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Monthly Archives: February 2017

The Fed’s Dilemma

The confusion at the Fed continues.

On Wednesday, Jerome Powell justified hiking rates 0.25%, while maintaining their projections of two further hikes this year, by painting an upbeat picture of the U.S. economy.

Such may have been the case in January when the Atlanta Fed sent the current Administration into a “tizzy” with a pronouncement of 5.4% economic growth in the 4th quarter, but not at 1.9% currently. Furthermore, as I discussed just recently:

“Since 1992, as shown below, there have only been 5-other times in which retail sales were negative 3-months in a row (which just occurred). Each time, the subsequent impact on the economy, and the stock market, was not good.”

“So, despite record low jobless claims, retail sales remain exceptionally weak. There are two reasons for this which are continually overlooked, or worse simply ignored, by the mainstream media and economists.

The first is that despite the “longest run of employment growth in U.S. history,” those who are finding jobs continues to grow at a substantially slower pace than the growth rate of the population.”

“Secondly, while tax cuts may provide a temporary boost to after-tax incomes, that income boost is simply being absorbed by higher energy, gasoline, health care and borrowing costs. This is why 80% of Americans continue to live paycheck-to-paycheck and have little saved in the bank.”

The Fed’s dilemma is quite simple.

The Fed must continue to “jawbone” the media and Wall Street as economic growth has continued to remain sluggish. As shown, the Fed continues to remain one of the worst economic forecasters on the planet.

While the Fed is currently “hopeful” of a stronger 2018 and 2019, they are likely once again going to be very disappointed. But in the short-term, they have little choice.

Unwittingly, the Fed has now become co-dependent on the markets. If they acknowledge the risk of weaker economic growth, the subsequent market sell-off would dampen consumer confidence and push economic growth rates lower. With economic growth already running at close to 2% currently, there is very little leeway for the Fed to make a policy error at this juncture.

The Federal Reserve has a very difficult challenge ahead of them with very few options. While increasing interest rates may not “initially” impact asset prices or the economy, it is a far different story to suggest that they won’t. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

The Fed understands economic cycles do not last forever, and after nine years of a “pull forward expansion,” it is highly likely we are closer to the next recession than not. From the Fed’s perspective, hiking rates now, even if it causes a market decline and/or recession, is likely the “lesser of two evils.”

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

Someone has it wrong.  Is it the bond market or the stock market?  Or the Fed?

As bond yields push up against multi-month highs and long-term levels of technical resistance, stocks have been in decline since peaking on January 26, almost two months ago.  In fact, as shown below, the difference between the 2-year Treasury yield and the Fed Funds overnight rate has been climbing sharply since September 2017, as shown below.  The gap between these two interest rates is a market-based estimate of how much the Fed will increase the Fed Funds rate in the coming months.

Moving from markets to the real-world, data from the transportation sector shows that shipments began spiking in Q4 2017.

A measure of traffic that combines shipments and shipping rates shown even more drastic acceleration.

The Fed agrees with the bond market and the economic data, given the following statement in the most recent FOMC press release and the changes to its economic forecasts for GDP growth in 2018 and 2019.

The economic outlook has strengthened in recent months.”

–FOMC Statement, March 21, 2018

The graph above further confirms this. The Fed now expects GDP growth of 2.7% in 2018 and 2.4% in 2019, up from previous forecasts of 2.5% and 2.1% as of December 2017.  The Fed’s forecast of long-run GDP growth (blue line) remained at 1.8%, meaning that the Fed believes the short-term economic performance will be greater than its long-term projection.

In summary, the Fed and the bond market believe that economic growth is accelerating, justifying a series of interest rate hikes that will stop the economy and inflation from growing too quickly.

However, an alternative explanation for the recent growth spurt is also possible.  The hurricanes that struck Florida, Texas and Puerto Rico in September 2017, and the subsequent rebuilding activity, may have been responsible for a one-time spike in economic activity.  Monthly data from the auto sector confirms the alternative explanation, showing a spectacular rise in auto sales in the wake of the hurricane.  But the most recent statistics show auto sales settling back into the range of the last 18 months.

The stock price of General Motors reflects the alternative explanation.  After the hurricane, GM’s stock rose 30% but has now given back almost the entire gain.

The stock price of home builder Lennar Corp. has also undergone a similar round-trip.

In addition, the declining slope of the yield curve is sending signals of disbelief in the narrative of persistently higher growth. The red circles highlight that every time the curve has flattened and inverted since at least 1980, recession has followed.

If indeed the hurricanes produced a spike in rebuilding and general economic activity and inflation in some sectors of the economy, the Fed seems to agree, given its most recent forecasts, shown below.  The Fed sees decelerating GDP growth and stable inflation over the next three years.

Year-End         GDP%               PCE%           Fed Funds

  • 2018                  2.7                   1.9                   2.25
  • 2019                  2.4                  2.1                    2.90
  • 2020                 2.0                  2.1                    3.40

Chairman Powell’s quote from the most recent FOMC press conference validates the Fed’s inflation forecast:

“There is no sense in the data that we are on the cusp of an acceleration of inflation,” Powell told reporters on Wednesday in Washington. “We have seen moderate increases in wages and price inflation, and we seem to be seeing more of that.”

Interestingly, the column on the right in the table above shows that the Fed expects to continue its program of interest rate hikes through the end of 2020.  That is, the Fed expects to tighten monetary policy at a time that GDP growth is slowing and inflation isn’t a threat to rise.  What could explain the Fed’s reaction?  Let’s quote Chairman Powell again:

“This decision marks another step in the ongoing process of gradually scaling back monetary policy accommodation — a process that has been under way for several years now,” Powell said.

With this quote, we are getting closer to the primary explanation of the Fed’s motives.  Maybe the Fed isn’t hiking rates to counteract a rise in GDP growth and inflation.  Instead, the Fed is probably focused on preserving its reputation as a powerful economic actor.

Consider the following scenarios.  Fed interest rate hikes today provide more room to cut them if a recession were to occur at some point in the future.  In that scenario, the Fed rides to the rescue with rate cuts, and could cut rates as an intermediate step before another bout of QE.  That’s important because QE is increasingly being perceived as a primary determinant of income inequality.

It is also possible that recession occurs just after the series of rate hikes.  In that scenario, the Fed’s rate hikes would be perceived as causing a recession. That may not be the ideal scenario because the Fed would take the blame for a “policy mistake.”

However, the third scenario is the worst one.  In that scenario, a recession occurs while the Fed’s interest rate policy is still “accommodative.” That’s a problem for the Fed for two reasons.  First, recessions aren’t supposed to happen when Fed policy is accommodative because it would undermine the main theoretical justification for the Fed’s manipulation of interest rates.  Second, a recession during an era of accommodative Fed policy would leave the Fed very little ammunition to fight it. It is difficult to reduce rates dramatically if they are already on the floor.  Another round of QE, and the political baggage that comes with it would be the likely response.

To be sure, the Fed cares about its executing on its mandates of controlling GDP growth and inflation, however, in conflict, those mandates may be.  But it cares even more about making sure it keeps those mandates, which can only be accomplished if Congress perceives the Fed’s actions actually have a positive impact.  Without the mandates, it can’t execute on them. Therefore, the worst-case scenario for the Fed is for a recession to occur while its interest policy is accommodative.


The conventional wisdom is focused on an upcoming economic boom which will inevitably drive inflation higher, forcing the Fed to respond with higher interest rates in coming years.  In this view, stocks can continue to rise because the boom will produce an upswing in corporate earnings.  It is possible that rising rates could halt a stock market rally, but if the bond market doesn’t have a tantrum, conniption, or some other emotional reaction to the rise in expected growth, then stocks will be good investments.  For bonds, disaster will be averted because modest capital losses in the bond market will be offset by annual coupon interest.

An alternative explanation is that economic growth is already slowing from a one-time spike that occurred in the wake of the hurricanes.  Transportation costs have spiked higher as goods needed to be physically transported to the affected areas.  But it is likely that transportation costs will retreat soon if it hasn’t already begun. Similarly, the stocks of auto and homebuilding stocks have retraced most of the gains they made shortly after the hurricane.  A recession is not necessarily in the cards for 2018 or 2019, but expecting a sustained boom in coming years based on hurricane-related activity is to extrapolate a one-time event.  In the alternative explanation, stocks and junk bonds are expensive while Treasury bonds are oversold and due for a trading bounce, and maybe even more.

As to the Fed, its behavior is better explained by concern for its institutional reputation than by a change in economic outlook.  The Fed plans on hiking rates in 2018, 2019, and 2020, even though it forecasts that GDP growth will decelerate and inflation will remain stable. In those conditions, the Fed would be expected to cut rates, not hike them.

It’s hard for one of the biggest bond managers in the world to forecast a recession when financial conditions are as favorable as they are now. Still, PIMCO isn’t sure if the global economy is being propelled by the “sugar rush” of easy financial conditions. The firm’s global Economic Advisor and Chief Investment Officer of Global Fixed Income, Joachim Fels and Andrew Balls, respectively, write in a new paper that their base case hypothesis remains that the global economic expansion is demand-driven, but they have “considerable uncertainty around this key question.”

Fels and Balls report that the bond behemoth in Newport Beach, Calif. now forecasts modestly higher 2018 GDP growth than it did at the end of 2017 in the U.S., eurozone, the U.K., and China. However, it has lowered its expectations for Mexico and India. Overall, the global forecast for growth remains in the 3.0%-3.5% range.

PIMCO concedes that their forecasts are baked into asset prices. In other words any disappointment on growth or inflation estimates would spell bad news for portfolios, so the firm remains conservatively positioned.

PIMCO views the U.S. Government’s infrastructure plan as having a “low probability” of passing through Congress anytime soon. The firm’s municipal bond team offered that contribution from the states to such a plan would be limited given “lack of fiscal space in many state coffers.”

On trade policy, PIMCO expects the tariff proposals on steel and aluminum to be “watered down further” beyond the exemptions already given to Canada and Mexico. Retaliation by Europe and others should also be limited. Neither would broader protectionist action against China regarding intellectual property spark an aggressive response.

On emerging markets, the firm remains mildly optimistic, but is aware of growth slowing due to deteriorating demographics, political risks, and protectionist sentiment.


New Neutral Intact?

Immediately following the financial crisis, PIMCO propounded a “New Normal” or “New Neutral” thesis arguing (correctly) that subsequent growth would be tepid and interest rates would be low. The firm relied on an influential book from economists Ken Rogoff and Carmen Reinhart called This Time It’s Different, a historical examination of debt crises that claimed past crises tended to slow future growth until the debt was worked off.

Currently, the firm thinks the thesis is intact because of all the debt that’s still accumulated and the need for economies to keep rates low in order to maintain growth. But PIMCO is slightly less certain about its view that rates must remain as low as they’ve been. Demographics influencing the new normal have not changed, however, and the firm doesn’t think tax cuts in the U.S will spur meaningful long-term growth. Fels and Balls write that while there is some risk to rising yields, “we do not think that we are at the start of a secular bear market for bonds.” The authors add that there is a good chance that there will be a recession over the next 3-5 years, and that there will be “limited capacity for conventional monetary policy, compared with historical experience” at that time.


Investment Implications And Portfolio Positioning

As a consequence of this analysis, PIMCO is avoiding big macroeconomic bets currently. The firm maintains “modest duration underweights,” including in Japan. The firm is also mildly overweight in TIPS. PIMCO tends to avoid generic corporate bonds, and gets its corporate exposure from short-dated structured products. The firm also likes some non-agency mortgages currently. The firm prefers to get exposure to emerging markets through currencies rather through bonds at the moment. Currencies are “the best way to express a positive view on EM fundamentals and to generate income.” PIMCO is neutral on U.S. stocks, but likes Japan, as it anticipates earnings growth there. Finally, the firm is modestly overweight in commodities – especially energy and base metals — “due to their stand-alone return prospects and their potential diversification benefits should the global economy accelerate, elevating realized inflation.”


Outlook for Major Economies

For the U.S., PIMCO expects above-trend real GDP growth in the 2.25% to 2.75% range in 2018. Low unemployment should continue, putting some pressure on wage growth and consumer price inflation. The Fed will gradually push rates higher under new leadership, making progress toward the 2% objective.

Growth momentum is strong and financial conditions are favorable in the eurozone. GDP growth should be between 2.25% and 2.75% for the year. The eurozone recovery is now broader than it has been in the past. Inflation and wage pressure are down, however, because of remaining labor slack and “persistent competitiveness gaps among member states.” PIMCO doesn’t anticipate a rate hike from the ECB until mid-2019.

In the U.K., PIMCO expects 1.5%-2% real GDP growth in 2018. Growth should pick up with progress toward separation from the EU. The Bank of England should hike rates twice unless Brexit talks break down.

PIMCO’s base case for Japan is a continuation of growth in a 1%-1.5% range. With an unemployment rate below 3%, wage growth should pick up, helping core inflation to rise to slightly below 1%.

Finally, PIMCO expects a “controlled deceleration” of China’s GDP growth toward around 6%-7%. Inflation should accelerate on a core basis and from higher oil prices. This should encourage the People’s Bank of China to hike rates. PIMCO is neutral on China’s currency, and expects China to control capital flows to damp exchange rate volatility.

Yesterday, on the Real Investment Hour” we were privileged to visit with Nomi Prins to discuss the Fed’s rate hike decision yesterday and the end result of the ongoing surge in debt combined with continued Central Bank interventions.

Spoiler Alert: “It Ain’t Good.” 

Nomi, is also graciously giving our readers an “exclusive 40% discount” on her upcoming book “Collu$ion”  just by clicking the link below:

Pre-Order “COLLU$ION” Now – 40% OFF

Enjoy the interview and order the book.

As noted by Robert Schroeder:

“Last week, the debt hit $21 trillion for the first time, rising from the $20 trillion mark it notched on Sept. 8. The debt is guaranteed to go higher, with President Donald Trump having signed a debt-limit suspension in February, allowing unlimited borrowing through March 1, 2019. Economists expect wider deficits to result from the tax cut Trump signed in December.

While a trillion-dollar increase over roughly six months isn’t unprecedented — there was one in 2009, during the Great Recession, and another in 2010 — it’s certainly fast.”

