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Monthly Archives: May 2017

“The sentence should have been: ‘I don’t see any reason why I wouldn’t’ or ‘why it wouldn’t be Russia’. Sort of a double negative…”  President Trump

Emma Gonzalez, the Marjory Stoneman Douglas High School student famously declared “we call B.S.” to the President, lawmakers and gun advocates after the high school shooting in Parkland,  Florida months ago.

Well, I call  B.S.  on the markets (on fundamental and valuation grounds).

Likewise in the corridors of the New York Stock Exchange and on the sets of the business media we are asked to believe in another new paradigm of a “long boom” uninterrupted by the emergence of a number of adverse headwinds (monetary pivot, ambiguous  indicators of global economic growth, the competition from short term interest rates (the three month T bill has just eclipsed 2% for the first time in a decade) and the risks of policy mistakes, among other issues). We are asked to bear witness to the products and strategies (that worship at the altar of price momentum) and, for periods of time, limit real price discovery.

Reality, not spin, will prevail in the fullness of time.

I call B.S. and I remain substantially net short.

If you’re retiree trying to use your saved capital to generate income, you’re basically trying to construct a pension for yourself. And that means you should think about how Jeremy Gold understood pensions.

Gold, who died recently (here are his obituaries in in the New York Times and the Wall Street Journal), made the first arguments that public employee pensions were more radically underfunded than most people thought. One of the questions he raised was why the payments pensions make, which are obligations, are funded with securities that are not obligations (stocks). Shouldn’t payment obligations be funded with investment obligations (bonds)? People complain that pension return estimates (or discount rates) are too high, which lowers the amount that needs to be saved today to fund future payouts. But why, Gold asked in articles like this one with his frequent collaborator Ed Bartholomew, pick securities whose returns need to be estimated in the first place?

“Risky assets (like stocks) are of course expected to return more than default-free bonds. If that weren’t true, no investor would hold risky assets. But expected to return more doesn’t mean will returns more,” Gold wrote. Indeed “[r]isky assets might well earn less than default-free bonds, perhaps much less, even over the long term – that’s what makes the risky. And if that weren’t true, no investor would hold default-free bonds.” These are all questions for retirees trying to generate income to ponder.

It’s hard for most people to estimate how much equity exposure they should have in an income-generating portfolio. Perhaps Gold’s suggestion of 0% for pension funds is too severe. What retirees should understand for their own accounts, however, is that they might not be able to take as much risk as they think they can.

Moreover, as Gold says, risky assets might earn less than risk-free assets even over the long term. That’s especially a possibility now with stock valuations so high. It shouldn’t shock anyone if bonds outperform stocks over the next decade given the starting valuations of stocks (current Shiller PE of 32).

Gold also tacitly seems to deny that risk is volatility. He speaks simply of stocks not performing as well as government bonds, not about whether stocks might be justified or not on a volatility-adjusted return basis. Retirees need to think about both definitions of risk – simple underperformance, even over a long period of time, and volatility. I’ve shown in a previous post that an asset class that has a slightly higher compounded average annual return can also inflict greater damage to a portfolio in distribution phase than an asset class with a slightly lower compounded annual rate of return, but lower volatility.

Should retirees trying to convert their assets into income lasting the rest of their lives own any stocks at all? Maybe they should own some. After all, even Gold says if stocks weren’t expected to return more than bonds, nobody would own stocks. But Gold’s arguments should make someone asserting confidently that longevity demands a lot of equity exposure blanch. Gold once had a discussion with finance professor Zvi Bodie, where Bodie repeated his famous thesis that stocks don’t get less risky over the long run if you try to insure against their delivering a loss with a put option. The option gets more expensive as you try to insure over a longer period of time. Bodie didn’t deny that the longer you go out in time, the lower the probability of a shortfall from stocks relative to a government bond. But he asserted that this lower probability of underperforming a government bond is offset by the fact that the worst possible outcome becomes worse. What Bodie calls “severity” increases over time.

Investors using their assets, saved over a lifetime of hard work, should think harder about how much stock exposure is enough.

If you need help understanding your risk tolerance and constructing an appropriate asset allocation in or before retirement, please click this link.

By Lance Roberts and Michael Lebowitz, CFA

In yesterday’s post on investor psychology, we discussed the issue of confirmation bias. To wit:

“As individuals, we tend to seek out information that conforms to our current beliefs. For instance, if one believes that the stock market is going to rise, they tend to heavily rely on news and information from sources that support that position. Confirmation bias is a primary driver of the psychological investing cycle.

To confront this bias, investors must seek data and research that they may not agree with. Confirming your bias may be comforting, but challenging your bias with different points of view will potentially have two valuable outcomes.

First, it may get you to rethink some key aspects of your bias, which in turn may result in modification, or even a complete change, of your view. Or, it may actually increase the confidence level in your view.”

A good example of this was a recent tweet, shown below, which stated the cumulative advance/decline (A/D) line of the NYSE Composite Index “bodes quite well for continued equity strength.” The argument is based on the lower graph which shows that the upward momentum in the cumulative A/D line has not shown any retreat despite the price consolidation of the S&P 500 (upper graph) since late January. The Tweet also points out, using red shaded bars, that the current behavior of the A/D line is not similar to how it behaved before the last three major drawdowns.

Before we analyze the tweet and graph, we think it may be helpful to provide a brief explanation of the A/D line.

“The A/D line is simply the number of advancing stocks less the number of declining stocks for a given day. The daily A/D is typically positive on up days and negative on down days. The graph above showing the cumulative A/D is simply each daily A/D figure added to the net sum of the A/D’s that preceded it. Importantly, there are occasions when the A/D line falls (more stocks down than up) but the market continues to rise. This kind of divergence can serve as a warning of a potential market correction. Conversely, when the market is trending lower and the A/D line begins to rise, it can signal a bottom and eventual turn higher.”

Here is the chart of the Cumulative Advance/Decline Line versus the S&P 500 index for a bit clearer understanding.

While technical analysis is a great way for investors to gauge market sentiment, and hopefully make more informed investment decisions, there are thousands of technical studies which can easily be turned to promote a bullish or bearish narrative to support one’s market view.

However, this is where technical studies should be carefully analyzed to ensure we are not “feeding” our own “confirmation bias.”

Before crunching numbers and looking at historical instances, we must first ask a basic question; what stocks does the NYSE Composite Index (NYA) measure? The NYA is comprised of securities that trade on the NYSE. With a little research, you will find this is not just the equity of corporations such as IBM, Google or McDonalds.

Per Paul Desmond, President of the Lowry Research Corporation:

“Since about 1990 the NYSE has allowed securities other than domestic common stocks to the trade on the NYSE. These include closed-end funds (that match the trends of bonds, not stocks) plus a proliferation of interest (rate) sensitive non-convertible preferred stocks and REITs (which mimic the movements of the bond market, rather than the stock market) plus ADRs of foreign stocks (that do not necessarily follow the trends of domestic common stocks).”

Based on his research, as of 2013, non-operating companies account for 52% of the issues trading on the NYA.

Simply put, the index, and by default, the daily or cumulative A/D of the index, does not provide a clear picture of the breadth of equities. In fact, one could argue it is every bit as much an indicator of the breadth of the fixed income markets.

Because of this composition problem we chose to analyze A/D data for the S&P 500. While the S&P 500 does include some REITs and possibly other non-operating companies, we believe that percentage to be significantly smaller than the NYA and therefore provides a clearer picture of equity breadth.

We take a different approach than the graph shown above. We plotted daily instances of the change in the S&P 500 and the associated net A/D for that day. Further, we only included instances when the S&P 500 was higher on the day. In a strong bull market, one would expect a larger than normal Net A/D on up days.

The graphs below isolate the daily instances occurring four months prior to the market peaks of 2000 and 2007 to the longer term trend occurring four years prior to each peak. Given the large number of data points, we make trend spotting easier by adding darker trend lines. The steeper the slope of the trend line, the higher the net A/D figure per percentage gain, and therefore the better the breadth. Conversely, a flatter line denotes not as many net stocks advanced on days the market rose and subsequently breadth is worse.

In the four months leading the market peaks of 2007 and 2000 the recent A/D trend line (orange) flattened versus the slope of the prior four years.

The graph below showing current data tells a similar story.

Here is another take on similar data. The chart below is the S&P 1500 Advance-Decline percent. The difference here is that instead of just the 500-largest capitalization companies in the S&P 500, it also includes 600 small-capitalization and 400 mid-capitalization companies as well. This analysis provides a much broader sense of the markets true underlying strength.

Again, we see that with roughly an equal split in participation, the overall strength of the market heading into the last half of the year may not be as robust as currently perceived.

While the “bulls” tend to take the data at face value, and extrapolate current trends into the future, investors should also consider the opposing view which suggests the outlook for the next few months is inconclusive at best. 

Battling “confirmation bias” is a difficult challenge because it forces us to consider views we absolutely disagree with. However, it also leads us into making much better decisions, not only in our portfolios, but in life.

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather

Click here to download our investment manifesto.

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

The Problem Of Psychology

During this series so far we have primarily discussed the more mechanical issues surrounding “investing myths” over the duration of an individuals investing “life-span.” 

Individuals are often told:

“There has never been a 10 or 20-year period in the market with negative returns.”

As we showed previously, such is not exactly correct once you account for inflation.

While “buying and holding” an index will indeed create a positive return over a long enough holding period, such does not equate to achieving financial success. But even if “investing your way to wealth” worked as advertised, then why are the vast majority of Americans so poorly equipped for retirement?

Every three years, the Federal Reserve conducts a study of American finances which exposes the lack of financial wealth for the bottom 90% of households. (Read: The Bottom 90% & The Failure Of Prosperity)

Other survey’s also confirm much of the same. Via Motley Fool:

“Imagine how the 50th percentile of those ages 35 – 44 has a household net worth of just $35,000 – and that figure includes everything they own, any equity in their homes, and their retirement savings to boot.

That’s sad considering those ages 35 and older have had probably been out in the workforce for at least ten years at this point.

And even the 50th percentile of those ages 65+ aren’t doing much better; they’ve got a median net worth of around $171,135, and quite possibly decades of retirement ahead of them.

How do you think that is going to work out?”

Another common misconception is that everyone MUST be saving in their 401k plans through automated contributions. According to Vanguard’s recent survey, not so much.

  • The average account balance is $103,866 which is skewed by a small number of large accounts.
  • The median account balance is $26,331
  • From 2008 through 2017 the average inflation-adjusted gain was just 28%. 

So, what happened?

  • Why aren’t those 401k balances brimming over with wealth?
  • Why aren’t those personal E*Trade and Schwab accounts bursting at the seams?
  • Why are so many people over the age of 60 still working?

While we previously covered the impact of market cycles, the importance of limiting losses, the role of starting valuations, and the proper way to think about benchmarking your portfolio, the two biggest factors which lead to chronic investor underperformance over time are:

  • Lack of capital to invest, and;
  • Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. It is also difficult to “invest” when the majority of Americans have an inability to “save.”

These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.

While “buy and hold” and “dollar cost averaging” sound great in theory, the actual application is an entirely different matter. The lack of capital is an issue which can only be resolved through financial planning and budgeting, however, the simple answer is:

Live on less than you make and invest the rest.

Behavioral biases, however, are an issue which is little understood and accounted for when managing money. Dalbar defined (9) nine of the irrational investment behavioral biases specifically:

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

George Dvorsky once wrote that:

“The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.

Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process.

Let’s dig into the top-5 of the most insidious biases which keep us from achieving our long-term investment goals.

1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs. For instance if one believes that the stock market is going to rise, they tend to heavily rely on news and information from sources that support that position. Confirmation bias is a primary driver of the psychological investing cycle.

To confront this bias, investors must seek data and research that they may not agree with. Confirming your bias may be comforting, but challenging your bias with different points of view will potentially have two valuable outcomes.

First, it may get you to rethink some key aspects of your bias, which in turn may result in modification, or even a complete change, of your view. Or, it may actually increase the confidence level in your view.

The issue of “confirmation bias” is well known by the media. Since the media profits from “paid advertisers,” viewer or readership is paramount to obtaining those clients. The largest advertisers on many financial sites are primarily Wall Street related firms promoting products or services. These entities profit from selling product they create to individuals, therefore it should be no surprise they advertise on websites that tend to reflect supportive opinions. Given the massive advertising dollars that firms such as Fidelity, J.P. Morgan (JPM), and Goldman Sachs (GS) spend, it leaves little doubt why the more successful websites refrain from presenting views which deter investors from buying related products or services. 

