa and Russia, and the market is forecasted to operate at a deficit

for the next few years. Having said that, you need more than strong fundamentals for the price to keep

rising, and palladium is having a tough year. In May, when it became apparent that Chinese auto sales

were much weaker than expected, the PGM finally gave way to the commodity bear market. Palladium,

long a favorite of hedge funds, was heavily overbought for much of the first half and when positions

started to liquidate, prices fell rapidly – down -35% between May 8 and August 28.

Prices bottomed once the Chinese stock market stabilized, but they got an unexpected boost last

week in the form of VW’s emission scandal. Diesel engines use platinum in catalytic converters (75% of

demand) versus gasoline engines that use palladium. This scandal could have major implications for

future demand of diesel cars, and palladium only stands to benefit. Both of these metals have strong long-

term prospects due to rising cost of production, but palladium is the clear short-term choice. Those

looking for longs to balance a short-heavy portfolio could do worse than adding the ETFS Physical

Palladium Trust (PALL).

Recession in Japan: Technically Speaking

Japan is on the verge of a technical recession after industrial production data for August

unexpectedly fell -0.5% M/M, after a -0.6% M/M decline in July. After GDP contracted -1.2% Y/Y in the

second quarter, economists are now anticipating a -1.0% Y/Y decline in the third. This would be Japan’s

second recession in two years, making Abenomics look like a total dud. JPY is weaker since the program

launched in 2012, but it has done nothing to cure Japan’s structural problems. In fact, the Nikkei priced in

USD is flat over the past 10 years; a different version of a lost decade.

Prime Minister Abe’s economic adviser gave an interview this week saying additional fiscal

stimulus was an “urgent task.” That might help but it would need to be a huge package in order to combat

the slump in demand from China. Similarly, the BoJ could step up its QE purchases, but when do they stop

beating this dead horse? At some point they’ll have to admit that QE does more harm than good. This

makes Japanese stocks interesting at these levels. Institutions are maintaining their long positions (more

than the US) because they know the correlation between NKY and the BoJ balance sheet has held for

several years. However, local pension funds are essentially done buying domestic stocks for now. If

equities in develop markets wobble from here, I expect Japan to fall further and faster than others.

Chart of the Week

The decline we’re witnessing could be about more than fundamentals, it could be a biblical move.

Buying stocks, even blessed ones, when the Pope comes to the US has been a bad move in each of his last

three visits.

One year after Pope John-Paul II visited St. Louis in 1999, the S&P 500 had lost a quarter of its

value. Six months after Pope Benedict swung through the White House, stocks were down 50%. Perhaps

we shouldn’t be surprised that stocks look extremely vulnerable right as Pope Francis heads back to the

Vatican. Some call this coincidence, others call it fate, but as euphoria fades from Pope Francis’s visit, let’s

pray we’re not on the precipice of a systemic crash. I’d like for this section to be longer, but I ran out of

religious puns.

Reader Question:

**Editor’s note: Every week we’ll try to answer at least one reader question. If you would like to submit a question,

please send us an email at info@cup-handle.com. We’d love to hear from you! **

Q: Regarding TLT, any concerns that despite all the macro concerns (Greece, China, commodities, poor equity markets, etc.) it is failing to re-test highs (and its down ytd!)? - CH

A: You make good points about TLT, but I think the issues you mentioned matter more for the 10Y UST.

TLT tends to trade more on long-term inflation/deflation pressures. 30Y yields jumped a lot earlier this

year after the QECB announcement, DXY stalling and several encouraging data points. But that has worn

off. Data is weakening, USD is bulldozing everything but EUR and JPY. It's increasingly clear that QE

doesn't work (or that QE is less effective in Europe and Japan than US QE). US 30Y yields are 150bps

higher than the equivalent in Germany. I think that spread contracts significantly before it widens.

That’s all. See you next week!

For any questions or comments, please email us at: info@cup-handle.com

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