Excessive borrowing by companies, households or governments lies at the root of almost every economic crisis of the past four decades, from Mexico to Japan, and from East Asia to Russia, Venezuela, and Argentina. But it’s not just countries, but companies as well. You don’t have to look too far back to see companies like Enron, GM, Bear Stearns, Lehman and a litany of others brought down by surging debt levels and simple “greed.” Households too have seen their fair share of debt burden related disaster from mortgages to credit cards to massive losses of personal wealth.

It would seem that after nearly 40-years, some lessons would have been learned.

Apparently not, as Congressional lawmakers once again are squabbling on not how to “save money” and “reduce the federal debt,” but rather “damn the debt, full speed ahead with spending.”

Such reckless abandon by politicians is simply due to a lack of “experience” with the consequences of debt.

In 2008, Margaret Atwood discussed this point in a Wall Street Journal article:

“Without memory, there is no debt. Put another way: Without story, there is no debt.

A story is a string of actions occurring over time — one damn thing after another, as we glibly say in creative writing classes — and debt happens as a result of actions occurring over time. Therefore, any debt involves a plot line: how you got into debt, what you did, said and thought while you were in there, and then — depending on whether the ending is to be happy or sad — how you got out of debt, or else how you got further and further into it until you became overwhelmed by it, and sank from view.”

The problem today is there is no “story” about the consequences of debt in the U.S. While there is a litany of other countries which have had their own “debt disaster” story, those issues have been dismissed under the excuse of “yes, but they aren’t the U.S.”

As I discussed recently in relation to the tax cut/reform package passed by Congress last year:

“Of course, the real question is how are you going to ‘pay for it?’

Even as Kevin Brady noted in our interview, when I discussed the ‘fiscal’ side of the tax reform bill, without achieving accelerated rates of economic growth – ‘the debt will balloon.’”

It is pretty simplistic math:

Cut revenue by $2 Trillion + add $2 Trillion is spending = $4 Trillion shortfall.

While it is true the debt doesn’t have to be repaid today, it does have to be serviced.

Committee for a Responsible Federal Budget president Maya MacGuineas recently published a commentary describing how interest is on a path to quadruple over the next decade, reaching over $1 trillion per year.

“Interest on the debt is the fastest growing part of the budget. While interest had already been projected to rise rapidly the recent tax and budget deals will significantly accelerate that growth. As a result, our latest estimate finds interest costs will almost quadruple between 2017 and 2028 in dollar terms and reach their highest share of Gross Domestic Product (GDP) in history.

As recently as last June, the Congressional Budget Office (CBO) projected interest spending would grow to above $800 billion and nearly 3 percent of GDP by 2027 as a result of rising interest rates and growing debt levels. Since then, lawmakers have added an additional $2.4 trillion to deficits over the next decade, and it will most certainly result in higher interest payments.

By our estimates, annual interest spending will rise from $263 billion (1.4 percent of GDP) in 2017 to $965 billion, or 3.3 percent of GDP, in 2028. The 3.3 percent of GDP total for interest in 2028 would be the highest on record. The previous record was 3.2 percent of GDP in 1991, a time when debt as a percent of GDP was much lower but interest rates were much higher. Under our “Alternative Scenario,” which assumes policymakers borrow an additional $3.6 trillion through 2028, interest spending will rise to $1.05 trillion, or 3.6 percent of GDP, by 2028.”

The Wrong Kind Of Debt

By the end of 2018, the United States, based on its current trajectory, will achieve a new TOP 10 ranking.

“Tell us what we’ve won Bob:

Coming in at #10 – the United States, at 111%, gets nothing but the privilege of being on the list of countries with the highest debt/GDP ratios.”

According to Keynesian theory, some microeconomic-level actions, if taken collectively by a large proportion of individuals and firms, can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession).

Keynes contended:

“A general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  

In other words, when there is a lack of demand from consumers due to high unemployment, the contraction in demand would force producers to take defensive actions to reduce output.

In such a situation, Keynesian economics states:

“Government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.”

Keynes’ was correct in his theory”

In order for government deficit spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

Read that again.

The problem is that government spending has shifted away from productive investments that create jobs (infrastructure and development) to primarily social welfare and debt service which has a negative rate of return.

According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

In 2017, the Federal Government spent an estimated $4.3 Trillion which was equivalent to roughly 21% of the nation’s entire GDP. Of that total spending, an estimated $3.68 Trillion was financed by Federal revenues leaving $657 billion to be financed through debt. In other words, it took almost all of the revenue received by the Government just to cover social welfare programs and service the interest on the debt. 

Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

It now requires $3.71 of debt to create $1 of economic growth.

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy growing at an average rate of just 2%, the economic deficit has never been greater.

The unsustainable credit-sourced boom, which leads to artificially stimulated borrowing, has sought out diminishing investment opportunities. Ultimately these diminished investment opportunities lead to widespread mal-investments. Not surprisingly, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk.

We see it again today with companies issuing massive amounts of debt to buy back unprecedented levels of outstanding shares and issues dividends.

The illusion of economic growth has been fueled by ever increasing levels of debt to support consumption. However, if you back out the level of debt you get a better picture of what is actually happening economically.

When credit creation can no longer be sustained the markets must begin to clear the excesses before the cycle can begin again. That clearing process is going to be very substantial. With the economy currently requiring roughly $3.50 of debt to create $1 of economic growth, the reversion to a structurally manageable level of debt would involve a $25 trillion reduction of total credit market debt from current levels.

The economic drag from such a reduction would be a devastating process, and why Central Banks worldwide are terrified of it. In fact, the last time such a reversion occurred it became known as the “Great Depression.”

Now you understand “why,” despite tax cuts and reforms, the economy continues to grow at sub-par levels. Heading into the future, given the Administrations inability to curb their “spending addiction,” it is highly likely we will witness an economy plagued by more frequent recessionary spats, lower equity market returns and a stagflationary environment as wages remain suppressed while costs of living rise.

Sure, $21 trillion isn’t a problem as long as we “print the money” necessary to make those payments. However, the longer-term consequences of doing so has a very negative consequence. One of those consequences is the ongoing detraction from economic growth.

As Ms. Atwood concluded:

“There’s nothing we human beings can imagine, including debt, that can’t be turned into a game — something done for entertainment. And, in reverse, there are no games, however frivolous, that cannot also be played very seriously, and sometimes very unpleasantly.

But when the play turns nasty in dead earnest, the game becomes what Eric Berne calls a ‘hard game.’

In hard games the stakes are high, the play is dirty, and the outcome may well be a puddle of gore on the floor.”

There is likely only one way the current lack of fiscal control turns out. History is replete with countries that have attempted the same. For now, the limits of profligate spending by Washington has not been reached and the ending of this particular story has not yet been written. But it eventually will be.

Just be careful where you step.

See Part 1 – Here

In this second installment relating my trip to the Research Affiliates Advisor Symposium in Newport Beach, CA, I will discuss the firm’s second major line of research, which involves the appraisal of global asset classes. The firm manages the PIMCO All Asset (PAAIX), and All Asset, All Authority (PAUIX) funds. These are global asset allocation funds that seek the maximum real return, often by emphasizing non-mainstream asset classes. The funds own stocks, bonds, commodities, and currencies through underlying PIMCO funds. Over the long haul, the goal of All Asset is to beat TIPS and inflation by 5 percentage points, while the goal of All Asset, All Authority is to beat the S&P 500 and inflation plus 6.5 percentage points. Research Affiliates thinks these inflation goals are tall orders currently.

For example, a glance at the asset allocation part of the firm’s website shows that U.S. stocks are poised to deliver no return over inflation over the next decade. Stocks from developed countries, by contrast, are expected to deliver a little more than a 4% annualized real return, and those from emerging markets are expected to deliver nearly a 6% annualized real return. Besides emerging markets stocks, no asset class, save private equity, is likely to deliver more than a 5% real return.

First, Chris Brightman, CIO of Research Affiliates, led the attendees through the firm’s asset class returns. Bonds returns, of course, follow starting yields closely throughout history with a correlation of 0.96 between starting yields and future 10-year returns. Similarly, strong correlations exist globally.

In equities future returns follow starting earnings yields, using the inverse of the CAPE Ratio (Price relative to the past decade’s worth of real average earnings). The correlation between starting earnings yields and subsequent 10-year returns is 0.75 since 1926, though admittedly, returns have been higher lately. Again, similar correlations exist in other countries.

The current level of the CAPE implies a roughly 80% overvaluation of stocks. Other metrics, including Market Capitalization relative to GDP, Tobin’s Q, and Hussman’s PE show similar overvaluation. There’s hardly a way to look at US stocks, and not conclude that they are overpriced. Among Western developed countries, only the UK appears as if it is priced to deliver a real return of more than 5% for the next decade.


A Demographic Interlude

During his talk, Brightman speculated on why valuations seem to be higher than in the past. He remarked that macroeconomic volatility is lower today than it’s typically been in an agrarian economy where bad weather can wreak economic destruction. There are arguably lower risks in a post-industrial economy, and perhaps this is properly reflected in lower return prospects. There is also a greater ease in investing with the advent of index funds and ETFs; it’s easier to obtain a more diverse, lower-cost portfolio.

Brightman also made a demographic observation – an increasing percentage of older people in an economy tends to lower productivity growth. This, in turn, has an influence on real rates of return. Brightman used the example of teenagers who consume a lot and produce nothing. But when teenagers get to be, say 25 years old, the rate of change in their productivity from the time they were 15 is extremely high. Similarly, there is a great rate of change in productivity from the ages of 25 to 35. But then there is a lower rate of change from 35 to 45, and after 45 there is no difference in growth. Then, when adults become old, they revert to being teenagers again – consuming a lot, but producing little. The difference is that teenagers have parents and senior citizens have assets – and that’s why asset prices are higher and return prospects lower.

All of this means that the U.S. enjoyed a period of superior growth as the baby boom generation matured and entered the work force. In other words, the post-war demographic trend flattered the superior growth of that period, and without similar demographic trends, the growth likely can’t repeat. It’s possible that stocks can deliver higher returns if earnings-per-share growth increases, but for three or four decades the ratio of profits to GDP has been growing. Brightman was skeptical that corporate profits could continue growth faster than the economy because, if that trend continued, it would likely violate rules of social equity. It’s likely that corporate profits will not grow faster than GDP from this point.


Non-Mainstream, Better Beta, and Rebalancing

Investors have a few options to boost returns. First they can consider non-mainstream stocks and bonds. Emerging markets, as previously mentioned, are poised to deliver higher returns than financial assets from developed countries. In fact, Rob Arnott, in his talk on after-tax returns, volunteered that one-third of his liquid net worth is in emerging markets equities. Second, investors can potentially extract greater returns from low-returning asset classes by using smart beta strategies such as fundamental indices. Capitalization weighted indices can’t deliver excess returns, and active management cannot collectively beat the market. Third, investors can rebalance diligently across asset classes instead of buying and holding, which tends to overweight recent winners. “Tactical over-rebalancings,” as Brightman puts it, can help boost returns.

Brightman’s three recommendations make me think investors need good advisors now as much as ever. Individual investors aren’t always comfortable choosing non-mainstream asset classes. They also aren’t as able to pick smart beta funds as they are plain index funds. Moreover, investors aren’t likely to pick the best smart beta funds, which, as Brightman’s colleague FeiFei Li noted, are not always characterized by the lowest expense ratio. Last, advisors are probably better equipped to accomplish the rebalancing that Brightman thinks will be a significant part of a successful investor’s future returns.

U.S. Treasury securities across the maturity spectrum are reaching yield resistance levels that have proven for decades to be extremely valuable to investors engaged in technical analysis. We believe it is possible the reaction of interest rates to these resistance levels will hold important clues about future economic activity and the direction of the stock market. While it is certainly possible that Treasury yields meander and prove these decade-old technical levels meaningless, strategic planning for what is certainly a heightened possibility of large asset moves is always wise.

Many investment pundits are scoffing at the recent move higher in Treasury yields. Since record low yields were set in mid-2016, the ten-year U.S. Treasury note has risen by about 1.50%. When compared to increases of three to five percent that occurred on numerous occasions over the last 30 years, it’s hard to blame them for barely raising an eyebrow at a mere 1.50%. What these so-called experts fail to grasp, is that the amount of financial and economic leverage has grown rapidly over the last thirty years. As such, it now takes a much smaller increase in interest rates to slow economic growth, raise credit concerns, reduce the ability to add further debt and generate financial market volatility.

The 1.50% increase in interest rates over the last two years is possibly equal to or even more significant than those larger increases of years past. In this article, we look back at how the economy and assets performed in those eras. We then summarize potential economic and market outcomes that are dependent on the resolution of current yields against their resistance levels.

Technical Analysis

In October 1981, following a period of strong inflation and dollar weakness, the yield on the ten-year U.S. Treasury note peaked at 15.84%. Since those daunting days, bond yields have gradually declined to the lowest levels in U.S. recorded history. To put the duration of this move in context, no investment professional under the age of 60 has worked in a true secular bond bear market.

During this long and durable decline in interest rates, there were periods were interest rates moved counter to the trend. In some cases, moves higher in yield were sudden and the effects on the economy and financial markets were meaningful. In our article 1987, we showed how an increase of over 3.00% on the ten-year Treasury note over a ten month period was a leading cause of Black Monday, the largest one-day loss in U.S. stock market history.

Interestingly, historical short-term peaks in yield have been technically related. When graphed, the peaks and troughs can be neatly connected with a linear downward sloping channel, which has proven reliable support and resistance for yields. The graphs below show the decline in yields and the respective channels for Two, Five and Ten-year Treasury notes. Our focus is on the resistance yield line, the upper line of the channels.

Two-Year Note

Five-Year Note

Ten-Year Note

The composite graph below shows all three securities together with labeled boxes that correspond to commentary beneath the chart for each era.