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”

This is why it is always important to consider both sides of every debate equally, analyze the data accordingly, and form a balanced conclusion. Being right and making money are not mutually exclusive.

2) Gambler’s Fallacy

The “Gambler’s Fallacy” is one of the biggest issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.

The bias is clearly addressed at the bottom of every piece of financial literature.

“Past performance is no guarantee of future results.”

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.

Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.”

We traced out the returns of the S&P 500 and the Barclay’s Aggregate Bond Index for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years. “Performance chasing” is a major detraction from an investor’s long-term investment returns.

Of course, it also suggests that analyzing last year’s losers, which would make you a contrarian, has often yielded higher returns in the near future.

3) Probability Neglect

When it comes to “risk taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.” As individuals, we tend to lean toward what is possible such as playing the “lottery.” The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning it. However, it is this infinitesimal “possibility” of being fabulously wealthy that makes the lottery so successful. Las Vegas exists for one reason; amateur gamblers favor possibility over probability.

As investors, we tend to neglect the “probabilities,” or specifically the statistical measure of “risk” undertaken, with any given investment. Our bias is to “chase” stocks that have already shown the biggest increase in price as it is “possible” they could move even higher. However, the “probability” is by the time the masses have come to discover the opportunity, most of the gains have likely already been garnered.

“Probability Neglect” is the very essence of the “buy high, sell low” syndrome.

Robert Rubin, former Secretary of the Treasury, once stated;

“As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty, we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecasted. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

4) Herd Bias

Maybe the best way to show how susceptible we are to follow the crowd is by watching this video from Candid Camera.

Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, and if I want to be accepted, then I need to do it also.

In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets, the “herding” behavior is what drives markets to extremes.

As Howard Marks once stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.

Moving against the “herd” is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is not necessarily knowing when to “bet” against the stampede but the psychologically debilitating action of being different. As they say, “it is lonely at the top.”

5) Anchoring Effect

This is also known as a “relativity trap” which is the tendency to compare our current situation within the scope of our own limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for.  However, can you tell me what exactly what you paid for your first bar of soap, your first hamburger, or your first pair of shoes? Probably not.

The reason is that the purchase of the home was a major “life” event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and, therefore, we are likely to assume that the next home purchase will have a similar result. When we become mentally “anchored” to an event we tend to base our future decisions around it.

When it comes to investing we do very much the same thing. If we buy a stock and it goes up, we remember that stock and that outcome. Therefore, we become anchored to that stock. Individuals tend to “shun” stocks which lost value even though the individual simply bought and sold at the wrong times. After all, it is not “our” fault an investment lost money; it was just a bad company. Right?

This “anchoring” effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you “anchor” on ABC and keep buying it as it rises. When the stock begins its inevitable “reversion,” investors remain “anchored” on past performance until the “pain of ownership” exceeds their emotional threshold. It is then they tend to panic “sell” and now become “anchored” to a negative experience and never buy shares of ABC again. Worse, DEF, despite your past experience owning it, may present great value at reduced prices, but your previous negative experience reduces your inclination to purchase it.


In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today. Are valuations at levels that have previously lead to higher rates of future returns? Are interest rates rising or falling? Are individuals currently assessing the “possibilities” or the “probabilities” in the markets?

As individuals, we invest our hard earned “savings” into a “speculative” environment where we are “betting” on a future outcome. The reality is the majority of individuals are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

The discussion of why “this time is not like the last time” is largely irrelevant. Whatever gains investors garner in the first-half of an investment cycle by chasing the “bullish thesis” will be almost entirely wiped out during the second-half. Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy,” but never “when to sell.”

“The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet it seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.” – John Coumarianos

It is an interesting comment and John is correct. Low rates, weak economic growth, cheap and available credit, and a need for income has inflated the third bubble of this century.

But when it comes to housing, as I was digging through the employment data yesterday, I stumbled across the “rental income” component which is included in national compensation. When I broke the data out into its own chart, I was a bit surprised.

Let’s step back for a moment to build a bit of a framework first. While there has been much speculation about a resurgent “housing boom” in the economy, the data suggests something very different which is that housing has simply become an asset class for wealthy investors to turn into rentals.

As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence levels of homeownership rates first seen in the 1970’s. (Also, note surging debt levels are supporting higher homeownership.)

The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate. As noted above, with owner-occupied housing at the lowest levels since the 1970’s, “renters” have become the norm. 

The surge in “renters” since the financial crisis, due to a variety of financial reasons, has pushed rental income to record levels of nearly $800 billion a year. Given the sharp surge in incomes, it is not surprising that multifamily home construction and “buy to rent” continues apace in the economy for now. For investors, it has become an alternative asset class with increasing asset values and income yielding well above the current 10-year Treasury rate.

With roughly a quarter of the home buying cohort either unemployed or underemployed and living at home with their parents, the ability to create households has become more problematic. The remaining members of the home buying, household formation, contingent are employed but at lower ends of the pay scale and are choosing to rent due to budgetary considerations. This explains why the 12-month moving average of household formation, used to smooth very volatile data, is near its lowest levels going back to 1955.

The risk to the “renter nation” bubble is a “rush for the exits” by the herd of speculative buyers turning into mass sellers. With a large contingent of homes being held for investment purposes, if there is a reversion in home prices a cycle of liquidation could quickly occur. Combine that with the onset of a recession, and/or a bear market, and the problem could well be magnified. Of course, it isn’t just the liquidation of homes that is an issue but the inability to find a large enough pool of qualified buyers to absorb the inventory.

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


Most Read On RIA

Research / Interesting Reads

“Risk comes from not knowing what you are doing.” – Warren Buffett

Questions, comments, suggestions – please email me.

“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.”

In “The Fed’s Real Target” it was explained that the Fed’s interest rate manipulations are intended to influence the behavior of borrowers, not investors.  Fed Chairman Powell agrees.  In his most recent press conference, Powell reiterated that the Fed Funds rate continues to be the Fed’s primary tool to influence the U.S. economy.  Based on the Fed’s analytical framework, the economy is slowed by a series of interest rates increases because the behavior of borrowers is constrained.  Using similar logic, the economy is stimulated by a series of interest rates declines because borrowers use the reduction in interest expense for other purposes that promote economic growth.

But the Fed also bought a non-trivial amount ($3.6 trillion) of government obligations during the Quantitative Easing (QE) experiment, in the belief that QE would also boost the U.S. economy. Unlike interest rate manipulations, QE is direct manipulation of bond prices and yields and is clearly directed at investors, not borrowers. This key difference between who QE and QT targets are incredibly important and often not fully appreciated by investors.

Since November 2017, the Fed has embarked on Quantitative Tightening (QT), a policy that forces investors to refinance trillions of U.S. government obligations that are maturing from the Fed’s portfolio.

Can the movement of asset prices during the QE period give clues about how asset prices might move during QT?  In this article, we show that the Fed’s QE policy produced the counterintuitive result of higher yields on Treasury bonds, not lower yields as implied by supply/demand analysis.  Using symmetrical logic, the Fed’s QT policy should be expected to reverse the effects of QE, and to produce the counterintuitive result of lower yields, not higher yields implied by supply/demand analysis.

QE was launched in 2008 and ended in late 2014 after three rounds of purchases plus Operation Twist which extended the duration of their holdings  Digging through the archives, the following chart shows that the S&P 500 index (SPX) rose 176% during the periods in which QE was operative (colored lines) while SPX declined 32% during non-QE periods (gray).  Since mid-2015, when the chart was created, SPX has risen from 2100 to 2785, a gain of 31% that offset almost all the 32% loss.  Clearly, QE produced an upward bias to stock prices. While the topic for another article, it is worth pointing out that many other central banks continued buying assets after QE ended via their QE programs and this activity played a role directly and indirectly in supporting SPX.

Moving to the market for U.S. Treasury bonds, QE produced quite a different result than many had expected.  The 10-year Treasury yield rose by 184bp during periods of QE and fell by 293bp during non-QE periods.  Despite massive bond purchases by the Fed, sales by other investors overwhelmed the Fed’s actions.  Since mid-2015, when the chart below was created, 10-year Treasury yields have risen from 2.25% to 2.85%, offsetting some of the decline in yields that occurred during non-QE periods since 2008.

Why might yields have risen during periods of QE, when the Fed was buying trillions of dollars of bonds?  The chart below shows that inflation expectations rose by a total of 274bp during periods of QE and fell by 104bp during non-QE periods.  Markets apparently believed that QE would produce a systematic increase in inflation.

Summarizing the results of stock and bond markets post-2008, during QE periods, the Fed bought $3.6 trillion of government obligations, but bond yields rose.  During non-QE periods, bond yields fell.  Almost nobody expected that a multi-trillion program of buying government bonds would result in declining prices (rising yields) for government bonds.  Yet that’s what happened.  Based on the movement in breakeven yields, investors believed QE would result in systematically higher inflation.  During QE periods SPX rose, and during non-QE periods SPX was basically unchanged.

Viewed from the perspective of a portfolio, QE clearly changed the risk tolerance of investors, who sold U.S. Treasury bonds to the Fed and used the proceeds to buy U.S. stocks and a variety of other risky assets that appreciated sharply (real estate, junk bonds, emerging market stocks and bonds, collectibles, etc).  To use technical language, the risk premium fell for risky assets relative to U.S. Treasury bonds.

Transition from QE to QT

Since November 2017, the Fed has been pursuing a policy of QT, allowing a portion of its portfolio of bonds to mature without reinvesting.  If QT is the opposite of QE (essentially, bond-selling instead of bond-buying), it is logical that asset prices will adjust in the opposite direction than what occurred during QE.  That is, bond yields should fall even though the Fed’s actions require investors to now buy $50 billion more of government obligations each month.  Stock markets should fall because investors will sell risky assets to meet the increased supply of Treasury bonds.   But what is the actual pattern of prices in the QT era?

SPX has risen by approximately 5% since November, but more than 100% of that gain occurred in December and January, possibly in anticipation of corporate tax cuts.  Since January, the trend has been downward and much more volatile.  QT began slowly, at $10 billion per month, but starting in July 2018 it has been ramped up to $50 billion per month in maturing bonds.  QT may already be taking a toll on the stock market.

How about the bond market?  The combination of higher deficits, higher short-term interest rates, and the Fed’s QT program means that investors will need to buy more than $1 trillion in newly-issued Treasury notes in each of the next few years.  A simple supply/demand analysis would suggest that bond yields should rise during a period of QT, just as a simple supply/demand analysis would suggest that bond yields should have declined during QE.

As shown below, bond yields have indeed risen since the beginning of QT, from 2.40% to 2.85%.  But just as with the stock market, most of the move occurred in December and January, as markets began to anticipate the stimulative effect of corporate tax cuts.   Since January, bond yields have gone sideways, defying the predictions of those who believed long-term interest rates would inevitably rise because of the Fed’s rate hikes and increased deficit spending, each of which increases the supply of U.S. Treasury bonds.

Are the bond markets expecting a return of inflation?  The chart of inflation expectations below is remarkable because inflation expectations have remained in a narrow range of 1.5-2.5% for most of the past 15 years.  As a result, relatively small changes can appear to be larger than they really are.  During the entire QE era, inflation expectations were also anchored in the 1.5-2.5% range, although as explained previously, inflation expectations rose during QE periods and fell during non-QE periods.  Since QE ended in late 2014, inflation expectations fell from 1.8% to 1.2% as the price of crude oil crashed from $110 to $26 per barrel.  Inflation expectations then rose to the current 2.1% level. That said, QT seems to have put a lid on rising inflation expectations, which have been stuck at 2.1% for the past six months.

Many, including the Fed, fear that inflation will spike higher.  But the ever-flattening yield curve, which is an excellent leading indicator of recessions, suggests that bond markets are beginning to believe that the next move in inflation is down, not up.  The flat yield curve also supports our analysis in “Does Surging Oil Costs Cause a Recession?” which shows that a combination of rising short-term interest rates and a doubling of crude oil prices preceded each recession since 1970, with no false signals.  Those conditions exist in 2018.

Finally, the prices of industrial metals such as copper are nosediving.  Many will attribute the recent weakness in metals to the threats of a trade war.  But it is also possible that the Fed’s combo-platter of QT (aimed at investors) and rising U.S. interest rates (aimed at borrowers) is a primary culprit.  Regardless whether the trade war or Fed actions are responsible, it is clear that commodities investors don’t like what’s on the menu.


The purpose of this article is to estimate the future direction of asset prices based on the logic that QT will have the opposite effect on asset prices then occurred during QE.

Here’s what we know happened during QE:

  • QE changed the behavior and preferences of investors, which greatly affected relative prices
  • QE produced an expected result of higher stock prices
  • QE produced an increase in inflation expectations, which produced the unexpected result of higher Treasury bond yields

If markets respond to QT symmetrically to how they responded during QE, then:

  • QT will change the behavior and preferences of investors and change relative prices
  • QT will produce lower stock prices
  • QT will reduce expectations for inflation, resulting in lower Treasury bond yields

So far, the QT era has not produced lower stock prices and bond yields.  That said, it is too early to make a definitive statement on QT’s ultimate impact.  The full force of QT ($50 billion per month) has just begun, and there are signs that stocks and bonds are beginning to change direction.  Since November when QT began, SPX has risen.  But since the January peak that occurred in the wake of tax cuts, the trend of SPX is downward and more volatile.  Since November, bond yields have also risen.  But as with SPX, since January a change has occurred; bond yields have stopped rising.

It is possible that the trends in effect since January will persist and possibly intensify throughout the QT era, which would be a surprise to the consensus view that interest rates will inevitably rise due to an increasing supply of Treasury bonds.  Other important data points also suggest that Treasury bond yields may continue to fall; inflation expectations have been static since QT was launched in late 2017, the yield curve continues to flatten to levels not seen since 2007, and industrial commodities are in freefall.

Last week, the Bureau of Labor Statistics published the latest monthly “employment report” which showed an increase in employment of 213,000 jobs. It was also the 93rd consecutive positive jobs report which is one of the longest in U.S. history. Not surprisingly, the report elicited exuberant responses from across the financial media spectrum such as this from Steve Rick, chief economist for CUNA Mutual Group:

“The employment report this month demonstrates yet again the robust strength of the labor market. After a red-hot May, June kept up steady momentum in jobs and certainly hit back at any worries among economists who thought hiring was beginning to plateau after an inconsistent past few months.”

There is little argument the steak of employment growth is quite phenomenal and comes amid hopes the economy is beginning to shift into high gear.

But if employment is as “strong” as is currently believed, then I have a few questions for you to ponder. These questions are important to your investment outlook as there is a high correlation between employment, economic growth and, not surprisingly, corporate profitability.

Let’s get started.

Prelude: The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current annual rate of employment growth is 1.6% which is lower than any previous employment level prior to a recession in history.

Question: Given the low rate of annual growth in employment, and the length of the employment gains, just how durable is the job market against an exogenous economic event? More importantly, how does 1.6% annualized growth in employment create sustained rates of higher economic growth?

Prelude: One thing which is never discussed when reporting on employment is the “growth” of the working age population. Each month, new entrants into the population create “demand” through their additional consumption. Employment should increase to accommodate for the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The next chart shows the total increase in employment versus the growth of the working age population.

Question: Just how “strong” is employment growth, really? 

Prelude: The missing “millions” shown in the chart above is one of the “great mysteries” about one of the longest economic booms in U.S. history. This is particularly a conundrum when the Federal Reserve talks about the economy nearing “full employment.”

The next several charts focus on the idea of “full employment” in the U.S. While Jobless Claims are reaching record lows, the percentage of full time versus part-time employees is still well below levels of the last 35 years. It is also possible that people with multiple part-time jobs are being double counted in the employment data.

Question: With jobless claims at historic lows, and the unemployment rate at 4%, then why is full-time employment relative to the working age population at just 49.9%?

Prelude: One of the arguments often given for the low labor force participation rates is that millions of “baby boomers” are leaving the workforce for retirement. This argument doesn’t carry much weight given the significantly larger “Millennial” generation which is entering into the workforce simultaneously.

However, for argument sake, let’s assume that every worker over the age of 55 retires. If the “retiring” argument is valid, then employment participation rates should soar once that group is removed. The chart below is full-time employment relative to the working-age population of 16-54.

Question: At 50.43%, and the lowest rate since 1981, just how big of an impact are “retiring baby boomers” having on the employment numbers?

Prelude: One of the reasons the retiring “baby boomer” theory is flawed is, well, they aren’t actually retiring. Following two massive bear markets, weak economic growth, questionable spending habits and poor financial planning, more individuals over the age of 55 are still working than at any other time since 1970.

The other argument is that Millennials are going to school longer than before so they aren’t working either. The chart below strips out those of college age (16-24) and those over the age of 55. Those between the ages of 25-54 should be working.

Question: With the prime working age group of labor force participants still at levels seen previously in 1988, just how robust is the labor market actually?

Prelude: Of course, there are some serious considerations which need to be taken into account about the way the Bureau of Labor Statistics measures employment.  The first is the calculation of those no longer counted as part of the labor force. Beginning in 2000, those no longer counted as part of the labor force detached from its longer-term trend. The immediate assumption is all these individuals retired, but as shown above, we know this is exactly the case.

Question: Where are the roughly 95-million Americans missing from the labor force? This is an important question as it relates to the labor force participation rate. Secondly, these people presumably are alive and participating in the economy so exactly how valid is the employment calculation when 1/3 of the working-age population is simply not counted?

Prelude: The second questionable calculation is the birth/death adjustment. I addressed this in more detail previously, but here is the general premise.

Following the financial crisis, the number of “Births & Deaths” of businesses unsurprisingly declined. Yet, each month, when the market gets the jobs report, we see roughly 200,000 plus jobs attributed to positive net business creation.

Included in those reports is the ‘ADJUSTMENT’ to account for the net number of new businesses (jobs) that were “birthed” (created) less “deaths” (out of business) during the reporting period. Since 2009, the number has consistently “added” roughly 800,000 jobs annually to the employment numbers despite the fact the number of businesses was actually declining.

The chart below shows the differential in employment gains since 2009 when removing the additions to the monthly employment number through the “Birth/Death” adjustment. Real employment gains would be roughly 7.04 million less if you actually accounted for the LOSS in jobs. 

We know this number is roughly correct simply by looking at the growth in the population versus the number of jobs that were estimated to have been created.

Question: If we were truly experiencing the strongest streak in employment growth since the 1990’s would not national compensation be soaring?

Prelude: If the job market was as “tight” as is suggested by an extremely low unemployment rate, the wage growth should be sharply rising across all income spectrums. The chart below is the annual change in real national compensation (less rental income) as compared to the annual change in real GDP. Since the economy is 70% driven by personal consumption, it should be of no surprise the two measures are highly correlated.

Side Question: Has “renter nation” gone too far?

However, if we dig in a bit further, we see that real rates of average hourly compensation remains virtually non-existent.

Question: Again, if employment was as strong as stated by the mainstream media, would not compensation, and subsequently economic growth, be running at substantially strong levels rather than at rates which have been more normally associated with past recessions?

I have my own assumptions and ideas relating to each of these questions. However, the point of this missive is simply to provide you the data for your own analysis. The conclusion you come to has wide-ranging considerations for investment portfolios and allocation models.

Does the data above support the notion of a strongly growing economy that still has “years left to run?”  

Or, considering the fact the Fed is tightening monetary policy by raising rates and reducing liquidity, does the data suggest a “monetary policy” accident and recession are an under-appreciated risk?

But then again, maybe the yield-curve is already telling the answer to these questions. That however depends on which yield curve you look at. For our latest on the Fed’s shifting narrative on the value of the yield curve please read our latest article – The Mendoza Line.

In professional baseball, there is a performance standard called the Mendoza Line, a term coined in 1979 and named after Mario Mendoza, a player that struggled to hit consistently throughout his career. The standard or threshold is a batting average of .200. If a player, other than a pitcher, is batting less than .200, they are not considered to be of professional grade.

Investors’ also have a Mendoza Line of sorts. This one, the yield curve, serves as an indicator of future recessions. Since at least 1975, an inverted yield curve, which occurs when the 2yr U.S. Treasury note (UST 2) has a higher yield than the 10yr U.S. Treasury Note (UST 10), has preceded recessions. Currently, the 2s/10s yield curve spread has been flattening at a rapid pace and, at only 0.33% from inversion, raises concerns that a recession might be on the horizon.

Interestingly, the Federal Reserve (Fed) recently introduced the merits of a new yield curve formula to supplement the traditional curve and better help forecast recession risks. Might it be possible the Fed has brought this new curve to the market’s attention as it does not like the message the traditional curve is sending? Given that the Fed Funds rate remains very low despite recent increases, is it possible the Fed is desperately attempting to increase the monetary ammo available for the next recession?

Regardless of the Fed’s intentions and whether the market takes the Fed’s bait and buys into a new recession warning standard, understanding the differences between the traditional curve and the new curve provides valuable insight into what the Fed’s reaction function might be regarding enacting monetary policy going forward.

Traditional 2s/10s Curve

*In this article we solely refer to traditional yield curve represented by UST 2 and UST 10. There are other curves that use different maturities and credits which provide value as well. 

The yield on the UST 10 not only reflects the supply and demand for ten-year government debt securities but importantly embedded in its yield are investors’ expectations for inflation and growth. These expectations are influenced to some degree by the Fed’s monetary policy stance.

The UST 2, on the other hand, is much more heavily influenced by the Fed Funds rate set by policy-makers and less so by long-term growth and inflation expectations.

Therefore, the UST 10 provides information about how borrowers and lenders view future economic activity and inflation, while the UST 2 affords us insight into how the Fed might change interest rates in the future. It is this intersection of the Fed’s interest rate policy and the heavy reliance on debt to fuel economic activity that makes the 2s/10s yield curve an especially compelling indicator today.

The graph below charts the correlation between Fed Funds rate expectations, as quantified by the rolling 8th Fed Funds futures contract, and benchmark maturity Treasury securities. The 8th Fed Funds contract denotes market expectations for eight months forward. It is the longest contract available without compromising price consistency due to illiquidity.

* = interpolated data

Data Courtesy: Bloomberg 

From 2000 to the present, the correlation of UST 2 and Fed funds futures is a positive 0.80. In other words, 80% of the price change of the UST 2 is explained by expectations for future rates of the fed funds rate. As shown, correlation declines as the time to maturity increases. The relationship between the UST 10 and Fed funds future is .56, which is significant but less dependent on Fed Fund expectations than the UST 2.

The difference between how investors price UST 2 versus UST 10 help us contrast expectations for economic growth/inflation and monetary policy. When the curve inverts, the market is warning us that the Fed’s monetary policy is restrictive or in market terms, tight or hawkish. In such an environment banks are not very willing to lend as their cost of borrowing does not provide enough profit margin to cover credit losses and meet profit thresholds. Conversely, when the curve spread is wide and monetary policy is deemed easy or dovish, banks are in a much better position to extend credit.

While there are many explanations for why the curve is flattening rapidly, the consensus seems to be that inflation and the long-term economic growth outlook for the future are benign despite a recent spurt in economic activity. In fact, the Fed’s long-term projected rate of economic growth is only 1.90%. Fed Funds are currently 1.75-2.00% and expected to increase at least two or three more times. The combination of views necessarily flattens the yield curve and importantly makes lending less profitable.

The New Curve

What if your local weatherman forecasted weather not based on atmospheric conditions and other scientific data but instead on his own forecast. “I dreamt it will rain in three days, therefore my forecast is for rain in three days.” His prediction method, if uncovered, would probably lead him to seek a new career.

The weatherman’s forecast is a good way to describe the new yield curve the Fed has recently publicized. This curve is calculated by comparing the current three-month rate for Treasuries versus what that rate is expected to be six quarters from now. The forward rate is calculated using the current rate and the interpolated rate on 1.50- and 1.75-year Treasury notes. Do not get caught up in the complexity of the math but in laymen’s terms the curve is simply a forecast of what the market thinks the Fed will do. Let that bit of recursive logic resonate before reading on.

Said differently, the Fed imposes unnatural control over the shape of the new curve. Consider again the correlation table above. For Treasury securities with two years to maturity or less, expected Fed policy has a strong influence on yield. Therefore, by saying they intend to hike interest rates, the Fed also influences the shape of their new yield curve metric. The logic behind the new curve logic confounds what they claim is a pure insight into expectations for a recession.