All Graphs Courtesy: Stockcharts

#1 1986-1990- This period followed a significant reduction of yields as then-Fed Chairman Paul Volcker (1979-1987) successfully employed higher interest rates to tame double-digit inflation and restore faith in the U.S. Dollar. Despite inflation being “conquered” and interest rates dropping meaningfully, interest rates reversed course and began moving higher again. In the first ten months of 1987, the ten-year U.S. Treasury yield rose approximately 3.00%. Higher yields coupled with several other factors produced Black Monday, a 22% decline in the Dow Jones Industrial Average that is still the largest one-day loss on a percentage basis in U.S. equity market history. Following the 1987 stock market turmoil, yields receded. This decline was short-lived, and by early 1989, yields had exceeded the levels of 1987. Marked by the Savings & Loan Crisis, a recession followed from July 1990 to March 1991 in which GDP declined by 5.3%. From peak to trough, the S&P 500 declined 20%, and the 10-year Treasury note yield would decline by 3.75% over the next three years.

#2 1994-1995- This period is coined “the Great Bond Massacre.” In only 14 months, 2-year Treasury note yields rose over 4%. Starting in February of 1994, the Fed increased the Fed Funds rate in a move that, despite previous warnings from Greenspan, caught investors and Wall Street off guard. The Fed continued a series of rate hikes that inflicted heavy damage on insurance companies, mutual funds, hedge funds and other leveraged bondholders. In the years preceding this era, the growing use of securitized fixed income products, derivatives and leverage magnified the damage that would typically be caused by a similar change in interest rates. The tail end of this period was marked by the Mexican Peso crisis and the Orange County, California bankruptcy. Both events were directly the result of the rise in interest rates. Despite damage to bondholders and the liquidation of some large funds, the effects on the economy and stock investors were surprisingly small.

For more information on this event, we recommend reading The Great Bond Massacre, published by Fortune in 1994.

#3 1998-2001- Despite a strong U.S. economy in 1997 and 1998, various financial events such as the Russian debt default, Asian financial crisis and the implosion of the poorly named hedge fund Long Term Capital Management (LTCM) resulted in Alan Greenspan and the Fed reducing the Fed Funds rate. Unlike other instances in which the Fed provided an economic boost to the economy, this stimulus occurred with an economy that, by all measures, was running hot. Productivity was rising as technological innovation seemed endless, and government deficits were turning to surpluses. Easy money fed rampant speculation in the stock market, especially the tech sector.

In 1999, the Fed started raising rates, and the entire yield curve followed. Over this period of slightly more than a year, ten-year notes rose by about 2.75% and reached their peak in January 2000. In March of 2000, the NASDAQ reached an all-time high that would not be eclipsed for another 16.5 years. By the third quarter, higher interest rates and the popping of the tech bubble resulted in a recession that would last three quarters. From the peak in yields to June 2003, ten-year note yields declined by 3.75%. From peak to trough, the S&P 500 fell by over 50% and the NASDAQ by a staggering 83%.

#4 2004-2007- In the aftermath of the tech crash and recession of 2001, the Fed kept the fed funds rate at or below 2% for over two years. Instead of setting rates at a level appropriate for the level of economic growth, they used generous monetary policy to help reignite the financial fervor of the late ‘90’s. While the benefits of excessive stimulus helped all financial assets, the housing sector seemed to benefit most. In 2004, the Fed sensed stronger economic growth. Over the next three years, they would gradually increase the Fed Funds rate by 4.25% from 1.00% to 5.25%. From 2003 to 2007, the ten-year note yield rose 2.25%. Shortly after the peak in yields, real-estate prices crashed nationwide, and the great financial crisis ensued. From 2007 to 2009, GDP declined 5.1%, and the S&P 500 again fell over 50%. To combat the crisis, the Fed lowered the fed funds rate to zero, provided a large number of generous bailouts for financial institutions and introduced Quantitative Easing (QE).


Monetary policy has remained in crisis mode ever since 2008. As a result, interest rates reached levels never seen before in U.S. history. The Fed bought over $3.5 trillion of U.S. Treasury and mortgage-backed securities via QE of which about two-thirds of the purchases occurred well after the economy was out of recession. In late 2015, the Fed began to slowly increase the fed funds rate, and the Fed appears set to take a more aggressive approach this year. They have also begun to slowly reduce their balance sheet by allowing securities purchased during QE to mature without being replaced. As a result of the tighter monetary policy, yields have begun to rise. Thus far, financial conditions remain stimulative, and the increase in yields has not been nominally comparable to the previous periods detailed above. As discussed at the beginning of the article, it is not just the level of rates but the amount of debt outstanding that matters. This was the lesson learned by many in 1994 and it holds even truer today.

Currently, all three Treasury note yields are perched up against their technical resistance lines. From this, we can conclude there are three likely scenarios.

  1. Resistance holds and yields decline sharply as they have done in the past
  2. Yields break above the trend line, marking the end to the 35-year-old bond bull market
  3. Yields meander with no regard for the dependable technical guideposts that have worked so well in the past.

Bond Investors and holders of other financial assets should pay close attention to this dynamic and be prepared. The following summarizes expectations for the three scenarios listed above.

  1. Resistance holds and yields decline sharply– If yields decline sharply as they have previously, it will likely be due to slowing economic activity and/or a flight to quality. A flight to quality, in which investors seek the safety of U.S. Treasuries, is typically the result of financial market volatility and/or a geopolitical situation. Given extreme equity valuations, investors should be prepared for significant stock price declines, as was witnessed three of the past four times the resistance level was reached and held.
  2. Yields break through the trend line – If resistance does not contain yields, it is quite likely that technical traders will take the cue and accelerate bond selling and shorting, leading to the possibility of a sharper increase in yields. This condition could be further aggravated by poor supply and demand dynamics for Treasury securities as noted in Deficits Do Matter. Given the amount of economic and financial leverage outstanding as well as the economy’s dependence on low interest rates, we expect growth will suffer mightily if yields rise aggressively. In turn, this will dampen corporate earnings and ultimately weigh on stock prices.
  3. Yields meander– This is the Goldilocks scenario for the economy and the financial markets. This scenario rests on a healthy equilibrium in the economy where growth is moderate, and inflation remains tame. Given that current interest rates are not high enough to significantly harm economic growth or hinder government borrowing, we suspect that the massive fiscal stimulus along with decent global growth will keep GDP propped up. We also suspect that, despite high valuations, stocks would likely be stable to higher.


Of the three possible scenarios, rates meandering holds the lowest probability.

The historical interest rate events discussed above offer hints that allow investors to better assess the possibility of each scenario but, unfortunately, with unusually poor clarity. The reason is our starting point on this occasion is without historical precedence. We are at the lowest levels of interest rates in the history of mankind and the highest amount of leverage. To make matters worse, central banks don’t understand the effects of their recent interventions.

The economy has just received a large fiscal boost via the tax cut and new budget agreement which will be accompanied by large deficits for years to come. The growth impulse over the next several quarters will be meaningful, but there are a variety of offsets. First, the Fed is hiking rates and removing unconventional stimulus (QE). Second, tariffs intended to level the trade paying field hold an uncertain outcome but run the risk of stoking both inflation and the ire of foreign trading partners. Geopolitical risks remain elevated, and those come with the small but real threat of an exogenous shock to the economy. Synchronous global growth appears to be forming, but recent data from China and Europe imply economic deceleration. Uncertainties remain quite high and are not being accounted for in the price of risky assets.

The one sure thing we would bet on for the remainder of 2018 is more volatility in every asset class, including interest rates. As a direct input into the pricing of all financial securities, higher volatility tends to imply lower stock prices and wider credit spreads on high-yield debt. As such, bond and stock investors should equip themselves to deal with volatile markets. The reprieve of the moment is a gift and should humbly be viewed as such.


Say the word and watch facial expressions.

They range from fear, disgust, confusion.

Billionaire money manager and financial pitchman Ken Fisher appears as the senior version of Eddie Munster in television ads for his firm.

He stares. Deep eyes ablaze with intensity. The tight camera shot. A dramatic pause, then solemnly he delivers the line:

“I hate annuities. I’d rather go to hell then sell annuities.”

Which obviously means you should too. The financial professional with a net worth of 500,000 Americans put together doesn’t need to worry much about lifetime income or portfolio principal loss. Obviously, he doesn’t believe you need to, either.

No offense but…

Let’s face it.

Ken Fisher is a master marketer. There’s no doubt of his prowess to pitch his wares. He’s raised megabucks for his firm. However, what he knows academically about annuities and how they mitigate life expectancy risk can fit in to a dollhouse thimble. And that’s fair because he doesn’t need to worry about running out of wealth. You most likely do.

Based on past comments he made in print about the financial planning industry, deeming it ‘unnecessary,’ I understand why he isn’t a fan of anything or anyone but himself. If you’re close to retirement or in retirement income distribution mode, you will pay for his overconfidence.

Unfortunately, what Ken Munster (I kid), is correct about is you as a consumer and investor must be skeptical of annuities as they are customarily offered. As they ‘sold first and planned for later.’

An annuity solution shouldn’t be on the radar until holistic financial planning is completed to determine whether there’s longevity risk – a strong probability of an investor outliving a nest egg. Annuities, especially deferred and immediate income structures, take the stress off a portfolio to generate lifetime income and places that risk with insurance companies. Fixed annuities that allow owners to participate in the upside of broad stock market indexes can be used as bond replacements.

Respected Professor Emeritus of Finance at the Yale School of Management and Chairman, Chief Investment Officer for Zebra Capital Management, LLC Roger G. Ibbotson, PhD, in a comprehensive white paper released last week, outlined how fixed indexed annuities which provide upside market participation and zero downside impact may be attractive alternatives to traditional fixed income like bonds.

In an environment where forecasted stock market returns may be muted due to rich valuations and bond yields still at historic lows, FIAs eliminate downside stock market risk and offer the prospect of higher returns than traditional asset classes. Ironically, at our Clarity investment committee two weeks ago, one of our partners, Connie Mack showcased a similar strategy based on our organization’s lowered return projections for traditional stock and bond portfolios.

Per Roger Ibbotson:

“Generic FIA using a large cap equity index in simulation has bond-like risk but with returns tied to positive movements in equities, allowing for equity upside participation. For these reasons, an FIA may be an attractive alternative to (long-term government bonds) to consider.”

In financial services, Ibbotson is a god. Brokers and advisors have been misrepresenting to consumers his seminal chart of 100-year stock market returns for as long as I’ve been in the business. The chart outlines how domestic large and small company stocks compound at 10-12% and beat the heck out of bonds, bills and inflation; financial professionals showcase the lofty past returns and convince customers that without buying and holding stocks for the long term (whatever that is), they’ll succumb to the vagaries of inflation. Adhere to the chart and your portfolio will have it made in the shade! (if invested in stocks for 100 years plus).

In all fairness to Roger Ibbotson, it’s not his fault that his data and graphics have been used to seduce investors to bet their hard-earned wealth on investment fantasy. He’s been in favor of annuities in retirement portfolios and in accumulation portfolios leading up to retirement for a long time.

Investment fantasy:

Investor reality:

It took nearly 14-years just to break even and 18-years to generate a 2.93% compounded annual rate of return since 2000. (If you back out dividends, it was virtually zero.) This is a far cry from the 6-8% annualized return assumptions promised to “buy and hold” investors and the 10-12% promised by financial pros who misrepresent Ibbotson’s work.

Investors if lucky, have 20 years to save interrupted. As labor economist and nationally-recognized expert in retirement security professor Teresa Ghilarducci shared with us recently on the Real Investment Hour – “Life has a way of getting in the way.”

I have yet in my 28 years in the business to meet a Main Street investor who’s achieved or achieving the long-term returns displayed in Ibbotson’s chart. The information is correct; how it’s used to sucker investors into “buy & forget” portfolios regardless of valuations and market cycles is unfortunate.

It’s time to provide the real story about annuities – the most popular types available, financial guardrails or rules to consider before annuities are purchased, what consumers should look for in a product and most important, what should be avoided.

Not every annuity product is ‘the devil.’

Unfortunately, all annuity types get lumped together and blanketed by the same sordid reputation.  Those who push annuities to collect attractive commissions ostensibly leave buyers confused (annuities by nature are complex), and regretful; these products are not explained well upfront and once the sale is complete, the consumer is usually left to figure out alone the intricacies of the contract.

Sales people tend to attach expensive riders (add-ons), to annuities that consumers may or may not need. Overall, the process is not a positive experience. Bad press and poor sales practices make annuities one of the most misunderstood products out there.  It’s a shame because annuities can help mitigate longevity risk and increase the survival rate of traditional stock and bond retirement portfolios.

Good-intentioned and knowledgeable financial professionals are not inured against falling for pervasive horror stories when in fact they could be doing their clients a disservice by ignoring benefits annuities can bring to the table for those who have high probabilities of outliving assets that generate income in retirement.

So, let’s get basic. Ground floor.

What is an annuity, anyway?

An annuity is a sum of money, generally paid in installments over a contract owner’s lifetime or that of the owner and a spouse or a beneficiary. Annuities are insurance products that guarantee a lifetime income stream. Pensions are considered annuities. Yes, Social Security is an annuity (guaranteed by the Federal Government).

For years, several well-known money managers and syndicated financial superstars have overwhelmed social, television and weekend radio media with negative information about annuities.

Several types of annuities can be incorporated into a holistic financial plan.

It’s time Real Investment Advice readers understand the truth.

Here’s real investment advice lessons for three of the most popular annuity structures:

Variable Annuities: “The Black Sheep.”

Variable annuities are a hybrid. A blend of mutual funds and insurance. Guarantees come in the form of death benefits to beneficiaries or payouts for life if annuitized which means the investment is converted by the respective insurance company into a series of periodic payments over the life of annuitant or owner of the contract. Variable annuities are ground zero for negative press as they can be expensive and generate big commissions for brokers.

Earnings are tax deferred and taxed as ordinary income upon withdrawal. Investments in variable annuities are best outside of tax-sheltered accounts like IRAs which are already tax deferred. Investment choices are plentiful. There are various riders that may be attached. The most common is the GLWB or Guaranteed Lifetime Withdrawal Benefit rider which guarantees a lifetime income withdrawal percentage on the principal invested or the account value, whichever is greater. Owners barely understand how variable annuities operate; many don’t realize their contracts contain riders, how much they cost, or what they do. I frequently deal with the frustration people feel.