The Fed is not coy about making that clear as witnessed in the most recent FOMC minutes:

The staff noted that this measure (new yield curve) may be less affected by many of the factors that have contributed to the flattening of the yield curve, such as depressed term premiums at longer horizons.

Click Here for more information on their new curve. 

Comparing Curves

The following graph compares the traditional 2s-10s curve and the new curve with recessionary periods represented by gray bars.

Data Courtesy: Bloomberg

As shown above, the orange line representing the traditional curve and the new curve in blue are well correlated and have both dependably warned of recession about a year or two before the beginning of previous recessions.

Closer inspection of the last six years, as shown below, however, yields a very different story.

The traditional 2s-10s curve spread is falling at a decent pace and has been in decline for the better part of the last five years. Conversely, the new curve has been in a slight uptrend over the same period. Clearly, the curves are sending different messages.

Calling Foul on the Fed

There is one key difference between the two curves that is vital to appreciate. The Fed has much more control over the shape of the new curve versus the traditional curve. For instance, if the Fed promises more rate increases and continues to deliver on said promises, there is a high likelihood the new curve will stay positively sloped. The traditional curve, as shown earlier, is much less influenced by the Fed directly. Instead, it is quite likely the traditional curve, in that situation, would continue to flatten and invert as further rate hikes are thought to have a dampening effect on economic growth and inflation. Per the Federal Reserve –“Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession.”

We believe the Fed is introducing this new curve to provide cover to allow them to keep raising rates. The trend and impending signal from the traditional curve is leading investors to second guess the Fed and their tightening campaign. The traditional curve could cause investors to lose confidence in the Fed. Given the state of excessive asset valuations built largely on confidence in the Fed, this presents a big problem. If, on the other hand, investors buy into the new curve and its upward sloping shape, might they be persuaded a recession is not in sight and their confidence in the Fed will remain strong?

It’s important to remind you why the Fed may be particularly anxious about raising rates. During the last two recessions Fed Funds reductions of 5.25% and 5.50% were required to stabilize the economy. Additionally, in 2008/09 the 5.25% rate cut wasn’t enough, and the Fed introduced QE which quintupled the size of their balance sheet. With Fed funds currently at 1.75-2.00%, the Fed has much less ability to stimulate the economy if economic growth were to slow.


In baseball, .200 is the line in the sand. It is widely accepted and understandably so given over 150 seasons of baseball. In economics, a flat or inverted 2s/10s yield curve is the line in the sand. It is widely accepted and its validity is broadly discussed in prior Fed research. Changing the Mendoza line to say .150% would allow some current substandard players to achieve “professional grade,” but the quality of players would remain the same. Likewise, changing the markets recession warning may change the perspective of some investors but will it nullify a recession?

The Fed may not like the market’s perceptions and implications of a flatter yield curve but changing it to one of their liking is not likely to alter reality. Importantly, if the goal of the current Fed is to convey a message that allows them to raise rates further, they may have found a good alternative. Our question is, however, in the name of transparency, why not just say that is the objective rather than sacrifice integrity?

Regardless of whether the Fed’s version of the economic Mendoza Line changes, we simply urge caution based on the signals of the traditional curve. Redefining key measurements of economic conditions may alter the eventuality of a recession but it will not make long-term expansions or contractions in the economy any more or less likely. It will only confuse and conflict Fed members charged with dispensing prudent policy.

We leave you with recent thoughts from the Federal Reserve on the value of the traditional 2s/10s yield curve:

“Forecasting future economic developments is a tricky business, but the term spread (traditional 2s/10s yield curve) has a strikingly accurate record for forecasting recessions. Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession. –March 2018 Economic Forecasts with the Yield Curve Federal Reserve of San Francisco.

(A previous version of this article appeared on MarketWatch on July 29, 2017.)

On July 1, the New York Mets sent a check to a former player, Bobby Bonilla, for $1.19 million. In fact, this past check was the eighth annual one the Mets have sent Bonilla, and they will send him 17 more, according to a deal they struck with their former player at the end of his career.

But Bonilla, a 55-year old retiree and former 3rd baseman/outfielder, hasn’t played a game of major league baseball since 2001. Why do the Mets still pay him? The reasons are instructive for anyone saving for retirement.

In 2000, the Mets released an aging and decreasingly productive Bonilla, while still owing him $5,9 million in salary. Bonilla and his savvy agent at the time, Dennis Gilbert, negotiated a deal whereby the Mets kept that $5.9 million for the next 10 years and then paid it out to Bonilla annually for the 25 years after that. In exchange, the Mets reportedly had to compound the amount of money they owed Bonilla by 8% annually for the next 35 years in total.

When we do the math, the 8% return checks out. If you compound $5.9 million for a decade at 8% annualized, you end up with $12.7 million. That comprises the “deferred period” of Bonilla’s deal when the Mets are investing Bonilla’s capital however they want, and hopefully generating a better-than-8% return without paying him anything. Then, after that deferred period, the math shows if the Mets continue to compound the $12.7 million at 8%, but also pay out $1.19 million of it to Bonilla every year, they pay out Bonilla completely after the 25th payment. That’s the “payout period” of Bonilla’s deal when the Mets continue to retain some of the capital, but also pay some of it out every year until Bonilla has all of it.

Lessons for Investors

Getting an annual payment for nearly $1.2 million is beyond possibility for most retirees, but there’s a lot people can learn from Bonilla’s deal. First, we are all Bobby Bonilla in that everyone who saves is deferring part of their paycheck to build a pile of assets they can live on in retirement. It’s true our former employer doesn’t necessarily hold our assets and guarantee a return on them. But if you’re saving for retirement in a 401(k) or some other vehicle , you’re doing the same thing Bonilla did with that $5.9 million the Mets owed him in the last year of his contract – you’re just doing it with less money over more pay periods. So keep saving and deferring money. You may not ever get to save and defer $5.9 million in one lump sum, but do what you can.

Second, don’t turn your nose up at 8%, but consider the source of the return and if there’s a guarantee. One of the things that encouraged the Mets to do this deal with Bonilla is that the Mets’ owners had some of their money “managed” by Bernie Madoff. They thought Madoff was producing 10%-12% annual returns, without down years, so it probably seemed like a no-brainer to guarantee Bonilla 8%.

Of course, we now know Madoff was a fraud. The lesson here is don’t believe an investment strategy can deliver 10%-12% on an annualized basis without declines. It’s true that the stock market has delivered around 10% annualized for the last century – though not at all for every 10- or 20-year period – but it has delivered that average annual return with a lot of volatility, including many gut-wrenching down years. It wasn’t Madoff’s returns that were so spectacular; it was their consistency. His Sharpe and Sortino Ratios (measures of volatility-adjusted return) were the clues to the fraud more than the annualized returns themselves.

On the other hand, if a healthy business or an insurance company contractually guarantees you an 8% return, chances are that’s a great deal. While the Mets should have been suspicious of Madoff, Bonilla was correct to take an 8% return on his capital from the Mets. Yes, he gave up some liquidity, but the Mets are obligated to pay Bonilla by a contract or in a way a stock investment or other investment strategy isn’t. That doesn’t mean an enterprise like the New York Mets can’t fail, but a guaranteed payment from a healthy enterprise is safer than counting on an 8% annualized stock market return or than counting on a high single digit payment from, say, a triple-C rated bond.

Additionally, although a Mets bankruptcy could be a blow to Bonilla, depending on where his payments rank relative to other team obligations, it’s likely that he has saved some of his other career earnings. The $5.9 million deferred payment that turned into this annual windfall for him in retirement only represents one year’s worth of income, and Bonilla had a 15-year career. Unless he squandered all of his other earnings, a Mets failure likely wouldn’t sink Bonilla in retirement.  In other words, all of Bonilla’s fortunes probably aren’t tied to the Mets’ financial success. He’s probably diversified his assets, and so should you.

Another lesson is to consider stock market valuation. When Bonilla made his deal in 2000, the stock market was roaring as the prices of technology stocks reached the stratosphere. But it was also very expensive so that it couldn’t keep up those returns. Bonilla and his agent seemed to know what others discovered, or rediscovered only after the technology meltdown – that 20% or greater annualized returns are unrealistic and that an 8% guaranteed annualized return from a solvent institution is great. I’ve never read interviews with Bonilla and Gilbert discussing this, but, judging from the deal they made, they didn’t think the world had entered a “new paradigm,” where 8% was a paltry return. You should be skeptical of new paradigms too.

Incidentally, if Bonilla had invested his money in the S&P 500 Index or in the Vanguard Balanced Index Fund, he would have underperformed what the Mets paid on his capital for the deferred period (2001-2010) by a 7 and 4 percentage points, respectively. I don’t know if Bonilla and Gilbert were looking at standard stock market valuation metrics, but when the Shiller PE hit 44 in 1999, it was a decent bet that stocks would do poorly for the next decade. So considering valuation can be useful for forecasting future returns, especially if valuations are at an extreme.

Last, inflation could hurt Bonilla. Anytime you make a deal for a fixed rate of return you are subjecting yourself to inflation risk. Fortunately, inflation is running at a low rate these days (in the 2% range), making Bonilla’s 8% an inflation-smashing return. It might not always be that way until 2035 though, so Bonilla might want to buy some real estate and gain some exposure to emerging markets stocks and commodities with some of that July 1 check every year. No publicly traded assets are screamingly cheap right now though, so building up another healthy pile of cash wouldn’t hurt him either.

As a small child, Washington yearned to be a British officer.

While other children were playing games, doing what children do, Washington gravitated to rigorous study of famous battles as recreation.

He lived the victories and defeats; with extraordinary precision, a young George envisioned and documented battle strategies, actions he would have taken to turn around and win losing engagements.

Washington possessed an indomitable fire fed by love for the home country. In his view, Britain was an honorable, unstoppable world force. Washington’s plan, early on in childhood, was to be an English patriot, ready, perhaps even anxious, to fight and die for king and country.

So, what series of events occurred that turned a searing heat of unstoppable love, dedication and passion for a home country into the ice of disappointment? How did a boy and young man eager to die for king and country turn and become the father of a new nation?

How does a passionate believer in and contributor to a country to take over the world morph into a searing combatant against his first and greatest love? What does that do to a person inside? How did that twist him? How did he mourn? How did Washington reinvent himself? Turn love into hate, ostensibly dispassion, to calculate and fight against a home country he now perceived as an oppressor of people he loved?

Virginians first. Then a scraggy mess of countrymen, Americans, he took on to fight a beast 100x the size? Awaiting the French, attempting to keep the cause alive until they arrived.

Listen, I couldn’t build out a fictional drama character or develop a protagonist for a full-length feature film as perfect as the circumstances which turned Mr. Washington.

A change of heart so dramatic, men with less resolve would have folded or disappeared into private life never to be heard from again. Washington did indeed do just that for a period. At 27, he retired from military service to Mount Vernon only to become an innovator at agricultural techniques founded by farming expert Jethro Tull.

Why did Washington retire? Ah, you’ll find out soon enough.

A man lives and breathes false truth, encounters a series of adverse circumstances, (some emotionally devastating), which continually confront and mar that truth.

Concurrently, an alternate truth begins to emerge. A truth this man doesn’t want to admit and fights against until one, last devastating personal setback, turns him completely, causes him to retrench, only to emerge different, beholden by a new truth.

Listen, this is the formula for every great fictional protagonist we embrace (and sometimes hate). Rick Grimes & Father Gabriel (tertiary protagonist) from The Walking Dead, John Wick, Maximus from Gladiator, Lucas McCain in a revamped The Rifleman, Benjamin Martin in The Patriot.

And there’s Washington.

Is one man’s fiction another man’s reality? I l believe it to be so. Every fictional character is in some part, another’s reality. I’m sure we all know people who have overcome obstacles that would have broken others.

The stock market is fiction. Prices of stocks are based on stories those who get sucked in to the stories. Supply and demand of stories, possibilities, hopes. All regulated. Mostly, fiction.

So, how and why did Washington change so radically? What can we learn?


Washington embraced strategic retreat, avoiding major engagements until he felt the opportunity was right. On occasion, it was never right, and he needed to re-group and find an alternative plan to victory.

Self-preservation and those of his men was paramount. Live to fight another day. Small victories, flanking attacks forged morale for a ragtag army that at times didn’t even possess shoes.

Britain scorned Washington numerous times, turning him down for major battles. A tremendous disappointment.

In 1754, British leaders galvanized against Washington when at the Forks of Ohio not far from Fort Duquesne (occupied by the French), Washington, an officer in the British Army along with men he marched through mountainous and dangerous terrain of Maryland and Pennsylvania, met up with a band of Iroquois to confront a French party of 35 men, fifty-five miles from the Forks.

What Washington perceived as his contribution to a first battle between two of Europe’s greatest empires, turned out to be an eventual well-publicized massacre of diplomatic messengers. One of the messengers named Jumonville was carrying a letter which was to be delivered to English authorities declaring Ohio Country as French territory. He was the first to be slaughtered by the Iroquois.

The attack was particularly gruesome and later didn’t write well in periodicals back in the home country, especially due to the brutality of the Indians who split open French scalps with tomahawks and rinsed their hands in victims’ brains.

As Russell Shorto wrote in his impressive tome – “Revolution Song,” – “The event, the series of fateful missteps by an inexperienced provincial officer, whose signatures carried the official weight of the British Empire, meant that, for the first time an event in North America would trigger a war in Europe.”

Back to the battle: It was only a matter of time before more than 1,000 French soldiers back at the Fork would know of the combat and seek to attack. Washington retreated with 400 men to a wide meadow and built a makeshift fort in the middle of it to await the next encounter.

French military head up ironically by the brother of Jumonville, passed through the gruesome massacre, now even more motivated to confront Washington and his men. With swift and diligent attack, the French took positions behind trees and rocks and precisely began to pick off Washington’s group.

They picked off men on horses, they killed more than 100, forcing Washington’s hand to surrender. The Indians had run off before the French arrived.

Military protocol at the time required George Washington surrender in writing. The French drafted a document. Washington signed it.

What the father of our country didn’t understand was that he was placing his name to a document that referenced the “assassination” of Jumonville. Washington believed the document referenced the death of the French leader, not an assassination. Unfortunately, it was probably due to the lack of skills by a novice interpreter. No matter. Washington signed a document of admission to the assassination which made the battle even more repulsive to the British.

To make matters worse (can you imagine?), a letter Washington wrote to his brother bragging about the encounter, referencing how the whistle of bullets to be a “charming sound,” was exposed and published in London Magazine.

A prominent writer portrayed Washington as foolish and the consequences dire – “The volley fired by a young Virginian in the backwoods of America set the world on fire.”

I’m not sure about you, but this series of events would have convinced me to leave the military and never be seen or heard from again. And Washington did indeed do so. For a bit. He went straight to the earth. He pondered a new life as gentleman farmer. He learned to grow tobacco on a commercial scale, he became a voracious reader and student of several heady topics including the law.

So, how do we take in what Washington experienced, how he reacted, and reinvented? Obviously, he was a Stoic in the making. He was a student of the German philosopher Nietzsche without knowing, either.

It was just who he was.

Nietzsche described human greatness as:

“Amor Fati or love of fate. Don’t bear what is necessary but love it.”

Marcus Aurelius said:

“A blazing fire makes flame and brightness out of everything that’s thrown at it.”

Epictetus lamented:

“Do not seek for things to happen the way you want them to; rather, wish that what happens happen the way it happens. Then you will be happy.”

Washington was an empath. He took in the pain of others. The Stamp Act and taxation by Britain forced oppression upon him and his brethren; denied him and his fellow man the freedom to prosper.

Thus, the rest is history. The man who loved and wanted so much to be loved by the British, found a new and greater love, a bigger mission, a higher truth. Mostly from great setback. Just like those incredible characters in films and series we are hooked on.

A non-fictional American story that resonates today.

A life we all can learn from.

At the time of his death in 1799, Washington’s estate was worth roughly $780,000 and that doesn’t include the valuation of his 7,000 acres at Mount Vernon. He was ranked as one of the richest colonialists. However, that wasn’t always the case. His finances dramatically ebbed and flowed. There were times in his life Washington was “land rich, cash poor.”

So, what lesson can we take from Washington’s life, good and bad? Here are 3 to consider.

Washington yearned for social status and went broke several times in an effort to keep up with the “Joneses.”

It was all about appearances. The finest clothing, expensive, outlandish accessories brought in from London designers. He borrowed (at 6%), to maintain his lifestyle for many years. Appears many Americans take after our first president when it comes to the use of credit to maintain standards of living.


Consumer credit per capita accelerated post-financial crisis as wage growth continued to suffer and job losses mounted. Unfortunately, unlike Washington who yearned for riding carriages with purple velvet-tufted seats and ivory handles, Americans are increasingly using credit to pay for the basics as wage growth although increasing, is not enough to keep up with rising costs, especially healthcare premiums.

According to the Pew Research’s Survey of American Family Finances, 46% of respondents reported making more than they spend; only 47% said they predictable household bills and income from month-to-month. More than third of those surveyed have suffered income volatility (a year-over-year change in annual income of 25% or more), in 2015.

Washington was a strong believer in education and the benefits of mathematics. He was also a gifted student throughout his life in agricultural sciences and the law.

A young Washington was fascinated with military strategy along with an aptitude for mathematics and geography. He was on the payroll of land baron Lord Fairfax at age 16 as a land surveyor of 5 million Virginia acres that was to be prepared for tenants arriving from across the Atlantic.

We are faltering as a country when it comes to math, science and reading proficiencies.

In a 2015 Pew Research Center report, only 29% of Americans rated their country’s K-12 education in science, technology, engineering and mathematics as above average or the best in the world.

As parents, we must help our children embrace these subjects. A Cleveland Fed study discovered that advancing past Algebra II strongly correlates with college graduation and thriving financially in the workforce.

Washington was a master networker.

America’s first president and one of its bravest leaders believed in the power of connections. He was not born of a rich family. He made connections, was a savvy social climber and married Martha Curtiss, one of the wealthiest widows in Virginia. Not that we all can marry wealthy, mind you!

Empirical studies outline how children who are better at socializing have above-average reading scores and better literacy skills. According to the Brookings Institute, social and emotional competence is critically important in the workplace. Traits that employers value in employees include self-esteem, goal setting, pride in work and interpersonal skills and teamwork.

Regardless of political affiliations, Americans can easily agree upon the respect for or relate to a trait or skill they admire when it comes to George Washington, the resilient leader of a new nation.

In this past weekend’s missive, I stated:

“The good news is the break above the 61.8% retracement level, as we noted last week, keeps the markets intact (Pathway #1) for now. And, as suggested above, a retest of recent June highs seems very likely. However, Monday will be key to see if we get some follow through from Friday’s close.”

Well, on Monday, the markets did indeed follow through and rose towards a retest of June highs.

With the markets now back to a short-term overbought extreme, the June highs may be a challenge for the bulls in the short-term. Also, it is worth noting that since the beginning of this year, “gap up” openings for the market have tended to be within a couple of days of a short-term peak. In other words, yesterday’s “gap up” opening was likely a good opportunity to trim positions that have become overweight in portfolios. For us, those were the technology and discretionary sectors, which we have now reduced back to target portfolio allocations.

However, on a positive note, if the bulls can indeed muster a rally above the June highs, and can hold it, it will likely be an easy stretch back to the highs of the year. With the market climbing an advancing trend (higher bottoms and higher highs), our portfolios remain weighted towards equities, although we do remain underweight from target goals. If the “bull market” reasserts itself and shows stronger breadth, then further increases in allocations may be justified.

But that point is not now. Over the last month, the bullish backdrop has become markedly less clear as the list of economic and market concerns persists. This great graphic came from Mark Raepczynski on Friday:

Liz Ann Sonders also took a stab at the list of headwinds facing the bulls currently:

“More broadly, at the midpoint of the year, there continue to be both headwinds and tailwinds for the economy and the market. Trade uncertainty clearly falls in the former. As you can see in the graphic below, I have loosely connected many of these, along the lines of an ‘on the one hand…on the other hand…’ analysis.” 

With concerns rising, it is not surprising to see that investor “optimism” has dwindled in recent weeks, particularly as price volatility has risen sharply this year. The chart below shows the daily price movements of the S&P 500 from 2017 to present.

The chart below is a composite “investor sentiment” index or rather how investors “feel” about the current investing environment.

Clearly, the “exuberance” of the market has given way to more “concern” since the beginning of the year, but given sentiment remains elevated, there is little to suggest real “fear” is present.

In other words, as I discussed this past weekend, despite the rise in “fear,” investors are not willing to “do” anything about. Or rather, F.O.M.O. (fear of missing out) still trumps F.O.L.M. (fear of losing money.)

“With valuations elevated and earnings expectations extremely lofty, the risk of disappointment in corporate outlooks is elevated. Furthermore, despite those who refuse to actually analyze investor complacency measures, both individual and institutional investors remain heavily weighted towards equity risk. In other words, while investors may be “worried” about the market, they aren’t doing anything about due to the ‘fear of missing out.’”  

“This is the perfect setup for an eventual ‘capitulation’ by investors when a larger correction occurs as overexposure to equities leads to ‘panic selling’ when losses eventually mount.”

Overall, the market continues to quickly discount the various risks facing the market. But almost as quickly as one is “priced in,” another emerges. With “trade wars” now live, “Brexit” running into trouble and the November elections in the U.S. quickly approaching, there are plenty of concerns which still lay ahead.

Also, we continue to be concerned about the lack of overall “breadth” of the rally, which was also noted by Jim Bianco, on Monday.

“The next chart shows the impact the so-called FAANMG stocks — Facebook Inc., Apple Inc., Amazon, Netflix Inc., Microsoft Corp., and Google parent Alphabet Inc. — have had on the S&P 500 Index since November 2017. These six stocks alone pushed the S&P 500 up 2.66 percent. The other 494 stocks were collectively down 0.40 percent. Overall, the S&P 500 was up 2.26 percent.”

We have seen this in our own data. Each week in the newsletter, I provide the relative performance of various sectors in our portfolio model to the S&P 500 index. When sectors are above trending positively, and the short-term moving average is above the long-term moving average, the sectors are on “buy” signals.  When the majority of sectors are on “buy signals” and the market is rising, it suggests the overall “breadth” of the rally is strong and the market should be bought. 

This is what the relative performance of the model was one year ago at the beginning of July, 2017.

Here is what it looks like today.

The deterioration in sector performance is indicative of a late stage market cycle, rising risks, and declines in risk/reward backdrop.

Combine the weakening performance backdrop with a market back to overbought conditions, following an abbreviated rally, and you can understand why we remain more cautionary on the intermediate-term outlook. 

As Helene Meisler noted Monday:

“Friday’s breadth continued the strength we’ve been seeing. This makes it six consecutive green days for breadth.

Since prior to this string of positive breadth readings we had seen breadth alternate positive and negative every other day for two weeks, it’s not going to be easy to pinpoint the day we get overbought. However, I can note that we will be maximum overbought Friday, July 13.”

“Last week we used the Nasdaq Momentum Indicator to pinpoint Tuesday as the day we got oversold. If I use this same method to find the overbought time frame it’s far too wide to be of use. For example, it shows an overbought reading sometime between this Tuesday and next Tuesday.

Then if we use the “what if” for the McClellan Summation Index we discover that it will currently take a net differential of -1,900 (advancers minus decliners) to turn the Summation Index from up to down. In 2017 this indicator was of no help but in 2018 once this gets to the point it needs -2,000 we have been overbought. It’s hard to pinpoint the day using this method but it’s likely that if the market’s breadth is strong on Monday this will go down under -2,000.”

“Thus the conclusion is that in the latter part of this week we should reach an overbought condition.

The number of stocks making new highs on the NYSE increased. It’s nothing to write home about but at least it increased.

Finally, I would note that while anecdotally sentiment seems to have turned bullish, it is not yet evident in the indicators. The put/call ratio was 100% on Friday and while that may have been “weekend” related, long-time readers will know I prefer not to rationalize an indicator.”

We remain cautious for now until the investing risk/reward scenario improves enough to warrant additional equity exposure.

Could we miss some of the rally before that occurs? Sure.

We have no problem with that. Opportunities to take on additional market risk come along about as often as a taxi cab in New York City. However, for us, the “fear of missing out” is much less important than the “fear of losing money.” Spending our time working to recoup losses is a process we prefer to avoid.

“When it comes to investing, it is important to remember that no investment strategy works all the time, but having some strategy to manage risk and minimize loss is better than no strategy at all.”

Click here to download our investment manifesto.