Candidly, I cannot consider a valid reason for consumers to purchase variable annuities. In its purest form, an annuity should provide lifetime income, increase retirement portfolio longevity and possess zero downside risk to principal. Most investors possess exposure to variable assets such as stocks and bonds through company retirement plans already. I see little rationale to mix financial oil and water through variable annuities that combine insurance and mutual funds. The marriage of these two appears to be nothing more than a mission to generate revenue for the respective industries.

If you own a variable annuity within an IRA, consider liquidating it and transferring to a traditional IRA, preferably at a discount brokerage firm. Be wary of surrender charges that may occur upon liquidation. Non-qualified or variable annuities purchased with after-tax dollars can be liquidated however, taxes and withdrawal penalties may apply. It’s best to sit with a fiduciary who is proficient with annuities to assist with a strategy to unwind from this product.

Fixed Annuities. “The Quiet Ones.”

Fixed annuities or “multi-year guaranteed” annuities or MYGAs are essentially CD-like investments issued by insurance companies. They pay fixed rates of interest in many cases higher than bank certificates of deposit over similar periods.

An important difference is while CDs are FDIC-insured, fixed annuities are only as secure as the insurance companies that issue them; financial strength of the organizations considered, is paramount.  A.M. Best is the rating service most cited. Search the rating service website for the insurance company under consideration here. There are six secure ratings issued by Best. Consider exclusively companies rated A (Excellent) to A++ (superior). For ratings of B, B- (Fair), understand thoroughly your state’s coverage limits. Avoid C++ and poorer rated companies altogether.

Fixed annuities in the case of insurance company insolvency, are backed by the National Organization of Life & Health Insurance Guarantee Associations and each state has a level of protection. For example, in Texas, the annuity benefit protection is $250,000 per life.

The predictability of a set payout and limited risk to principal make MYGAs a popular option for retirees who seek competitive fixed rates of interest.

Fixed Indexed Annuities – “A Cake & Eat Some Too.”

Fixed indexed annuities get under the skin of one financial superstar asset allocator who dismisses stock market losses as no big deal (I mean markets rebound eventually, correct?). Losses don’t appear to be a big concern for him or his clients.

As the granddaddy of financial radio personalities, the gentleman relishes the calls in to his radio show that express concerns about annuities, especially fixed indexed annuities as he gets another opportunity to proudly remind his national audience – “so, with these products, you don’t get all the market upside!” Believe me, he’s all about the upside because markets only move in one direction from where he sits. From where you sit and what Roger Ibbotson believes, there’s a strong probability ahead for lower returns on traditional asset classes which include long-term bonds.

So, what are fixed indexed annuities?

First, they are not products that invest directly in stock markets. They are insurance vehicles that provide the potential for interest to be credited based on performance of specific market indexes. Selections within these fixed annuities allow owners to participate in a fixed percentage of the upside of a market index or earn a maximum rate of interest that’s based on the percentage change in an index from one anniversary date (effective date of ownership), to the next. A strategy identified as “point-to-point.”

Second, fixed indexed annuities are characterized by a ‘zero floor,’ which simply means there’s no risk of market downside. Owners may get a goose-egg of a return for a year, that’s true. However, there’s no need to make up for market losses, either.

As stated in the academic research published by Mr. Ibbotson:

“This downside protection is very powerful and attractive to many individuals planning for retirement. In exchange for giving up some upside performance (the 60% participation rate), the insurance company bears the risk of the price index falling below 0%. The floor is one way to mitigate financial market risk, but also gain exposure to potentially higher equity performance than traditional fixed income investments.”

Third, Roger Ibbotson and his team analyzed fixed index annuities performance compared to periods of outperformance and underperformance for long-term government bonds. They isolated 15 three-year periods where bonds performed below the median like above, where the average 3-year annualized return was 1.87% compared to the FIA average of 4.42%. Through fifteen 3-year timeframes where bonds performed above median, returns for bonds and fixed index annuities averaged 9% and 7.55%, respectively.

Last, the research is limited to a simulation of the net performance of a fixed index annuity tied to a large cap equity index with uncapped participation rates. A participation index rate strategy is mostly effective under strong stock market conditions as interest credited is a predetermined percentage multiplied by the annual increase in a market index’s return. For example, a fixed indexed annuity offers an uncapped point-to-point option with a 40% participation rate. If the chosen market index the participation rate is connected to increases by 10%, your return for the year will be 4%. The participation percentage may be changed annually.

A “point-to-point” cap index strategy incorporates a ceiling on the upside and will not perform as well during periods when stocks are characterized by strong performance. The point-to-point cap index choice is best when markets are expected to provide limited growth potential and provides 100% participation up to the annual cap set by the insurance company. Let’s say a fixed indexed annuity has a 3% index cap rate and is tied to the performance of the S&P 500. For the year, the S&P 500 returns 2%. The interest credited to your account would be 2%, which is under the 3% cap. Under the participation index rate strategy outlined above, interest credited would be less at 40% of the S&P return, or .8%.

Since credited interest increases the original investment and downside protection is provided, your money compounds in the true sense of the definition. As we’ve written previously at Real Investment Advice – compounding works only when there is NO CHANCE of principal loss.

Fixed indexed annuities offer a fixed interest rate sleeve in addition to stock market participation options. There’s the choice to select multiple strategies (to equal 100%) and change allocations every year on your anniversary or annuity effective date.

Generally, annuities are immediate or deferred as well as fixed and variable as described above. Deferred annuities are designed for saving and interest accumulation over long periods, usually 5-10 years. They most popular are outlined here in Part 1. Immediate and guaranteed income annuities which I’ll cover in Part 2, are designed to provide lifetime income and longevity insurance for consumers who are concerned about outliving their retirement investments.

Below are Real Investment Advice and Clarity’s financial guardrails or rules to consider before the purchase of accumulation and income annuities:

  1. Annuities tend to get sold, not planned. Annuities are primarily product-sales driven. Comprehensive financial planning which includes your current asset allocation, ongoing savings and investing habits, anticipated income needs in retirement and survivability of investment assets based on estimated life expectancies either for you or you and a spouse, should be a mandatory first step. Most annuity salespeople are not going to undertake a holistic planning approach before an annuity solution is offered; it’s important to partner with a Certified Financial Planner who is also a fiduciary to complete a financial plan before you commit resources to annuities. A plan can determine whether an annuity improves retirement income sustainability and specifically, how much investment to commit. If your plan reflects the probability of meeting your retirement goals at 85% or greater, forgo the annuity and create an action plan to bolster savings, reduce debt or work a year or two longer.
  2. Consider fixed indexed annuities as intermediate to long-term bond replacements. Or to improve risk-adjusted portfolio returns during market cycles of extended stock valuations and/or less potential for appreciation in bond prices (like we’re in now). Roger Ibbotson estimated that a 60% stock, 20% traditional bond, 20% fixed indexed annuity allocation returned 8.12% from 1927-2016 in periods where bond returns were below median, compared to a traditional 60/40 portfolio which returned 7.6%. If future returns for traditional risk assets will be muted due to rich stock valuations and lower capital appreciation for bonds (which we believe is the case), a fixed indexed annuity may be employed to replace up to 20% of a total fixed income allocation. A FIA may provide attractive returns compared to stocks and bonds combined with zero downside risk.
  3. Avoid or minimize exposure to variable annuities. Variable annuities do not appear worthy of investment in our opinion. Meet with a financial professional, preferably a fiduciary, to create and implement a liquidation or transfer plan.
  4. Understand surrender charges, costs, tax and withdrawal penalty implications. Annuities must be considered long-term products designed solely to meet retirement goals. Deferred annuities will include a hefty 5-10 year decreasing annual percentage charge to discourage liquidations. There will be ordinary income taxes incurred and possibly penalties (if younger than 59 ½), upon withdrawals. Charges are incurred for commissions and cost of insurance, too. Most annuities will permit up to 10% annual withdrawals free of surrender charges. It’s important to understand how to withdraw as a last resort if a financial emergency arises.
  5. Slow your riders. Riders are supplementary features and benefits that can add anywhere from .35 to 1.50% in additional costs per year. Available riders range from enhanced liquidity benefits (ELBs) which allow surrender-charge free return of premiums in the second year, ADL (activities of daily living such as bathing & dressing), or custodial care withdrawals that provide access to up to 100% of accumulation value without surrender charges, to the most popular – GLWBs or Guaranteed Living Withdrawal Benefits for one life or for you and a spouse. Lifetime income is guaranteed even if the accumulation value of the annuity falls to zero. I have yet to encounter an annuity owner who can explain to me why they purchase riders or how they’re supposed to work. Unless a comprehensive financial plan indicates a 25% or greater probability of outliving your retirement savings (75% success rate), and expected single or joint life expectancies are age 95 or older, paying 1-1.5% a year for a living withdrawal benefits rider seems excessive. If outliving your investment source of retirement income is a concern, there are deferred and immediate income annuities on the market that can fill the gap along with other solutions like reverse mortgages.
  6. Seek a second opinion. An annuity is a long-term financial commitment. Before purchase, due diligence is mandatory. A fiduciary professional can outline the pros and cons of your prospective purchase. A deliberate, well-researched decision will minimize regret, later. Contact us for objective guidance.

See? Annuity is not such a scary word. In some cases, it’s the difference between a secure retirement or not. Along with a strategy backed by a comprehensive plan, fixed indexed annuities can be employed to minimize losses or enhance portfolio returns.

Indeed, annuities are complicated. There’s no getting around that obstacle. However, I hope our guardrails will help you gain perspective.

Annuity means ‘check for life,’ and who is against that?

The billionaire Ken Fisher. That’s who.

You may need to think differently.

  • But we likely have entered an important regulatory inflection point
  • The steady ride higher for FANG may now be bumpy and more difficult for investors to navigate
  • Valuations may continue to contract as margins are compressed and ambitious consensus secular growth forecasts are reduced
  • I would avoid Twitter (TWTR) , FANG and most other social media stocks in this changing backdrop

Technology (and more specifically social media stocks (e.g., Twitter) and some of FANG) have become the foundation of the post 1980 American economy.

Data is everywhere, and an increasingly flat and interconnected world means that social media companies must take on more responsibility for protecting the proliferation of personal data.

As I have repeatedly pointed out over the last six months, social media’s technological achievements and progress have outsped regulatory supervision and oversight.

This in turn, as highlighted by disclosures at Facebook (FB)  [e.g. with Cambridge Analytica and others, have potentially jeopardized the trust of users – a fundamental and necessary ingredient to future corporate success (measured in engagement)].

Government reactions have already surfaced, in the recent EU moves (implementing digital taxes and in EU fines of Alphabet’s Google (GOOGL)  and in the surfacing of US 2016 election issues. Now US trade policy (using tariffs as a tactical tool) raise the issue of more push back on technology companies from foreign actors.

While I do not think the emergence of the Facebook problem is anywhere insurmountable for the company (and I am long a trading position in FB), recent developments will likely accelerate regulatory oversight for the powerful social media industry. With this will come pressures forcing these companies to operate differently.

With the need to protect data much more rigorously in the future than in the past — much higher costs of operations (leading to some contraction in profit margins) — seems virtually inevitable.

And so may a continued decline in social media price earnings multiples be more likely.

Even before the recent discoveries, eight days ago I questioned, “What Is Mr. Market Thinking… About Technology?” – the large weightings of the group were at levels symptomatic of an historical top :

“The question is will the techs be challenged, too?

I keep thinking about two things, the first is the theft of intellectual property that hasn’t yet been addressed by the administration and, second, is the hold up over the NXP (NXPI)  deal by the Chinese regulatory authorities. I think that we got through the gauntlet just fine last week with the tariff signing and the employment number but that too many people at the end of the week seemed to be smug enough to believe that somehow the pressure is off and that this is all about a couple of old industries.

That’s a mistake. The theft of intellectual property can be challenged by a Section 301 challenge directly from the trade representative and I think the Chinese are going to come under this section quickly.

Why is this so negative? We know that tech’s been the leader by far. We know that the President probably feels emboldened to roll on this. We know that the “defense” gambit seems to have worked. To me that means that tech could be next. Not now. Not this week. But soon.” – Jim “El Capitan” Cramer, Will The Techs Be Challenged, Too?

As seen in the above excerpt, Jim “El Capitan” Cramer presents an objective, balanced and thoughtful opener this morning, in which he questions the possible future vulnerability of the tech space.

Societe Generale, in “What Are You Thinking? Does Nasdaq‘s Surge Point to a Last Hoorah for Equities” could help us in diving an answer – or at least give us some historical perspective and serve as a good addendum to Jim’s thought piece:

“Firstly, as longer duration assets (i.e., currently expensive but with high expectations of future growth) and supposedly less cyclical, the Nasdaq usually outperforms the S&P 500 when bond yields are declining. This correlation does move around but tends to peak just before S&P 500 EPS growth slows down. Hence a strong rally in the Nasdaq is often perceived as a ‘last hoorah’ for equities. That the Nasdaq has rallied strongly since the slump then perhaps reflects still bullish spirits in the US equity market but continuing anxiety over the fate of the economic cycle?

We are not huge fans of market cap to GDP ratios as you are often comparing an international stock market to an individual country’s economic size. Notwithstanding such issues, it is worth reflecting on the size of the Nasdaq relative to the GNP of the US economy. At the peak of the TMT bubble, the Nasdaq represented 33% of the US economy. Today it stands at over 40% after a 20% surge in market cap over the last six months. To expect such a big part of the economy to grow so quickly in the absence of a very rapid acceleration in global GDP is, in our view, clearly a fallacy of composition, and with the likes of Facebook and Netflix valued at over 10x sales, we are reminded of the quote from Sun Microsystems Co-founder Scott McNealy in the aftermath of the Tech crash; to paraphrase “What are you thinking?”


Just 5 stocks account for over 50% of the entire NDX rally since the 02/09/18 low: MSFT, AMZN, NETFLIX, INTC, and AAPL , as the acronym implies: it is a “MANIA”

Prior to this week’s drubbing five Nasdaq stocks (MSFT, AAPL, NFLX, INTC and AMZN) accounted for over 50% of the entire NDX rally since 02.09.2018.

Move over “FANG,” say hello to “MANIA”?