“In reference to a post yesterday on “Investing Like Warren Buffett,” Doug sent us the following article he penned in 2014 on a similar issue.”

“I start almost every column I have ever written about Berkshire Hathaway (BRK.A/BRK.B) with the sincere message that, similar to many investors, I worship at the investment altar of Warren Buffett and Charlie Munger. But that adulation doesn’t preclude me, as an investor, from questioning their and the company’s direction/strategy nor does it inhibit me from being short Berkshire’s stock (which I have been over the last nine months).

Recent earnings reports at Coca-Cola (KO) and IBM (IBM), two large Berkshire Hathaway investments totaling almost $30 billion, suggest that the companies’ moats appear to be vanishing.

Healthier drink choices and the penetration of the cloud seem to have weakened the previously seen moats and have damaged the profit results at Coca-Cola and IBM.

In the past Warren Buffett has hunted gazelles (that are undervalued); he is now hunting elephants (that are fairly valued to overvalued).

I remain short Berkshire’s shares.

Last year Warren Buffett labeled me a “credentialed bear” and invited me to ask some hard-hitting questions at Berkshire Hathaway’s annual shareholders meeting. I did quite a lot of research in preparation for that day, and I think that is what Warren expected of me and why he invited me.

It was important for me to balance my hard-hitting and pointed questions with a courteous and respectful delivery, considering the extraordinary accomplishments and the respect we all have of the men that I was addressing and the unique invitation to a short seller who was negative on their company. Initially, each of my original six questions was far too lengthy (500-1,000 words). Given the setting and Warren’s crafty ways of answering questions, my mission was to condense each into a tightly worded question.

Upon reflection, I was pleased with the questions as well as Warren and Charlie’s responses — my mission was accomplished.

Question No. 1 — Size Matters

Q: As it is said, Warren, “Size matters!”

In the past, Berkshire bought cheap or wholesale — for instance, Geico, MidAmerican Energy, the initial Coca-Cola purchase and Benjamin Moore. Arguably, your company has shifted to becoming a buyer of pricier and more mature businesses — for instance, IBM, Burlington Northern Santa Fe, Heinz (HNZ) and Lubrizol, which were done at prices to sales, earnings and book value multiples well above the prior acquisitions and after the stock prices rose.
Many of the recent buys might be great additions to Berkshire’s portfolio of companies, however, the relatively high prices paid for these investments could potentially result in a lower return on invested capital. In the past you hunted gazelles, but now you are hunting elephants.

To me, the recent buys look like preparation for your legacy, creating a more mature, slower-growing enterprise. Is Berkshire morphing into a stock that has begun to resemble an index fund that is more appropriate for widows and orphans rather than past investors who sought out differentiated and superior compounded growth?

In the past, you have quoted Benjamin Graham, saying “price is what you pay — value is what you get.” Are your recent deals and large investments bringing Berkshire less value than the deals done previously?

A: Warren admitted that Berkshire won’t grow as rapidly in the future as it has in the past but it will still generate a lot of incremental value.

“We think we will do better than the giants of the past,” he said. Charlie chimed in and said much of the same. Warren then exclaimed, “Doug, you haven’t convinced me to sell the stock, but keep trying!” — Doug Kass, “My Berkshire Q&A Recap

Unasked Question No. 2 — Are Some of Berkshire’s Bank Moats Damaged or Disappearing?

A changing bank regulatory climate has put constraints on leverage and has produced less robust return on assets and capital. As well, banking has become more homogenous and less differentiated, what Charlie and you describe as, “standing on tiptoe at a parade” — when one bank offers a new product, every bank has to offer or match it.
Given the fact that the banking industry has a lower profit growth rate potential going forward (think of it as damaged and shrinking moats of profitability), why is Berkshire continuing to acquire shares and becoming more exposed to banks, specifically Wells Fargo (WFC)?

Note: This question, too, was one of my six original questions. But, Charlie and Warren had already discussed the impact of Dodd-Frank legislation on reducing bank industry returns. – Doug Kass, “My Berkshire Q&A Recap”

There’s Something About Coca-Cola and IBM

Ted (Ben Stiller): So you’re moving down to Miami?
Pat Healy (Matt Dillon): I accepted a job offer.
Ted: With who?
Pat Healy: With… uh… Rice-a-Roni.
Ted: Isn’t that the San Francisco treat?
Pat Healy: It was. They’re changing their image.
— There’s Something About Mary

Berkshire Hathaway owns about 9% of Coca-Cola (valued at over $15 billion) and approximately 6% of IBM (valued at $13 billion). The total investment in these two companies approaches $30 billion, which represents about one sixth of the market capitalization of Berkshire Hathaway.

Recent earnings reports at Coca-Cola and IBM suggest that the companies’ moats appear to be vanishing.

Some of the more significant questions I had for Warren Buffet at last year’s Berkshire Hathaway annual meeting had to do with a changing acquisition strategy that settled for moat-less or less threatening moats — that is, large cash flow and market share elephants rather than significantly undervalued gazelles that faced a long runway of growth ahead. I further questioned whether the company’s more defensive acquisition and investment strategy would result in Berkshire Hathaway gaining the look of an index fund and remarked that its ever larger size might provide a continuing headwind for the company to differentiate its results and expand its intrinsic value relative to the S&P 500.

These questions continue to raise issues that have a direct bearing on Berkshire’s investment in IBM and Coca-Cola and speak to the general attractiveness of Berkshire’s shares.

“From 2008 to the end of 2013, the S&P 500 returned 128%. Berkshire (which computes return based on book value per Class A share) returned 80% from 2008 through September 2013, according to Bloomberg. That won’t be enough to get him past the index when the company reports 2013 results.” — Steven Perlberg, “Chart: Warren Buffett Will Fail Berkshire Hathaway Shareholders for the First Time in 44 Years,” Business Insider (Jan. 2, 2014)

To date, we’ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five-year wins will end.” – Warren Buffett, 2012 annual letter to Berkshire shareholders

In defense of my conclusions, I would note that for the first time in 43 years Berkshire’s five-year rolling returns (defined as book value gains) in the period ending Dec. 31, 2013, failed to outperform the change in the S&P 500.

The answers to my questions last May in Omaha help to understand and frame why, in part, I have been short Berkshire Hathaway since last May.

Forever Is a Long Time

“Forever is a long time, and time has a way of changing things.” – The Fox and the Hound

Warren Buffett has historically invested with a forever time frame based on the notion that his investment holdings would be enduring, consisting of profitable companies that possessed moats that provided them with a nearly invulnerable market share position, sustainable profit margins and returns on invested capital, and superior earnings growth.

Recent results for IBM and Coca-Cola, which represent sizeable investments at Berkshire Hathaway, have seemingly unearthed an unexpected vulnerability to both companies’ forward revenue and profit growth rates. Specifically, major secular industry changes are exposing weaknesses in the moats that Warren thought might have existed when he initially purchased the shares of IBM and Coca-Cola.

  • IBM faces a serious competitive threat from the cloud. (As Stanley Druckenmiller said on Bloomberg TV, “Buy IBM if you want to be short innovation.”)
  • Coca-Cola faces a secular deterioration in the carbonated soft drink market — volumes in North America dropped an eye popping three percent in the most recent quarter — as healthier drink choices rip into their market share.

Forever is a long time.

While IBM and Coca-Cola started out as forever holdings for Warren, developing headwinds have unexpectedly surfaced and have threatened what might have been previously considered impenetrable franchise moats.

While there is recent evidence that both companies are trying to adapt to a changing industry environment (through internal moves and growth by acquisition), it is unclear whether the needles of growth can be moved significantly over the next few years in order to diminish the headwinds.

Those headwinds have weighed on the price performance of the shares of IBM and Coca-Cola, and I am short both of them.

As well, I remain short Berkshire Hathaway’s shares.

This Year in Omaha?

“If I forget you, O Jerusalem, let my right hand wither.” – Psalm 137 (in which the Jews lament and weep by the rivers of Babylon)

My Grandma Koufax always used the phrase, “Dougie, next year in Jerusalem.”

This was meant to be an expression of spiritual hope, as Jerusalem was the spiritual center of the Jewish world.
As I learned last year, the pilgrimage to Omaha (to Berkshire’s annual shareholders meeting) is also a religious experience to many.

Last year’s appearance in Omaha was one of the most exciting experiences of my investment career. Warren, Charlie and the rest of the Board of Directors couldn’t have been nicer to me last year.

I have more questions to be addressed toward The Oracle of Omaha and to Charlie Munger, and regardless of my view on Berkshire’s shares, I am hopeful that I will be invited back to the 2014 Berkshire Hathaway annual shareholders meeting to ask some more penetrating questions.”

Imagine two portfolios, A and B, worth $100 each. In the first time period, portfolio A gains 90% and Portfolio B loses 90%. So A is worth $190 and B is worth $10. Then, in the second period, Portfolio A loses 50% and Portfolio B gains 50%. So at the end of the second period, Portfolio A is worth $95 and Portfolio B is worth $15.

You now understand why ETFs that deliver the inverse daily return of an index don’t always work, and sometimes deliver radically unexpected returns. After the second period Portfolio A has lost 5% cumulatively; it has gone from an initial value of $100 to $95. But Portfolio B is far from being up 5% cumulatively, despite having delivered the inverse of Portfolio A for two periods. Instead Portfolio B is down 85% cumulatively.

Something like this is what happened to ETFs that shorted volatility or the VIX in February. When volatility spiked 90%, ETFs shorting it dropped by a commensurate amount. But when volatility calmed down again, the ETFs couldn’t bounce back. They were finished.

Now the stock market rarely moves more than 10% in one day. So how realistic is what happened to inverse VIX funds with regard to inverse S&P 500 funds? It’s true that there will not likely be that kind of quick meltdown in an inverse S&P 500 Index fund, but it’s also true that investors can be surprised in an inverse fund. And those surprises can be magnified in multiple inverse funds. For example, a 3x inverse fund can produce a return that more than one percentage point away from what you’d expect in just one volatile trading week.

Now, one could say that the difference between the actual return of the inverse fund and what one might have expected isn’t that large in our hypothetical example. However, the discrepancy between the actual result of the inverse fund and what one might expect occurs just after one week. A longer volatile period could create a bigger discrepancy.

In a real life situation, over a period of time greater than one week, the difference can be large. For example, in 2011, when the S&P 500 Index gained 2.11%, the ProShares UltraPro Short S&P 500 ETF (a 3x inverse fund) lost a whopping 32%, according to Morningstar. Again in 2015, when the index gained 1.38%, the fund dropped more than 16%.

Perhaps stock market inverse funds can be used over short periods of time for trading purposes. But the experiences of 2011 and 2015 with the ProShares 3x inverse fund should deter anyone from using them for an extended period of time.

A better way to short the market would be to short a long ETF like the SPDr S&P 500 ETF (SPY) or to buy put options on this or any other S&P 500 ETF. A put option gives you the right to sell an underlying security at a prearranged price conferring protection on you if the underlying security’s price drops.

Otherwise,  holding some extra cash can help combat a volatile, overpriced market. That doesn’t mean selling all your stock holdings if your investment goal is years away, even if you think stocks are overpriced. Moving completely into or out of markets rarely produces a good outcome. It means making adjustments to your allocation to reflect your views. Remember your views can be wrong, or it can take a long time before you’re proven correct. So make your adjustments gently. And, if you need help managing a portfolio, please click this link.

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

Should You Invest Like Warren Buffett?

Whenever we discuss this issue of the fallacies to “buy and hold” investing, invariably there is the comment:

“Then why does Warren Buffett say that the ideal holding period is forever?”

First of all, we have the utmost respect for Warren Buffett. If investing had a “hall of fame,” Warren’s bust would be displayed in the front row along with Benjamin Graham. Through hard work, a grounded set of value principles, and great timing, he has been able to amass a great amount of wealth for himself and his shareholders.

Buffett’s specialty is value investing. That means buying stocks with long-term prospects that are believed (by a value investor) to be undervalued. The unloved underdog, for instance, which has been unfairly cast aside by Wall Street and whose value will be rediscovered in the future.

He articulated this approach succinctly in his 2008 letter to Berkshire Hathaway (BRK/A) shareholders:

“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

While there is often a rush in trying to justify “buy and hold” investing by selectively choosing quotes from Warren Buffett as noted above, Mr. Buffett’s most basic premise is that of active asset management:

“Be fearful when others are greedy and greedy when others are fearful.”