Since then, in the last few weeks, technology stocks have taken a beating.

My article above followed a steady stream of columns in my Diary that addressed the existential regulatory risks to Facebook, Amazon and Google – which may now come to the forefront.

Here are my current views and game plans for each of the four FANG components:

  • Facebook: I see more government intervention and regulation ahead. Recommendation: A trading opportunity might be developing, but avoid intermediate term (See upcoming column).
  • Amazon‘s growth plans might be stifled going forward by government regulation. Political and antitrust forces represent an existential threat to the company’s horizontal and vertical expansion plans. Click here to see more of my views. Recommendation: Short on an investment and trading basis.
  • Netflix (NFLX): I would avoid NFLX, but high short interest precludes selling it short. Remember, Adam Sandler will eat before Netflix shareholders do. Recommendation: Avoid/Sell.
  • Alphabet/Google: Alphabet’s dominance in the search-engine space, coupled with consumer reliance on Google, leaves the company vulnerable to government interference. I’m negative on the stock, but not short. Recommendation: Avoid.

Bottom Line

Advancements in social media technology has far outsped regulatory supervision and oversight.

While Facebook, Google and Amazon are now “too big too fail,” the existential regulatory risk that I have been writing about since last year is now less of a potential threat and is likely to be more of a kinetic and current threat.

Social media companies will now be forced to comply with greater regulatory supervision in the overall protection of their users’ personal data.

While the companies’ business models are generally in tact, profitability assumptions are now at risk and valuations are likely to continue to contract.

I would avoid Twitter, most of FANG and many other social media stocks in this changing backdrop of regulatory oversight.

For the past several weeks, I’ve been watching triangle patterns form in crude oil after its slide in early-February. Breakouts from triangle patterns often lead to important directional moves, which is why I believe it is worthwhile to pay attention to these formations. Both WTI and Brent crude oil finally broke out of their triangle patterns today due to Middle East tensions and speculation regarding more cuts in Venezuelan output.

Here’s West Texas Intermediate crude oil’s breakout:

WTI Crude Daily

Here’s Brent crude oil’s breakout:

Brent Crude DailyWhile I believe in respecting price trends instead of fighting them, I’m still concerned about the fact that crude oil’s rally of the past two years has been driven by “dumb money” or large speculators, who are more aggressively positioned than they were in the spring of 2014 before the oil crash. At the same time, the “smart money” or commercial hedgers have built their largest short position in history.

WTI Crude Monthly

Last week, I showed that U.S. Treasuries had broken out of triangle patterns of their own. Crude oil’s recent bullish move has been threatening the Treasury breakout (the two markets trade inversely):

30 Year Bond

10 Year Note

The U.S. Dollar Index is worth paying attention to when analyzing the crude oil market. Bullish moves in the dollar are typically bearish for crude oil and other commodities, and vice versa. Today’s bullish crude oil move and breakout is not confirmed by the U.S. Dollar Index, which is up .64 percent today. The U.S. Dollar Index has been trading in a directionless manner for the past two months, but its next major trend is likely to affect crude oil. If the Dollar Index can break above its trading range and downtrend line, it would likely lead to further bullish action (which would hurt crude oil). If the Dollar Index breaks down from its trading range, however, it would likely lead to further bearish action (which would push crude oil higher).

Dollar Daily

The longer-term U.S. Dollar Index chart shows that it is trading in a downward-sloping channel pattern. The dollar will remain in a downtrend as long as it trades within this channel. A breakout from this channel would increase the probability of a rebound, which would hurt crude oil. As I’ve been showing, the “smart money” or commercial hedgers are bullish, while the dumb money are bearish.

Dollar Weekly

This is an admittedly confusing time in the financial markets: correlations are breaking down, many technical breakouts and breakdowns are failing and whip-sawing, and the market is chopping all over the place. For these reasons, I’m not making any short-term market predictions, but just showing key charts that I believe are worth paying attention to. Yes, I believe they must be taken with a healthy grain of salt. I am suspicious of today’s crude oil breakout because it’s not confirmed by the U.S. dollar and because of the large bearish position held by the “smart money.” The smart money are usually right in the end, but it’s not prudent to fight the trend in the short-term. As usual, I will keep everyone posted regarding the recent crude oil and Treasury bond breakouts.

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“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via EmailFacebook or Twitter.

In May of last year, I wrote a blog post debating the likely path of the market through 2019. To wit:

“The chart below is a Fibonacci retracement/extension chart of the S&P 500. I have projected both a 123.6% advance from the 2009 lows as well as a standard 50% retracement using historical weekly price movements.”

From the bullish perspective, a run to 3000, after a brief consolidation following an initial surge to 2500, is a distinct possibility. Such an advance is predicated on earnings and economic growth rates accelerating with tax cuts/reform being passed.

However, given the length of the economic and market cycle, there is a significant bear case being built which entails a pullback to 1543. Such a decline, while well within historical norms, would wipe out all gains going back to 2014.”

Since that time, tax cuts/reform have been passed, earnings estimates have exploded higher, and corporate stock buybacks have surged to record levels while wage growth has remained non-existent for the bottom 80% of workers.

Not surprisingly, with those tailwinds, the market has pushed sharply higher towards our original target of 3000.

Currently, the pathway that target remains intact along with the longer-term bullish trend. However, the risk of a deeper correction, particularly given the signs of current economic weakness and weaker than anticipated revenue growth, continues to prevail.

Let me repeat, for those who may be “hard of reading,” the bullish trend remains intact and corrections should remain confined to the bullish trend for now which has been the case since 2009.

From the bullish perspective, a run to 3000, assuming the current consolidation completes successfully, is still a possibility as I detailed in last weekend’s missive:

“While I gave option (1) the greatest odds, it was option (2) that came to fruition as shown in the updated chart below.”

Chart updated through Monday

“The predicted path of decline, so far, has held at the 50-dma, which is bullish. However, the overbought condition, combined with the previous resistance level, proved too formidable for investors to push the market higher.”

On Monday the market broke back through the 50-dma and retested the top of the downtrend line which coincides with the 75-dma. Importantly, the short-term “buy signal” is threatening to reverse which could provide further selling pressure if it occurs.

This breakdown on Monday has not yet completely broken the “bullish case” for the market yet, however, a failed rally from current levels will bring “Option 3” into focus.

With the recent failure at the previous resistance level, we can now adjust our consolidation process for the market.

As long as the pattern of “higher lows” remains, a breakout above the current downtrend line and resistance should signal a move to old highs and the current 2018 target of 3000.

However, a break below the uptrend line will confirm a change to the current market and will require a shift in allocations to a more neutral stance.

We are potentially at a very critical juncture of this particular “bull market cycle,” and as Doug Kass noted yesterday:

“I expect a 2018 trading range of 2200-2850 – with a ‘fair market value’ (based on higher interest rates, disappointing economic and corporate profit growth, political and geopolitical uncertainties) of approximately 2400.

Compared to the expected trading range, downside risk relative to upside reward is approximately 5x.

Against ‘fair market value’ (based on my probability distribution of a host of independent variables – interest rates, inflation, corporate profits, economic growth, valuations, etc.) downside risk relative to upside reward is about 3x.”

I agree.

Risk/Reward Not Rewarding

My numbers are a little different than Doug’s but the premise is the same.

Given the length of the economic and market cycle, there is a significant bear case being built which entails a pullback towards the 2100 level. Such a decline, while well within historical norms, would wipe out all gains going back to 2015. 

Just for the mathematically challenged, this is NOT a good risk/reward ratio.

  • 3000 – 2733 (as of Monday’s close) =  267 Points Of Potential Reward 
  • 2733 – 2100 = -633 Points Of Potential Loss

With a 2.37 to 1 risk/reward ratio, the potential for losses is far more damaging to your long-term investment goals than the gains available from here.

Moreover, the bearish case is also well supported by the technical dynamics of the market going back to the 1920’s. (The red lines denote levels that have marked previous bull market peaks.)

It is important to note that a full “mean-reverting event,” which has occurred numerous times throughout history will currently wipe out all stock market gains going back to 2000.

For investors planning on retirement, this eventual reality will devastate those goals. It will also correspond with the often repeated warnings of current stock market valuations (which are repeatedly scoffed out by the mainstream media.)

“What drives stock prices (long-term) is the value of what you pay today for a future share of the company’s earnings in the future. Simply put – ‘it’s valuations, stupid.’  

That’s banal, I know, but everyone seems to forget it. And it means equity returns depend on how much you pay for their future profits, not on how much price volatility you can endure.”

With valuations at levels that have historically been coincident with the end, rather than the beginning, of bull markets, the expectation of future returns should be adjusted lower. This expectation is supported in the chart below which compares valuations to forward 10-year market returns.”

“The function of math is pretty simple – the more you pay, the less you get.”

Whether Doug’s numbers are correct, or mine, it will make little difference. The simple fact is that all “bull markets” do end.

The difference is identifying and reacting to the change when, not if, it occurs which is what will separate “Survivors” from the “Walking Dead.”

Yes, a breakout and a move higher is certainly viable in the “riskless” environment believed to exist currently.

However, without a sharp improvement in the underlying fundamental and economic backdrop, the risk of failure is rising sharply. Unfortunately, there is little evidence of such a rapid improvement is in the making.

There are two laws of physics worth remembering:

  1. What goes up…must come down, and;
  2. Gravity is a bitch.

I’ve just returned from the Research Affiliates Advisor Symposium in Newport Beach, California last week. If the cloudy and sometimes rainy weather disappointed some of the attendees, the conference itself didn’t. As I reflect on it now, it stands as one of the finest investment conferences I’ve attended. This will be the first in a three-part series on the conference.

The argument against traditional indexing

Before I talk about the conference, a few words about Research Affiliates are in order for readers who aren’t familiar with the firm. Research Affiliates is the company of Robert Arnott who is the author of influential papers on investing and a former board member of the Jounral of Portfolio Management. Arnott arguably devised the first “smart beta” stock strategy which he calls the “fundamental index.” Instead of ranking stocks in an index based on market capitalization, which is how most index funds function, the fundamental index ranks them on four economic factors of the stocks’ underlying businesses – sales, cash flow, dividends and book value. In other words, the fundamental index or “RAFI” (Research Affiliates Fundamental Index) “breaks the link,” as Arnott puts it, between a stock’s rank in an index and its market capitalization or price. In fact, that’s what all smart beta strategies do; they are all based on some newly devised “beta” or index that doesn’t rank stocks based on their price or market capitalization. I like Arnott’s approach because it forces investors to think of stocks as ownership units of businesses and to rank stocks based on characteristics of their underlying businesses.

Products that use the fundamental index include the PowerShares FTSE RAFI US 1000 ETF (PRF) and the PIMCO RAE Fundamental PLUS Fund (PXTIX). Other funds apply fundamental indexing to foreign stock markets. Arnott’s insight that capitalization weighted indexes necessarily give an investor more exposure to more expensive stocks and his research into other forms of index construction started the smart beta revolution. Other “factors” or characteristics of groups of stocks that could help those stocks beat the market – namely small and value —  were identified in a famous paper by Eugene Fama and Kenneth French. While Dimensional Fund Advisors took its bearings from the Fama/French research and built funds with capitalization weighted indexes that it tilted toward small-cap and value stocks, nobody created an alternative index or helped create funds that were invested in one until Arnott.

One award-winning academic paper has argued that the fundamental index has a “value bias” making the PowerShares fund’s S&P 500 Index-matching performance over the past decade, when value has underperformed growth, striking. (Arnott also classifies his index as value-oriented on the smart beta portion of the Research Affiliates website.) The PIMCO fund has outperformed the index by more than 300 basis points annualized, but it’s structured differently than the PowerShares fund. The PIMCO fund gains exposure to the fundamental index through a derivative, which it colateralizes with a bond portfolio. So it has two sources of return – the fundamental index and the bond portfolio that PIMCO manages in an effort to overcome the price of the derivative.

Since the development of products using the fundamental index, other funds with other “factors” have hit the market. Along with plain capitalization weighted index funds, smart beta funds have been attracting assets in droves while traditional active managers mostly bleed capital. But there aren’t as many factors that can consistently beat capitalization weighted indices as marketers might have you think. The “factor zoo,” as Research Affiliates calls it, may be well populated, but only a few species are worth much. Those are value, size, income, momentum, low beta, and quality. In some of its papers, Research Affiliates isn’t even sure “quality” is a legitimate factor, although the firm includes it in its factor appraisals on its website.


Not All Factors Are Equal — Or Always Well-Priced

The question about which factors might be overpriced comes from an argument about data mining. Most factors reflect data mining or observance of a one-time bump in valuation that isn’t sustainable. This has caused a public argument between Research Affiliates and Clifford Asness of AQR Management. If illegitimate factors are the result of a one-time or random bump in valuation, legitimate factors that have persistence can get expensive too. Furthermore, those factors can be embraced or shunned – in effect, timed — based on their relative historical valuations. By contrast, Asness thinks investors are better off sticking with a factor or two they like rather than trying to time them.

Parts of the conference addressed the valuations argument. Research Affiliates thinks momentum and low-beta or low-volatility strategies are expensive. That makes sense given that some investors have driven up the prices of Facebook, Google, and Amazon, and others have sought stock exposure with lower volatility in the aftermath of the financial crisis.

Most value strategies, on the other hand, are relatively cheap. They have suffered as Facebook, Amazon, Apple, Netflix, and Google have propelled growth and momentum indices higher in recent years. But investors might be wrong to choose the factors that have performed the best. Research Affiliates Head of Investment Management, FeiFei Li, gave a presentation showing among other things that choosing the worst performing smart beta factors can lead to better performance than choosing the best performing ones. Valuations are predictive of future returns. In other words, contrarian smart beta investors looking for a “reversion to the mean” might overweight value over momentum based on how each factor is priced relative to its history on the Research Affiliates website.

Li also argued that investors should look at how smart beta funds implement their strategies, because implementation can have a much greater effect on returns than the expense ratio. In particular, high turnover, low weighted-average market cap, and a low number of holdings can be warning signs to investors that a fund isn’t implementing its strategies in the most cost-effective ways.