Or, as Baron Rothschild once quipped:

“Buy cheap, Sell dear.”

Not only is the most basic tenant of value investing, but it is the most basic premise of investing…period.

Like Buffett, as value-based portfolio managers ourselves, we also prefer extremely long holding periods. However, just because we “prefer” extremely long holding periods, things can and do change which can shorten that holding period immensely.

We also realize there are tremendous differences which we, and other “Buffett” disciples, cannot replicate. Yes, you can buy the same stocks as Buffett, but your outcome is going to be dramatically different from Berkshire Hathaway for several reasons.

There is an old joke that goes:

“The first step in investing like Warren Buffett: start with $1 billion…”

The joke, however, only begins to highlight the incredibly unique position Buffett enjoys in the investing world. Buffett is an anomaly; he is part private-equity deal broker, part investment bank, part Wall Street insider and part activist investor. He is also an investing icon, and as such, many investors copy his actions which lend price support to his investments.

Investors flock to Omaha for his annual shareholder meetings in hopes of glimmering information on how he is able to produce such great returns. Yet, no one has been able to come close to matching his track record. While many think Mr. Buffett has found the secret formula to investing – it is actually a combination of several “special” circumstances which have afforded Mr. Buffett his edge over the years.

Timing Is Everything – we have discussed through this entire series the importance of valuation analysis at the “beginning” of the investing journey. When you start your investing journey is one of the most important facets of long-term investing returns. While Buffett clearly bested the S&P 500 index over the years, he benefited greatly from the luck of catching the greatest bull market run in history in the 80’s and 90’s.

“Timing” and “good luck” are two of the most critical aspects of successful long-term investing. For Buffett, his timing could not have been better as a bulk of his outperformance in the early years came from his nimbleness to capture opportunities as the U.S. emerged from back-to-back recessions, low-valuations, high dividends and falling rates of inflation and interest rates.

As of this writing, those factors no longer exist for investors wishing to replicate his performance going forward. Valuations are elevated, interest rates and inflation are low, and economic growth remains weak. As for Berkshire, the fund has grown to nearly $500 billion and accordingly the opportunities for outsized performance are rarely available in a size which moves the “performance alpha” needle much.  As noted by Michelle Perry Higgins

Buy what I’ve found most insightful is to chart the trend in Berkshire’s annual stock performance compared to the S&P 500. As an example, this is Berkshire’s alpha, for its excess return over the broader market through 2016:”

(Note: Berkshire’s first 5-years were problematic as market valuations were still falling through the 1974 market crash. However, that crash set Buffett up for a spectacular run over the next two decades.)

“This shows that Berkshire’s best days were in the late 1970s, a tumultuous decade thanks to wildly fluctuating energy prices and rapidly accelerating inflation. Since then, Berkshire’s performance relative to the S&P 500 has steadily narrowed. The rolling five-year average of Berkshire’s alpha dipped into negative territory in three out of the past five years.

Working against Berkshire is its growing size, a point Buffett has pointed out in the past. It has the fifth largest market capitalization on the S&P 500, behind only AppleAlphabetMicrosoft, and Facebook. It also owns a vast assortment of subsidiaries, from home builders to car insurers to restaurants.

The net result is that Berkshire’s annual returns theoretically should, and increasingly are, mirroring that of the economy and thus the broader market. Buffett has said this would happen. He’s obviously right.”

Management Control – As individuals, we can buy shares in a company and hope the company makes good decisions which leads to future rates of increased profitability. Buffett, on the other hand, often takes significant positions in companies which allow him direct input into the decisions the company makes.

“Warren Buffett walks into a board meeting, looks at the guy at the head of the table and says ‘excuse me, you’re sitting in my chair.’” – Wall Street humor.

While humorous, it is also true. We make speculative bets in companies by buying ethereal pieces of paper at one price and hoping to sell them at a higher price later to someone else. In every sense of the word, while we wish to fancy ourselves as investors, we are “speculating” on a future outcome.

Buffett, on the other hand, actually “invests” in companies not only through his influx of capital but also through his ability to provide insight, opportunity, and connections. The seat in the boardroom that Buffett is able to acquire helps pick executives, set the future course for the company, and create opportunities that might not have otherwise existed through synergies with other Buffett related holdings. Their direct hand in management also provides them information not available to most shareholders.

Private investments/Special Opportunities – Unlike the vast majority of portfolio managers and individuals, Mr. Buffett is not limited to just publicly traded stocks and other securities available to the public. Their size and clout gives them access to invest in private situations that many investors have no access to.

A good example was in September 2008. Goldman Sachs (GS) offered Buffett a deal which was too good to be true. With GS trading at $123/share and having capital issues due to market illiquidity, they offered Buffett the right to buy $5 billion of preferred stock yielding 10% and an attached warrant allowing Buffett a five-year option to buy the common stock at $115/share. Five years later, GS was trading at $185/share resulting in a 60% return on the warrants. As if 60% was not enough, it was on top of the 10% dividend they received annually. Needless to say, the average investor was never offered such a deal.

Time horizon – Buffett has no time horizon. In other words, while individuals have a set time frame based on retirement goals and life expectancy, which factor heavily into both the accumulation and distribution phases of the wealth building process, Buffett does not. As discussed previously, capital destruction can wreak havoc on financial goals.

Buffett buys companies. As such, he is focused on the long-term growth potential acquisition. Berkshire Hathaway is also a company, with a board of directors, officers, etc., which also provides the portfolio an “eternal” lifespan. As such, Berkshire can truly act as a long-term investor without concern for market volatility, living requirements, or death. As we have continually mentioned throughout this series, you and I will likely fail to meet our retirement goals if we have to endure a 10-20 year period of no gains. For Berkshire, it will simply be a function of economic growth and the resultant net profitability to investors and shareholders.

Leverage – One of the most interesting aspects, and one of Berkshire’s biggest advantages, is unique in they own an insurance company. The insurance float represents the available reserve, or the amount of funds available for investment once the insurer has collected premiums, but is not yet obligated to pay out in claims. The money is invested for future claims by the insurer.

Here is where Buffett has a huge advantage over every else as explained by Vintage Value:

“During that time, the insurer invests the money. Insurance float is so valuable that insurance companies often operate at an underwriting loss – that is, the premiums received are not enough to cover the eventual losses (hurricanes, car accidents, etc.) that must be paid and the expenses required to resolve those claims, operate the business, etc.

Why would an insurer operate at a loss? Again, because the insurer can invest the insurance float and make even more money. In this sense, insurance float is like a loan and the underwriting loss is like the interest rate on that loan (i.e. cost of capital).

Now, for most insurers the cost of float is usually a few percentage points. Berkshire Hathaway’s insurance operations, however, are so well run that the company’s historical cost of float has actually been positive… meaning Berkshire Hathaway is actually being paid to take other people’s money!”

The ability to leverage portfolios over time provides a huge amount of potential alpha generation to returns. However, for the average investor, leverage can also be extremely destructive when used improperly.

Don’t Get Swept Up By The Crowd

While we are avid Buffett admirers, with a deep respect for value investing and long-term returns, which is why we model our equity portfolios on value and fundamental factors, we also are well aware of the limitations of our client’s portfolio duration, capital needs and risk tolerance.

As we addressed in Part 2 of this series, simply buying and holding a basket of stocks over long periods will likely map you fairly closely to the S&P 500 index. (Repeated studies show that more than 30-stocks in a portfolio will essentially replicate the return of the S&P 500 index.) However, historically speaking, while over a given 20 to 30-year investing period an investor will make money, there can be huge shortfalls in meeting investment goals.

As Tom Brakke once stated in an interview:

“No name gets dropped quite as much as Warren Buffett’s by those writing about investments, including me.

The infatuation with Mr. Buffett is understandable given his success and his folksy manner. But investors should be aware that he plays a different game than the rest of us. He gets the first call on deals and he gets attractive terms on his investments. We can’t replicate those advantages.

Another thing to keep in mind is how much Mr. Buffett’s strategy has changed over time. Whereas most investors are urged to adopt a plan and stick to it, Mr. Buffett showed that different times and different circumstances mean that core principles should be examined and adapted as necessary.”

Yes, it is true that Buffett prefers long-holding periods, however, it is a mistake to suggest that he is not an “active” portfolio manager. Buffett has regularly sold parts, or all, of the companies he owns when “value” is no longer present. Furthermore, you should not make the mistake of thinking that anything that Mr. Buffett holds is worth owning currently. As Tom concludes:

“Many investors did that in the ’90s, buying Coca-Cola and other stocks because Buffett owned them, even though they were trading at historic levels of overvaluation. The results weren’t good. So, don’t cherry-pick Mr. Buffett’s ideas and expect to do well. That’s not a great way to emulate him.”

The theme of this series is to avoid these pitfalls as much as possible. Given current valuations the risk/return framework of the market and BRK/A are poor. The graph below highlights this concern. It shows that 90-day rolling correlation of price changes in BRK/A and the S&P 500 are statistically similar. In the market crash of 2008/09 BRK/A’s price was cut in half, similar to the S&P 500. Based on correlations we suspect a similar relationship will hold true for the next big market drawdown.

Be Like Warren

The hardest thing for investors to do is to turn off the media, discount the “buy and hold” mantra, and focus on what matters for long-term investing – valuation. As Tom Brakke concluded:

The most important lesson that Mr. Buffett can offer anyone: Don’t get swept up by the crowd.

For example, he has been willing to sit on a mountain of cash, even though interest rates are extremely low. Most financial advisers would scoff at that, but Mr. Buffett will wait in cash if there aren’t compelling values available elsewhere.

And he is willing to be out of step for long periods in order to do well in the end. Most of us have a very hard time doing that.”

The patience required to withstand a low return on the cash while the market moves higher is high. To put this concept in a different light, we potentially give up short-term gains in exchange for the opportunity to “buy” when market prices are “cheap” and potential returns are high.

Want to invest like Warren? Then follow his rules:

  1. “Don’t lose money.”
  2. Refer to Rule #1
  3. Buy that which is “cheap”
  4. Sell that which is “dear”
  5. Hold excessive levels of cash if necessary
  6. Do not follow the herd
  7. Have patience, patience and even more patience
  8. If you want to beat the market, you cannot look like the market

There is nothing “passive” about Warren Buffett or his investment strategy. But there is one lesson in particular that every long-term investor should remember which is the core staple of our investment philosophy and discipline.

“A patient, long-term value investor is the one that sees the big picture and understands stock-market cycles. He or she will likely not fall into the greed or fear trap. Warren Buffett is a brilliant man and has many lessons that investors should emulate. One of his most valued quotes for me is, ‘We (must) simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.’ That is the epitome of breaking away from the herd.”Michelle Perry Higgins

Come senators, congressmen
Please heed the call
Don’t stand in the doorway
Don’t block up the hall
For he that gets hurt
Will be he who has stalled
There’s a battle outside
And it is ragin’.
It’ll soon shake your windows
And rattle your walls
For the times they are a-changin’

The Times They Are A-Changin’ – Bob Dylan

America’s populace is politically divided in a way that has not been seen in decades. The growing rift is rapidly changing the landscape in Washington D.C. and has major implications for the nation. Amazingly, as voters from different parties espouse views that are worlds apart, they share a strikingly similar message.

This article considers the juxtaposition of colliding worldviews and the unified message that voters across the political spectrum are sending. While many investors are aware of the political change afoot, it seems that very few have considered how said changes might affect the economy and financial markets. In this article, we share some of our thoughts and encourage you to give the topic more consideration going forward.

Given the importance of the subject, this article will likely be the first of several discussing the intersection of politics and markets.

The Changing Faces in Congress

Speaker of the House Paul Ryan and Congressmen Bob Corker and Jeff Flake are a few of the well-established Republicans not seeking reelection. While each has their reasons, it appears the prospect of losing re-election played a significant role in their decision making. Is this a case of “playing not to lose” as opposed to “playing to win”? Political capital can be delicately converted to monetary capital only if a politician, in or out of office, plays his or her cards wisely.

This is not just a story about Republican discontent. In New York’s Democratic 14th Congressional District primary, Alexandria Ocasio-Cortez, a totally unknown candidate months ago, recently upset incumbent Joseph Crowley, the fourth-ranking Democrat in Congress and possible successor to Nancy Pelosi as the Democratic House leader. Crowley has represented New York since 1999, most recently as a representative of the Bronx and Queens.