Morningstar’s Director of Global ETF Research, Ben Johnson, followed Li’s talk with some similar themes. Johnson argued that re-framing factor investing as an evolution of active management was useful. Many traditional stock pickers use factors that characterize ETFs, just not as systematically and mechanically. Johnson also warned investors to be wary when funds with similar factors are introduced at once. That can be an indication that a factor has had a run that’s probably not repeatable.

In my next installment, I will report on the portions of the conference that were concerned with global asset allocation and asset class valuations.

“There are no signs of recession. Employment growth is strong. Jobless claims are low and the stock market is up.” 

This is heard almost daily from the media mainstream pablum.

The problem with a majority of the “analysis” done today is that it is primarily short-sighted and lazy, produced more for driving views and selling advertising rather than actually helping investors.

For example:

“The economy is currently growing at more than 2% annualized with current estimates near 2% as well.”

If you are growing at 2%, how could you have a recession anytime soon?

Let’s take a look at the data below of real economic growth rates:

  • January 1980:        1.43%
  • July 1981:                 4.39%
  • July 1990:                1.73%
  • March 2001:           2.30%
  • December 2007:    1.87%

If you look at each of those dates, the economy was clearly growing. But each of those dates is the growth rate of the economy immediately prior to the onset of a recession.

You will remember that during the entirety of 2007, the majority of the media, analyst, and economic community were proclaiming continued economic growth into the foreseeable future as there was “no sign of recession.”

I myself was rather brutally chastised in December of 2007 when I wrote that:

“We are now either in, or about to be in, the worst recession since the ‘Great Depression.’”

Of course, a full year later, after the annual data revisions had been released by the Bureau of Economic Analysis (BEA), the recession was officially revealed. Unfortunately, by then it was far too late to matter.

It is here the mainstream media should have learned their lesson. But unfortunately, they didn’t.

The chart below shows the S&P 500 index with recessions and when the National Bureau of Economic Research dated the start of the recession.

There are three lessons that should be learned from this:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

For example, the level of jobless claims is one data series currently being touted as a clear example of why there is “no recession” in sight. As shown below, there is little argument that the data currently appears extremely “bullish” for the economy.

However, if we step back to a longer picture we find that such levels of jobless claims have historically noted the peak of economic growth and warned of a pending recession.

This makes complete sense as “jobless claims” fall to low levels when companies “hoard existing labor” to meet current levels of demand. In other words, companies reach a point of efficiency where they are no longer terminating individuals to align production to aggregate demand. Therefore, jobless claims naturally fall.

But there is more to this story.

Less Than Meets The Eye

The Trump Administration has taken a LOT of credit for the recent bumps in economic growth. We have warned this was not only dangerous, credibility-wise, but also an anomaly due to three massive hurricanes and two major wildfires that had the “broken window” fallacy working overtime.

“The fallacy of the ‘broken window’ narrative is that economic activity is only changed and not increased. The dollars used to pay for the window can no longer be used for their original intended purpose.”

If economic destruction led to long-term economic prosperity, then the U.S. should just regularly drop a “nuke” on a major city and then rebuild it. When you think about it in those terms, you realize just how silly the whole notion is.

However, in the short-term, natural disasters do “pull forward” consumption as individuals need to rebuild and replace what was previously lost. This activity does lead to a short-term boost in the economic data, but fades just as quickly.

A quick look at core retail sales over the last few months, following the hurricanes, shows the temporary bump now fading.

The other interesting aspect of this is the rise in consumer credit as a percent of disposable personal income. The chart below indexes both consumer credit to DPI and retail sales to 100 starting in 1993. What is interesting to note is the rising level of credit card debt required to sustain retail sales.

Given that retail sales make up roughly 40% of personal consumption expenditures which in turn comprises roughly 70% of GDP, the impact to sustained economic growth is important to consider.

Furthermore, what the headlines miss is the growth in the population. The chart below shows retails sales divided by the current 16-and-over population. (If you are alive, you consume.) 

Retail sales per capita were previously on a 5% annualized growth trend beginning in 1992. However, after the financial crisis, the gap below that long-term trend has yet to be filled as there is a 23.2% deficit from the long-term trend. It is also worth noting the sharp drop in retail sales per capita over just the last couple of months in particular.

Since 1992, as shown below, there have only been 5-other times in which retail sales were negative 3-months in a row (which just occurred). Each time, the subsequent impact on the economy, and the stock market, was not good. 

So, despite record low jobless claims, retail sales remain exceptionally weak. There are two reasons for this which are continually overlooked, or worse simply ignored, by the mainstream media and economists.

The first is that despite the “longest run of employment growth in U.S. history,” those who are finding jobs continues to grow at a substantially slower pace than the growth rate of the population.

If you don’t have a job, and are primarily living on government support (1-of-4 Americans receive some form of benefit) it is difficult to consume at higher levels to support economic growth.

Secondly, while tax cuts may provide a temporary boost to after-tax incomes, that income boost is simply being absorbed by higher energy, gasoline, health care and borrowing costs. This is why 80% of Americans continue to live paycheck-to-paycheck and have little saved in the bank. It is also why, as wages have continued to stagnate, the cost of living now exceeds what incomes and debt increases can sustain.

As I have discussed several times during the 4th-quarter of 2017:

Very likely, the next two quarters will be weaker than expected as the boost from hurricanes fade and higher interest rates take their toll on consumers. So, when mainstream media acts astonished that economic growth has once again slowed, you will already know why.”

Not surprisingly the economic data rolling in has been exceptionally weak and the first quarter GDP growth is now targeted at less than 2% annualized growth.

However, it is not only in the U.S. the economic “bump” is fading, but globally as well as Central Banks have started to remove their monetary accommodations. As noted by the ECRI:

“Our prediction last year of a global growth downturn was based on our 20-Country Long Leading Index, which, in 2016, foresaw the synchronized global growth upturn that the consensus only started to recognize around the spring of 2017.

With the synchronized global growth upturn in the rearview mirror, the downturn is no longer a forecast, but is now a fact.

The chart below shows that quarter-over-quarter annualized gross domestic product growth rates in the three largest advanced economies — the U.S., the euro zone, and Japan — have turned down. In all three, GDP growth peaked in the second or third quarter of 2017, and fell in the fourth quarter. This is what the start of a synchronized global growth downswing looks like.”

“Still, the groupthink on the synchronized global growth upturn is so pervasive that nobody seemed to notice that South Korea’s GDP contracted in the fourth quarter of 2017, partly due to the biggest drop in its exports in 33 years. And that news came as the country was in the spotlight as host of the winter Olympics.

Because it’s so export-dependent, South Korea is often a canary in the coal mine of global growth. So, when the Asian nation experiences slower growth — let alone negative growth — it’s a yellow flag for the global economy.

The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

You can see the slowdown occurring “real time” by taking a look at Personal Consumption Expenditures (PCE) which comprises roughly 70% of U.S. economic growth. (It is also worth noting that PCE  growth rates have been declining since 2016 which belies the “economic growth recovery” story.)

The point here is this:

“Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed.” 

While there may currently be “no sign of recession,” there are plenty of signs of “economic stress” such as:

The shift caused by the financial crisis, aging demographics, massive monetary interventions and the structural change in employment which has skewed the seasonal-adjustments in economic data. This makes every report from employment, retail sales, and manufacturing appear more robust than they would be otherwise. This is a problem mainstream analysis continues to overlook but will be used as an excuse when it reverses.

While the calls of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000 or 2007 either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

As Howard Marks once quipped:

“Being right, but early in the call, is the same as being wrong.” 

While being optimistic about the economy and the markets currently is far more entertaining than doom and gloom, it is the honest assessment of the data, along with the underlying trends, which are useful in protecting one’s wealth longer-term.

Is there a recession currently? No.

Will there be a recession in the not so distant future? Absolutely.

But if you wait to “see it,” it will be too late to do anything about it.

Whether it is a mild, or “massive,” recession will make little difference to individuals as the net destruction of personal wealth will be just as damaging. Such is the nature of recessions on the financial markets.

The Return of Volatility  “Maybe it’s because of the experience of the last month and because we tend to read the latest trend into our forecast, but there was a consensus at SIC that market volatility is going to resume its normal place in our lives. Five percent drawdowns are actually quite normal in any given year and sometimes occur several times in a year. What is not normal is 15 months of less-than-2% drawdowns, which we just experienced. The volatility of February was not the odd thing; it was the preceding 15 months that was extraordinary. Have we seen a market peak, as my friend Doug Kass thinks? Maybe. I have no idea. That is why I have my personal portfolio and those of the clients who work with me structured to be in diversified trading strategies and not be actually long (or short) everything. And then we rifle-target specific investments that I think have long-term potential or can produce reasonable fixed-income returns.” – John Mauldin, SIC Perspectives 

In my Bloomberg “Market Surveillance” interview on Thursday with Tom Keene and Jon Ferro I suggested that there is an increased probability that the S&P Index has peaked for the year.

Here are my Top 10 Reasons why the markets may have already peaked in 2018:

* A Presidency of One: Trump’s behavior may finally matter to the capital markets as the Administration’s disorganization, revolving door and impulsive policy actions may soon intersect with market valuations.

* The Outcome of the Mueller Investigation Could Be Market Unfriendly  

* A Blue Wave in the Mid-Term Elections Could Also Be Disruptive to the Markets and the Trump Agenda

* The Expectations of a Synchronized Global Economic Recovery May Be Wrong: Though many are focused on the big upside reported in last Friday’s jobs market — I would emphasize that employment data is a notoriously rear view or lagging economic indicator.  Recently the Atlanta Fed said its GDP model sees 1Q2018 Real GDP at only +1.9% (and JPMorgan has moved down their estimate to +2%) — that’s fairly disappointing considering we have been in a respend and rebuilding period following the hurricanes and we are now nearly three months post the passage of meaningful corporate tax cuts. Several high frequency economic data points now suggest that the much anticipated acceleration in the rate of US economic growth may disappoint investors. And, even in the EU, several economic prints have stumbled recently.

* Global Central Bankers are Pivoting Towards Tighter Money: In marked contrast to the last nine years, the Fed is no longer our friend. 

* The US Lacks Fiscal Discipline: The recently enacted tax bill will exacerbate risks associated with a rising debt load and expanding fiscal deficit. The Fed’s $4 trillion balance sheet is problematic and $2 to $3 trillion of newly issued Treasuries will likely place pressure on interest rates.

* Inflation Pressures Are Building and Interest Rates are Heading Higher On rates, few appreciate that it took only a thirty basis points increase in the ten year US note to blow up a trillion dollar global short volatility trade.  And, from Peter Boockvar this morning: “Another 2.4 bps rise in 3 month LIBOR on Friday to 2.20% brings the year to date gain to 50 bps. It is now up 105 bps over the past 12 months which of course is greater than the pace of Fed rate hikes and thus the LIBOR/OIS spread keeps widening. It’s been a topic of discussion for the past month but regardless of what’s causing it, the impact grows on the trillions of dollars of LIBOR based loans.”

* Trade Wars Seem More Likely – Threatening World Trade: Recent policy moves force us to unfavorably answer question, “Am I a Clever Man (Westley) or a Fool (Vizzini)?” 

* With Their Growing Dominance, Facebook (FB) , Alphabet’s Google (GOOGL) and Amazon (AMZN) Face the Existential Threat of Regulations and More Legislation:  FANG is the center piece of the decade old Bull Market. For one year I have been fearful of their increased market dominance and horizontal acquisition strategy which is disrupting industry after industry – and having a consequential impact on those industries, their employees and, even the real estate markets. 

* Expanding Individual Investor Optimism: Recent fund flows are at record levels – often seen as a contrarian and bearish signpost. From Barron’s over the past weekend (H/T Randy Forsyth): “Following the stock market’s brief but violent drop in February, investors came roaring back with record purchases of equity funds in the most recent week ended on Wednesday. According to EPFR data cited by Bank of America Merrill Lynch, some $38.3 billion was poured into mutual funds, including the exchange-traded variety.” 

Bottom Line

Based on the above, and other factors, I am currently net short and expect heightened volatility and a widening trading range in 2018.

The S&P Index is currently at 2740.

I expect a 2018 trading range of 2200-2850 – with a “fair market value” (based on higher interest rates, disappointing economic and corporate profit growth, political and geopolitical uncertainties) of approximately 2400.

Compared to the expected trading range, downside risk relative to upside reward is approximately 5x.

Against “fair market value” (based on my probability distribution of a host of independent variables – interest rates, inflation, corporate profits, economic growth, valuations, etc.) downside risk relative to upside reward is about 3x.

Chart of the Day

Today’s chart of the day shows cumulative U.S. GDP growth minus federal debt issuance. Most studies and discussions of U.S. economic growth assume that it’s natural, organic, and sustainable, but the reality is that it’s largely juiced by deficit spending (particularly since the Great Recession). According to Peter Cook, CFA:

The cumulative figures are even more disturbing. From 2008-2017, GDP grew by $5.051 trillion, from $14.55 trillion to $19.74 trillion.  During that same period, the increase in TDO totaled $11.26 trillion.  In other words, for each dollar of deficit spending, the economy grew by less than 50 cents.  Or, put another way, had the federal government not borrowed and spent the $11.263 trillion, GDP today would be significantly smaller than it is.

Cumulative GDP growth less Fed. debt issuance

How much longer can we continue juicing economic growth like this? The U.S. federal debt recently hit $20 trillion and is expected to hit $30 trillion by 2028. Despite what Modern Monetary Theorists (MMTers), Keynesians, and similar schools of thought claim, common sense dictates that the endgame is not far off.

Have Treasury Yields Peaked for 2018? BMO Thinks So (Bloomberg)

Strong Demand For 30Y Paper Shows No Shortage Of Buyers Amid Surge In Issuance (ZeroHedge)

Gundlach Says 10-Year Treasury Above 3% Would Drive Down Stocks (Bloomberg)

SP500 performance around Fed tightening cycles (The Macro Tourist)

Dodd-Frank Rollback Optimism Hands Bank ETFs Record Inflows (Bloomberg)

FANG Rally Is Outpacing the Heyday of the Tech Frenzy (Bloomberg)

Apple is inching towards a $1 trillion valuation (Business Insider)

Buying Stocks Now Is Betting On Buybacks (Forbes)

Record Stock Buybacks at Worst Possible Time (Mike “Mish” Shedlock)

4 Reasons To Sell Tesla Stock (Forbes)

Everything is shrinking at GE except its massive debt (CNN Money)

Remembering Bear Stearns & Co (Institutional Risk Analyst)

A Worrying Shift for U.S. Pensions: Retirees Will Soon Outnumber Kids (Bloomberg)

The Coming Pension Crisis – Part I, Part II (Daily Reckoning)

The U.S. Retirement Crisis: The Elderly are Broke (Gold Telegraph)

The stock-market correction may be only half over, if history is any guide (MarketWatch)

JPMorgan Moves Closer to Urging a Rotation Away From Equities (Bloomberg)

Bullish On Oil Because of Trump? Don’t Be! (Mike “Mish” Shedlock)

What Event Will Sink the Stock Market? Yields? Tariffs? Trump? (Mike “Mish” Shedlock)

The Netflix Bubble (Seeking Alpha)


The U.S. Inflation Scare May Be Over (Bloomberg)

Subdued CPI Disappoints Economic Illiterates (Mike “Mish” Shedlock)

Yield-Curve Flattening Gets New Life After Inflation Fears Subside (Bloomberg)

10 years after the financial crisis, have we learned anything? (CNN Money)

Cramer on 2008 crisis: It could happen again ‘because no one went to jail the first time’ (CNBC)

A Decade After Bear’s Collapse, the Seeds of Instability Are Germinating Again (Wall Street Journal)

U.S. CEO Optimism Hits Record (Bloomberg)

Yield Curve Turns Threatening – Again (

Fed Admits ‘Yield Curve Collapse Matters’ (ZeroHedge)

It’s Just Starting: Moody’s Warns A Deluge Of Retail Bankruptcies Is Coming (ZeroHedge)

Economist Lacy Hunt: These Conditions Preceded The Last 7 Recessions (Forbes)

Subprime Auto Bonds Caught in Vise of Rising Costs, Bad Loans (Bloomberg)

Goldman, Atlanta Fed Slash Q1 GDP Forecasts Below 2.0% (ZeroHedge)

America’s inflation problem isn’t high wages, it’s high rent (MarketWatch)

Investors “Unconcerned” About Record Corporate Debt (Dollar

Trillion-Dollar Deficits Far as the Eye Can See (Daily Reckoning)

The Everything Bubble – Waiting For The Pin (David Stockman)

Is The U.S. Economy Really Growing? (Peter Cook, CFA)

Why It’s Right To Warn About A Bubble For 10 Years (Jesse Colombo)

Are U.S. Treasury Bonds Breaking Out? (Jesse Colombo)

BTFD or STFR? (Michael Lebowitz)

Technically Speaking: Chart Of The Year? (Lance Roberts)

March Madness For Investors (Michael Lebowitz)

Is The Dot.Com Bubble Back? (Lance Roberts)

Volatility Is Back (John Coumarianos)

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

Most people are aware that GDP growth has been lower than expected in the aftermath of the Global Financial Crisis of 2008 (GFC).  For example, real GDP growth for the past decade has been closer to 1.5% than the 3% experienced in the 50 years prior to 2008.  As a result of the combination of slow economic growth and deficit spending, most people are also aware that the debt/GDP ratio has been rising.

However, what most people don’t know is that, over the past ten years, the dollar amount of cumulative government deficit spending exceeded the dollar amount of GDP growth.  Put another way, in the absence of deficit spending, GDP growth would have been less than zero for the past decade.  Could that be true?

Let’s begin with a shocking chart that confirms the statements above, and begins to answer the question.  The black line shows the difference between quarterly GDP growth and the quarterly increase in Treasury debt outstanding (TDO).  When the black line is above zero (red dotted line), the dollar amount is GDP is growing faster than the increase in TDO.  From 1971 to 2008, the amount of GDP typically grew at a faster rate than the increase in TDO, which is why the black line is generally above the red dotted line.

Chart 1

During the 1971-2008 period, inflation, budget deficits, and trade deficits varied widely, meaning that the relationship between GDP growth and TDO was stable even in the face of changes in other economic variables. Regardless of those changing economic variables, the US economy tended to grow at a pace faster than TDO for four decades.  The only interruptions to the pattern occurred during recessions of the early 1980s, early 1990s, and early 2000s when GDP fell while budget deficits did not.

The pattern of GDP growth exceeding TDO changed after 2008, which is why the black line is consistently below the red dotted line after 2008.  A change in a previously-stable relationship is known as a “regime change.”  Focusing first on 2008-2012, the increase in TDO far exceeded GDP growth, due to an unprecedented amount of deficit spending compared to historical norms.  Focusing next on 2013-2017, the blue line has been closer to the red dotted line, meaning that the dollar amount of GDP growth was roughly equal to TDO.

If the pattern of the past was in effect, the black line should have been far above the red dotted line for most of the entire period of 2009-2017, because it would be expected that a recovering economy would have produced an excess of GDP growth over TDO.  But that didn’t happen.  This article will not speculate on why there was a regime change.  Instead, this article is focused strictly on identifying that a regime change occurred, and that few people recognize the importance of the regime change, which is probably why it persists.

Taking a quick detour into the simple math of GDP accounting, the level of GDP is calculated by adding up all forms of spending:

GDP = C + I + G + X

In the equation above, C is consumer spending; I is investment spending by corporations; G is government spending; and X is net exports (because the US has become such a heavy net importer, X has been a subtraction from GDP since 2000).

For context, at the end of 2017, the level of US GDP was $19.74 trillion, per the Bureau of Economic Analysis (BEA).  Of that $19.74 trillion, the Congressional Budget Office (CBO) calculated that the US government spent $3.98 trillion, all of which counts toward GDP. In 2017 the government borrowed $516 billion, meaning that the government spent more than it received via taxes and other sources.  The main insight in understanding how the government calculates GDP is that all government spending counts as a positive for GDP, regardless of whether that spending is financed by tax collections or issuing debt.

Because deficit spending is additive in the calculation of GDP, it makes sense to compare the amount of deficit spending to the amount of GDP growth produced each year. The first four columns in the table below show the annual GDP, the annual dollar change of GDP, the total amount of Treasury debt outstanding (TDO) and the annual dollar change of TDO.  Comparing the second and fourth columns, it is easy to see that the annual increases in TDO regularly exceed the increases in GDP.

Chart 2

The final column to the right shows the increase in TDO as a percentage of the annual change in GDP growth.  When the ratio is greater than 100%, the increase in TDO is responsible for more than 100% of annual GDP growth.  Reinforcing the message of Chart 1, the annual increase in TDO exceeded annual GDP growth in each of the years from 2008-2016. The only year in which annual GDP growth was greater than the increase in TDO was in 2017, possibly due to the debt ceiling caps, which have now been lifted.

The cumulative figures are even more disturbing.  From 2008-2017, GDP grew by $5.051 trillion, from $14.55 trillion to $19.74 trillion.  During that same period, the increase in TDO totaled $11.26 trillion.  In other words, for each dollar of deficit spending, the economy grew by less than 50 cents.  Or, put another way, had the federal government not borrowed and spent the $11.263 trillion, GDP today would be significantly smaller than it is.

It is possible to transform Chart 1, which shows annual changes in TDO and GDP from 1970-2017, into Chart 3 below, which shows the cumulative difference between the growth of TDO and GDP over the entire period from 1970-2017. The graph below clearly shows the abrupt regime change that occurred in the aftermath of the GFC.  A period in which growth in GDP growth exceeded increases in TDO has been replaced by a period in which increases in TDO exceeded GDP growth.

Chart 3

Unfortunately, extending the analysis forward tells us the problem will only get worse.

Chart 4

Over the entire period from 2008 to 2021, the increase in TDO will exceed GDP growth by $7.531 trillion ($15.843 trillion of TDO compared to $8.312 trillion of GDP growth).  While most people would accept that deficit spending is required for short periods to offset economic disturbances, even John Maynard Keynes wouldn’t expect it to become the norm.  Nor would he expect that a dollar of deficit spending would produce less than a dollar of GDP growth.

Investment and Policy Implications

The purpose of this article is to clarify the changing relationship between the dollar amounts of GDP growth and budget deficits, which are funded by TDO.  If indeed GDP growth has become reliant on budget deficits post-2008, there are many implications for investment policies across all asset classes. For example, might poor organic growth in the private sector explain the unexpectedly-low inflation environment and historically-low capital investment?  If so, what are the implications for stocks and bonds?

Also, government policy should acknowledge the regime change and adapt policies accordingly. If massive deficit spending is required to produce a “positive” sign for GDP growth, is it possible that the private sector of the economy is not growing but shrinking?  Is the private sector’s health now completely reliant on continued government deficits?  If so, is there a limit to the government’s ability to run deficits by issuing bonds?  If a dollar of increase in debt leads to less than a dollar of GDP growth, should the US continue to borrow?  Should the Fed raise rates because of increased fiscal stimulus if the link between deficit spending, GDP growth, and inflation has experienced a regime changeCan any economic theory explain what is going on?

These questions will be addressed in upcoming articles.


  • All government spending boosts GDP calculations, regardless of whether government spending is financed by tax collections or deficits financed by debt issuance.
  • Isolating the interaction between increases in TDO and the dollar amount of GDP growth, the data show a regime change post-2008 compared to the period 1971-2007.
  • In the period 1971-2007, the dollar amount of GDP growth exceeded increases in TDO except in years in which the economy was in recession.
  • In the period 2008-2017, annual increases in TDO regularly exceeded the dollar amount of GDP growth, which remarkably occurred during years that GDP was calculated to be growing.
  • In the period 2008-2017, the cumulative increase in TDO was a multiple of cumulative GDP growth. The dollar amount of GDP growth was completely dependent on deficit spending.
  • The efficiency of each dollar of deficit spending is declining, because the dollar amount of TDO is greater than the dollar amount of GDP growth.
  • In the period 2018-2021, the increase in TDO will continue to exceed GDP growth, per forecasts made by the BEA and CBO. That is, GDP growth will be dependent on continued deficit spending.
  • Importantly, if the economy slips into recession, it is possible TDO will grow at well over $2 trillion per year, meaning that the gap between TDO and GDP will get much larger.

As a long-time anti-economic bubble activist (both in the mid-2000s bubble cycle and the post-2009 cycle), a very common charge that’s leveled against me is “you’ve been warning about bubbles for years, but the market keeps going up, up, and away!”, “you’re a permabear!,” and “you’ve been missing out on tons of profits!”

Because of the large scale that I’ve been warning on in the media, I’ve probably heard this criticism over a thousand times. The tweet below (from today) is a perfect example of this criticism:



I find these criticisms to be extremely frustrating, factually incorrect, and completely ignorant of the message that I’ve been preaching over and over – here are the reasons why:

  • I’ve always said that the best bubble warnings are the earliest bubble warnings, because society needs as much lead time as possible to take action to prevent the bubble. Early bubble warnings also give individuals and families time to prepare for a coming bust and deep recession. Just think of how many people lost their homes, businesses, and jobs during the U.S. housing bust 10 years ago: don’t you think they could have benefited from an early warning?! Of course they would have! It’s common sense (which is not so common, unfortunately).
  • “You’re a permabear!,”You’ve missed the bull market!”, etc. This is flat-out wrong: I foresaw and warned of the coming debt and bubble-driven bull market in early-2012 in great detail. I said that we were likely headed for a huge bull market, but it wasn’t going to be a sustainable economic boom, but one that leads to a depression when it pops (which is still ahead).
  • “You’ve been calling for a bear market all along, but the market keeps going up!” – Yes, there will be a tremendous economic crash when this false economic recovery/bull market ends, but I’ve always said that you need to “trade with the trend, not against it” (if you must invest or trade). I have said this probably hundreds of times throughout the years, yet I keep receiving the same criticisms over and over. People simply do not listen. I’m at a complete loss as to how to communicate my ideas so that everyone clearly understands my positions. I think people just assume – without paying attention to the important nuances and caveats – that I’m a stereotypical “bear,” which means that I’m calling for a crash at all times.

Lately, I’ve been hearing the criticism “you’ve been warning about this bubble for 10 years now! When are you going to admit you were wrong?!” Yes, I know it’s been seven years (I started warning about the current bubble in June 2011), but even warning about a bubble for ten years isn’t crazy at all – for an example of this, we only need to look to the U.S. housing bubble, which inflated from roughly 1997 until 2007. I believe that someone would have been completely justified for warning about this disastrous bubble for a full decade. Just imagine the kind of criticisms that would be leveled in the latter stages of the bubble in 2005, 2006, and 2007 at someone who had been warning about the U.S. housing bubble since 1997! They’d probably want to hide under a rock, yet they would have been completely correct. I believe that the current bubble is no different.

The chart below shows the U.S. housing price bubble from 1997 to 2007. I believe that bubbles are a process rather than a specific point in time right before they burst. The U.S. housing bubble was actually a bubble even as early as 1998 and 1999, just like the current “Everything Bubble” was a bubble even back in 2011, 2012, and 2013. A bubble is differentiated from a sustainable economic boom and bull market because of what drives it: cheap credit (typically due to central banks holding interest rates low), rapid credit growth, asset overvaluation, rampant speculation, “fool’s gold” booms in various sectors and industries, and the “gold rush” mentality. Sustainable economic booms and bull markets, however, are driven by technological and scientific advances, rising productivity, improvements in governance and regulation, society or the world becoming more peaceful, individuals and corporations saving and investing for the long-term, debts being paid down and improving credit ratings, and so on.

Case-Shiller Chart #1

Similar to housing prices, the U.S. mortgage bubble inflated from approximately 1997 to 2007. While someone who warned about this credit expansion for ten years would have been written off as a total crackpot in the latter stages of the bubble, there was a method to their madness. If society had actually paid attention to those early bubble warnings, the ultimate crash would have been far less severe or may not have happened at all. Today’s bubble will prove to be no different: if society had listened to people like me back in 2011 and 2012, the coming crash would be far less severe. Instead, people like me are currently being labeled as crackpots, even though everything we’re saying will make complete sense in the next crisis.

U.S. Mortgage Bubble, Chart #1

Contrary to the two charts above, the two charts below illustrate how the mainstream economics and financial world thinks about bubbles: they think you are only correct if you warn about a bubble immediately before it pops. How does that make any sense? To me, it’s completely counterintuitive, but I’ve learned that the mainstream world really does think this way based on my interactions with them and the criticisms they keep hurling at me. Wouldn’t you want to try to prevent an economic crisis as early as possible? Of course, but they just don’t see it that way. The greed encouraged by the speculative bubble completely blinds them from seeing the truth. They can only think in terms of their Profit & Loss statement and tactical market timing signals – ie., if you warn about a bubble, that means that you’re calling “THE TOP,” right here and right now. Heaven forbid you’re slightly early, your financial career and reputation is basically ruined.

Case-Shiller Chart #2

The chart below shows the U.S. mortgage bubble and how the mainstream economics and financial world thinks of it.

U.S. Mortgage Bubble, Chart #2While I believe that the best bubble warnings are the earliest bubble warnings as an anti-economic bubble activist, I obviously don’t approach trading this way! As I explained earlier, I believe you need to trade with the trend, not against it (if you must trade). You should not short early on in a bubble, otherwise you will get destroyed. Again, this is common sense and I’ve said this all along, but people automatically assume that skeptics like me are short all the time. Anti-economic bubble activism is a completely different discipline from successful trading, and this is why people are often confused by my message and position.

"Trade with the trend"

The chart below shows total U.S. system leverage vs. the S&P 500. Rising leverage or debt is driving stock prices higher and has enabled the so-called “recovery” from the 2008 – 2009 crash. I have been warning about this bubble since 2011 and I am proud of it. If I could go back, I would warn about it even earlier – in 2009 or 2010. Every economist should have been warning about it. Each year that has passed since the 2009 bottom, leverage continues to increase, which means that the next crash is going to be even more extreme than 2008 was.

U.S. system leverage

Thanks to the current phase of the bubble that has inflated since 2009, the U.S. stock market is as overvalued as it was in 1929, which means that a painful mean reversion is inevitable. How did the market get to this point? It did so by inflating in 2010, 2011, 2012, and so on. Had society listened to people like me who warned about this inflating bubble back then, the market would not be this overvalued. Now, a massive bear market and financial crisis is “baked into the cake” or guaranteed.

Stock Market Valuation

Right now, with the market as inflated as it is, greed is the dominant emotion by far. Most economists, traders, and the general public only see Dollar signs right now, not the extreme risk that we’re facing as a society. In their minds, the greatest risk or “crisis” is to have missed out on the bull market. Anyone who plays the role of a naysayer and warns about these risks gets shunned. It is really “uncool” to be an economic skeptic right now, but I’m an unusual person – I don’t care about being popular or cool; I care about doing what’s right, which is warning society against dangerous inflating bubbles. I believe vindication is not far away.

Please follow or add me on TwitterFacebook, and LinkedIn to stay informed about the most important trading and bubble news as well as my related commentary.

In recent weeks, I’ve been keeping my eye on an interesting situation: while the majority of market participants expect higher interest rates (and lower bond prices), the “smart money” are expecting the opposite. The mainstream view is that the economic boom is humming along nicely, jobs are being created left and right, there are few economic or financial risks to worry about, and that inflation will start picking up any day now. The reality, however, is that our economy is far too saturated with debt to grow at a very high rate like in past economic cycles and that investors are overestimating the potential efficacy of President Trump’s pro-economic growth policies.

From a strictly technical analysis perspective, U.S. Treasuries have been forming triangle patterns in the past several weeks as market participants digest the February market correction and its implications, as well as wait for more data to confirm the risk of a pickup in inflation. Interestingly, these triangle patterns are breaking out to the upside today.

Here’s the 30-year U.S. Treasury bond:

30 Year Bond Daily

Here’s the 10-year U.S. Treasury note:

10 Year Bond Daily

Here’s the 5-year U.S. Treasury note:

5 Year Note Daily

A slew of weak economic and inflation data has been causing investors to pare back their expectations for much higher interest rates in the shorter-term: the CPI-U increased only 0.2 percent in February (after increasing 0.5 percent in January), retail sales fell for the third month in a row, and Goldman Sachs and the Atlanta Fed have cut their Q1 GDP forecast to under 2.0 percent. I will certainly be watching this Treasury breakout to see if the “smart money” are about to be vindicated on interest rates. A breakdown in crude oil (which is forming its own triangle pattern) would be another catalyst that would send Treasury bonds higher.

Please follow or add me on TwitterFacebook, and LinkedIn to stay informed about the most important trading and bubble news as well as my related commentary.

“Stability breeds instability.” – Hyman Minsky

The answer to the title of this article, the polite version of which is “Buy The Dip or Sell The Rally”, may well be the most important question facing stock investors this year and possibly for years to come. The bull market, now almost ten years old, has been supported by a number of technical pillars. Of these, three of the more significant ones are the “BTFD” mentality, shorting volatility (often referred to as vol), and corporate share buybacks. We are strongly of the opinion that when these technical pillars fail, the stock market will as well. It is important to note that while we wait on technical indicators for price guidance, there is a preponderance of fundamental warnings that should also be considered.

Expanding on Minsky’s theory, former Federal Reserve governor Laurence Meyer clarified the concept stating that “a period of stability induces behavioral responses that erode margins of safety, reduce liquidity, raise cash flow commitments relative to income and profits, and raise the price of risky relative to safe assets–all combining to weaken the ability of the economy to withstand even modest adverse shocks.”

Short Volatility

Over the last ten years, volatility has been transformed from a purely quantitative barometer of perceived future stability and a key input for options pricing to a full-fledged investment vehicle. It has gone from an obscure gauge of price movements, like the tachometer on the dashboard of your car, used mainly by sophisticated investors to one of the pistons in the engine helping propel markets. Since the financial crisis, investors and traders have learned that shorting volatility can provide significant and durable returns to help supplement low yields in traditional asset classes. The recent spike in volatility from all-time lows instantly put an end to this myth.

Many of those shorting vol, via a plethora of exchanged-traded funds and notes (ETF’s and ETN’s) that were designed to profit as market volatility dropped, were badly uninformed about how vol is computed or its longer-term history. The graph below charts the steady price increase in XIV, a short volatility ETN, since 2016 and the rapid evaporation of gains that occurred over just a few days.

A majority of short volatility ETF/ETN holders were of the mindset that the Fed, through its extraordinary interest rate and QE policies and its implicit statements supporting the market, would never let the markets fall again. They erroneously believed the Fed had once-and-for-all ushered in an unprecedented era of stability. There is no question that a lack of volatility, or perceived market stability, in recent years was unlike any other historical period. Given this prevailing mindset, why not short fear and go long stability?

This is exactly what many investors did. As more money chased the easy profits of short volatility strategies, investors were indirectly and unknowingly propelling the market higher in a self-reinforcing fashion. Ironically, as investors went “long stability” (short vol) they were making the markets inherently less stable. These poorly constructed securities came to a punishing end during the first week of February when the VIX index increased by over 100% on February 5th and wiped out or severely impaired those short volatility. XIV has since been delisted closing out at a final observed price of $6.04 per share.

This important technical pillar of equity strength has been permanently damaged and will likely provide much less support going forward.


Another major pillar of support for equity prices is corporate buybacks. The graph below shows the correlation between buybacks and the S&P 500 since 2000 (note that 2018 is an estimate).

Further support for this theory comes from Goldman Sachs who claims that corporations have been the biggest class of buyer of equities since 2010 easily surpassing ETF’s, foreign investors, mutual funds, households and pension funds.

There is currently nothing that leads us to believe that corporations will stop buying their shares back, and if anything the recent tax reform further supports this trend. While buybacks currently show no signs of slowing, the recent increase in interest rates may make buybacks more difficult to conduct as debt has been a main source of funds for buybacks as shown below. Furthermore, higher interest rates may cause the credit rating agencies to downgrade companies who have accumulated large debt loads which would add to the cost of issuing debt and make buybacks more challenging. While this pillar of the bull market is still standing tall, it is worth following.


Since the lows of 2009, BTFD or “buy-the-dip” has gone from a catchy acronym to a most trusted investment strategy.  Those that have followed this advice and bought when the market has shown temporary weakness are batting 1,000%.

When individuals, financial institutions, corporations, and even some central banks have a “can’t lose” strategy, sustainable market support is generated. The initially tentative investor response of BTFD has become emboldened over time and eventually turned in to a muscle memory-like reaction.

We believe it will take a series of market dips followed by rallies that do not quite get back to recent highs to erode confidence in the BTFD strategy. A period of such price action, sequential lower highs and lower lows, will cause “easy” profits to turn in to losses. As doubt and anxiety rise with losses mounting, it will challenge investor beliefs and with it remove critical support underlying the bull market.

Beginning in late January, the S&P 500 fell about ten percent and subsequently recovered about 75% of it. If the equity market fails to reclaim the January highs, then this would begin to look like a textbook technical topping formation. It is not unusual for a topping process to develop at a time of extreme optimism as is currently being experienced.

If, however, the market pushes to record highs, the BTFD’ers will have again been rewarded. Investor confidence reinforced, and the timeline for a major correction would be extended into the future.

When BTFD fails, we suspect investors will slowly gravitate to an STFR (Sell the Rally) mentality. Contrary to BTFD, they will sell or establish short positions when the market rallies. That transition, however, will only occur after much pain has been felt by those whose optimism gradually gives way to the reality of having incurred a series of losses.


Despite fundamental warnings and the collapse of the short volatility trade, we must give the bull market trend and its two remaining key pillars the benefit of the doubt. We believe it is reasonable to maintain long positions but only while remaining cautious and nimble. Watch closely for signs of lower highs and lower lows as well as indications that buybacks may be slowing down.

This bull market, like all others that have preceded it, will eventually fail and years of gains will be erased. Those focused on building wealth will once again face tough choices. Do you continue to trust in the crumbling pillars of the bull market or do you exhibit prudence and protect what you have and wait for the future when prices are much lower and valuations far more reasonable?

We leave you with a few words from Lance Roberts

“The Fed has not put an “end” to bear markets.  In fact, they have likely only succeeded in ensuring the next bear market will be larger than the last.”

Well, I jinxed it.

In this past weekend’s missive I wrote:

“There are generally two events that happen every year – somebody forgets their coat, goggles or some other article of clothing needed for skiing, and someone visits the emergency clinic with a minor injury.”

The tradition continues as my wife fell and tore her ACL. The good news is she tore the right one three years ago, and after surgery is stronger than ever. Now she will get to do the left one.

But, while I was sitting in the emergency clinic waiting for the x-rays to be completed, I was sent a chart of the technology sector with a simple note: “Chart Of The Year.”

Chart Of The Year

Yes, the technology sector has broken out to an all-time high. Yes, given the sector comprises roughly 25% of the S&P 500, it suggests that momentum is alive and well keeping the “bullish bias” intact. (We removed our hedges last week on the breakout of the market above the 50-dma on a weekly basis.)

This is why we are currently only slightly underweight technology within our portfolio allocation models as shown below.

But why “the chart of the year” now? As shown below the technology sector has broken out to all-time highs several times over the last 18-months. What makes this one so special?

The Last Breakout

As stated, breakouts are indeed bullish and suggest higher prices in the short-term. This time is likely no different. However, breakouts to new highs are not ALWAYS as bullish as they seem in the heat of the moment. A quick glance at history shows there is always a “last” break out of every advance.



As I discussed yesterday, the technology sector is once again the darling of “Wall Street” just as it was at the peak of the previous two bull-markets.

“When we compare the fund to Shiller’s CAPE ratio, not surprisingly, since Technology makes up a quarter of the S&P 500 index, there is a high correlation between Technology and overall market valuation expansion and contraction.”

“As was the case in 1998-2000, the fund exploded higher as exuberance over the transformation of the world was occurring before our eyes. Investors globally were willing to pay “any price” to “get in on the action.”  Currently, investors are once again chasing returns in the “FANG” stocks with little regard to underlying value. The near vertical ramp in the fund is reminiscent of the late 1990’s as valuations continue to escalate higher.”

I am not suggesting the current breakout is “THE” last breakout, and from a “trading perspective” the breakout is certainly bullish and should be bought.

However, from a long-term investing viewpoint, the problem is knowing the difference in a “breakout” and “the last breakout.”

In both previous instances, there were no warnings, no fanfare, or any glaring impediment to the technology sector, or the markets. Investors were bullishly optimistic, fully invested, margined, and willing to overlook fundamental valuation problems on the “hope” that “reality” would soon catch up with the price.

They were wrong on both previous occasions and suffered large losses of capital not soon thereafter.

Once again, we are witnessing the same mistakes being played out in “real time.”

But there is a “difference this time” as noted by the brilliant Harold Malmgren yesterday;

The importance of the point should not be overlooked as it has been the key source of liquidity pushing markets higher since 2009.

But that is now coming to an end via ZeroHedge:

“Yet the time of this unprecedented monetary experiment is coming to an end as we are finally nearing the point where due to a growing shortage of eligible collateral, the central bank support wheels will soon come off (the ECB and BOJ are still buying massive amounts of bonds and equities each month), resulting in gravity finally regaining control over the market’s surreal trendline.

It’s not just central banks, however: also add the one nation which 5 years ago we first showed has put the central bank complex to shame with the amount of debt it has injected in the global financial system: China.

Appropriately, this central bank handoff is also the topic of the latest presentation by Matt King, in which the Citi credit  strategist once again repeats that “it’s the flow, not the stock that matters“, a point we’ve made since 2012, and underscores it by warning – yet again – that “both the world’s leading marginal buyers are in retreat.” He is referring to central banks and China, the world’s two biggest market manipulators and sources of capital misallocations.”

With markets heavily leveraged, global growth beginning to show signs of deterioration, breakeven inflation rates falling, and liquidity support being removed – the markets have yet to recognize the change.

So, yes, the breakout in the Technology sector may indeed be the “Chart Of The Year” for 2018. But not for the reason as touted by the overly optimistic “hopefuls,” rather because this could very well mark the “last breakout” of this particular bull market cycle.

Just something to consider.