Ocasio-Cortez is a 28-year old Latino woman who was tending bar only a year ago. She ran on campaign promises that were decidedly left of the mainstream Democratic agenda represented by Crowley. Her political stance was not surprising given her support for Bernie Sanders during the last Presidential primary and her membership in the Democratic Socialists of America.

While there are many messages 14th District voters are sending us; we believe there are two that are representative of voters of both parties throughout the country.

  1. Voters appear to prefer political views that are less centrist and offer a change from the status quo of the existing parties.
  2. Voters are looking to buck established party leaders in favor of someone different.

The Washington Post, in an article about Ocasio-Cortez’s victory, summed up these messages well – “Many of the key Democratic House primaries this year have been competitions over biography, with a premium given to those who break new ground or remove old barriers.”

Economic and Market Implications

Assuming this trend continues, the implications for the economy and the financial markets will become increasingly important to follow. While the topic for another article, simply consider the massive social changes that occurred in the late 1960’s and early 1970’s. Those changes had profound and lasting effects on culture and society as well as the economy, monetary policy, fiscal policy and the financial markets.

The following provides a summary of factors worth considering as this new era of politics takes hold:

Deficit – Despite a Republican-controlled Congress and President, the size of the fiscal deficit is surging. Current forecasts by the Congressional Budget Office (CBO) estimate that Treasury debt will increase by over $1 trillion a year for the next four years. While it seems that the Democrats and Republicans cannot agree on much, they currently seem to agree on increased government spending. Given a President that is not averse to debt financing and deficit spending and a slew of politicians concerned about future elections, collectively they may opt for more spending to please their constituents. Given the importance of retaining (or not losing) power, the tendency towards higher fiscal deficits will continue regardless of which party controls the House and Senate. Discipline of any form appears outdated in the halls of Congress and certainly not a popular political platform.

Recession and stock market crash response – During the great financial crisis of 2008/09, extreme fiscal and monetary stimulus were employed to right the economy and stabilize the markets. In just three years from 2009-2011, a timeframe spanning the recession and immediate recovery, the aggregate fiscal deficit was $4.006 trillion. In those three years, the government accumulated a deficit that equaled that of the 22 years immediately prior.  The Fed’s monetary policy response was even more brazen. They lowered the Fed Funds rate to zero which helped push longer-term bond yields to historically low levels. Further, they introduced QE and purchased over $4 trillion of U.S. Treasury, Agency and Mortgage-Backed Securities.

Our concerns for the next recession and stock market drawdown are twofold. First, will the Fed acquiesce with unprecedented monetary policy as they did repeatedly during and well after the financial crisis and recession?   Second, will the vastly different political views of Congress and the likely infighting make negotiations on fiscal bailouts harder than those that occurred in 2008 and 2009?

Under Jerome Powell’s leadership, the Fed appears less concerned with financial asset prices than did the leadership of his immediate predecessors. Further, inflationary aspects of fiscal deficits may make them more apprehensive about easy policies that can have inflationary impulses. One of the key signals for a change in monetary policy came when outgoing New York Fed President William Dudley gave a speech on January 11 characterizing three to four rate hikes in 2018 as “gradual.” Although there was no immediate market response, within two weeks the stock market convulsed. The market has yet to regain those losses and the Fed thus far has not walked back Dudley’s comments.

The fiscal situation could also become problematic if the political parties continue down the path of discordance.  Either party might be willing to push or block emergency fiscal stimulus to affect the President’s reelection chances heading into the 2020 presidential campaign.

Geopolitical – The changes occurring in our political system are closely monitored by other nations. While some nations are experiencing similar changes, especially in Europe and the United Kingdom, we have little doubt that our allies, our enemies, and everyone in between will try to capitalize on the situation. Trade and the dollar’s status as the world’s reserve currency are the foremost concern. We believe many nations want to unseat the U.S. dollar as the world’s reserve currency. Trade tariffs and fair trade negotiations are likely fueling the desire even more so. Will political change and the possibility of a stalemate in Congress provide these nations an opportunity to reduce their reliance on the dollar? The implications, as discussed in Triffin Warned Us, are massive.

Public/Corporate confidence and spending habits – Consumers tend to spend when they are most confident about their own financial situation and that of their nation. As the political issues collide and political rhetoric from both sides increase, will consumers’ confidence waver?

Alternatively, what if current consumer spending has less to do with confidence and is largely based not on what they want to spend but what they need to spend? Food, gas, healthcare, housing, and education are all making unreasonable demands on consumer spending habits. These expenditures are being funded by dis-savings and credit as opposed to rising salaries and wages. The evidence for this lies in the concurrent rise in consumer credit data and decline in household savings. The demand for political change is not coming from the elite that profited from corporatism and speculation, but in large part from the majority being left behind. These are the marginal consumers and play a large role in determining the pace and quality of economic activity.

Similarly, what of the confidence of corporate executives? We suspect that as political differences become acuter and the future less predictable, executives will hold back on investments in new projects, plants, equipment or employees.


Currently, the market seems indifferent to the recent wave of political upheaval. The relative stability in the economy and strong performance of stocks over the last few years is likely mesmerizing many investors.  We believe investors should consider that the changes in the political landscape may only be in its infancy. Whether the recent move towards political divergence is a fad or the start of something much larger is anyone’s guess. However, we believe the increasing influence of millennials at the expense of baby boomers will have impacts which we are just starting to see.

Given that equity markets are perched at extreme valuations, implying that the risks are significant and future returns well below normal, we believe the political unknowns and the associated risks they carry are among the reasons to maintain a conservative investment stance.

The following video provides a historical perspective of how Congress has become increasingly divided over the last 80 years. While it stops in the year 2013, the differences have only widened since then.

Last week, I discussed the ongoing debt issue in the U.S. with respect to the recent CBO report and the trajectory of debt growth over the next 30-years.

The fiscal issues facing the U.S. are nothing new and have been a frequent discussion on this site. More importantly, I have discussed these issues directly with members of Congress, and especially with Congressman Kevin Brady, Chairman of the House Ways and Means Committee, who agree with my concerns yet have been unable, and unwilling, to tackle the “tough” issues. While conservatives in Congress talk a great game of fiscal responsibility, the reality is there is little “will” to actually be “fiscally responsible.”

While the country today is more politically divided than at just about any other point in history, “spending money” is the one thing that all members of Congress willingly agree to.

As I discussed previously, this is the same path Japan took previously.

“Debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service. 

The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and increasingly drawing on social benefits.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.”

“Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.”

I was reminded of this previous discussion this past week when Tyler Durden discussed a new bill in Japan limiting overtime work to 99-hours a month to cure “Death by Overwork.”

“Recently released government data revealed that Japan’s jobless rate touched 2.2% in May, the lowest level in 26 years. And as Japan’s working-age population dwindles, job openings have outpaced the number of workers available to fill them: As a reference, two months ago, there were 160 job offers available for every 100 workers seeking a job.”

What got my attention was the similarity to an issue that has stumped economists over the last couple of years – surging job openings that go unfilled. We can restate quote above to apply to the U.S.:

“Recently released government data revealed the U.S. jobless rate touched 3.8% in June, the lowest level in 48 years. And as Japan’s working-age population dwindles, job openings have outpaced the number of workers available to fill them: As a reference, two months ago, the ratio of offers to unemployed hit the highest level of this century.”

Employment growth has essentially done little more than to absorb population growth over the last several years but has begun to deteriorate over the last few years. With net hires (hires less layoffs and quits) declining the ratio of job openings to hires is likely to rise further.

While the surge in “job openings” has remained a conundrum for economists, the answer may not be so difficult as employers continue to report the problems with filling jobs as:

  1. unfit to do the job (too fat/unhealthy/old),
  2. lack of requisite skills (education/training), and; 
  3. unwilling to accept the job for the rate of pay.

This was noted in the recent FOMC minutes:

Contacts in several Districts reported difficulties finding qualified workers, and, in some cases, firms were coping with labor shortages by increasing salaries and benefits in order to attract or retain workers. Other business contacts facing labor shortages were responding by increasing training for less-qualified workers or by investing in automation.”

A recent job posting revealed what we already suspected about the “new economy.”

While these are anecdotal examples, it potentially explains why labor force participation remains stuck at multi-decade lows as government benefits provide more income than working. Currently, social welfare makes up a record high of 22% of disposable incomes. The reality is that if the jobless rate was actually near 4%, job openings would be filled, wages would be surging for the bottom 80% of workers along with interest rates and economic growth. Instead, we see more evidence of economic stagflation than anything else.

Despite many exuberant hopes of an “economic resurgence,” the vast majority of the data continues to point to a very late stage economic cycle. While I am not suggesting the U.S. actually IS Japan, I am suggesting we can look to Japan as “road map” as to the consequences of high debt levels, aging demographics, deflationary pressures and opting for “short-term fixes” rather than fiscal responsibility.

Unfortunately, the Administration has chosen to follow the path of Japan which is unlikely to have a different outcome. There is no evidence that monetary interventions and government spending create organic, and sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

There is certainly time to change our destination, but it will require a massive shift in perspective and desire to do so. With a rising number of Millennials starting to embrace socialism over capitalism, the future of the U.S. may be more like Japan than we readily wish to admit. 

Just something to think about as you catch up on your weekend reading list.

Economy & Fed


Most Read On RIA

Research / Interesting Reads

“If you have large cap, mid cap, and small cap, and the market declines, you are going to have less cap” – Martin Truax

Questions, comments, suggestions – please email me.

Monthly Fixed Income Update – June 2018

At the half-way point of 2018, there are a multitude of interesting stories to cover in the fixed income markets. Beginning with June’s performance, the headline remains the divergence in performance between investment grade (IG) and high yield (HY) credit. From a total return standpoint, junk bonds (HY) were the best performing sector for the first six months while IG was only kept out of the fixed income cellar by the poor performance of emerging markets (EM).

**Please note there was an error which has since been corrected in the May performance table. For reference, May’s corrected table is shown below June’s.

June’s Performance:

May’s Corrected Performance:

The primary culprit for IG underperformance versus HY is heavy supply from merger and acquisition-related issuers in the healthcare, food & beverage and retail sectors so far this year. At the same time, HY supply has been on the decline.

The performance of the high yield sector also stands out against the poor performance of EM bonds as the comparative spread between the two are back near multi-year lows.

The emerging market index total return has been negative in 5 of the first 6 months of 2018. Turbulence in EM is more troubling than the supply-related problems seen in IG. Federal Reserve (Fed) rate hikes and the slowing/reversal of easy monetary policies in the developed world has led to meaningful investment outflows from emerging markets. In conjunction with the Fed policy shift, elections in Mexico, Brazil and Turkey as well as the continued escalation of global trade tensions, have been disruptive. As long as central banks, politics and trade remain concerns, it seems reasonable to continue to expect EM assets to struggle.

The Aggregate Index declined for the month of June due to the poor performance of investment grade corporates. Like IG, it has been negative in 4 of the first 6 months of the year. Apart from the fluctuations in high yield and emerging markets, other sectors rose only slightly for the month.

Credit markets in general remain rich on an absolute and relative basis as yields are low, spreads are tight and thus offering a low ratio of return per unit of risk. Despite the outlook for three to four more Federal Reserve rate hikes, tighter financial conditions and the macro uncertainties associated with global trade, investors seem content sticking with a horse that has been a proven winner for so long. That said, the underlying quality of credit is poor and the risk-reward fulcrum seems clearly skewed toward the “risk” side of the equation.

It is worth mentioning that over the last thirty years IG and U.S. Treasuries have provided investors a reasonable hedge in times when equity markets declined. The S&P 500 remains nearly 5% below the record highs of January and does not appear nearly as strong as in 2017 despite improving corporate earnings. History tells us that we should expect flows into the more durable fixed income sectors to increase if the equity market shows continued weakness.

As we wrap up Q2 of 2018, Michael Lebowitz and I present our “chartbook” of the “most important charts” from the last quarter for you to review.

In addition to the graphs, we provided a short excerpt from the article as well as the links to the original articles for further clarification and context if needed. We hope you find them useful, insightful, and importantly we hope they give you a taste of our unique brand of analysis. In most cases, the graphs, data, and commentary we provide are different from that of the business media and Wall Street. Simply put, our analysis provides investors an edge that few are privy to.

There Will Be No Economic Boom

“Wages are failing to keep up with even historically low rates of “reported” inflation. Again, we point out that it is likely that your inflation, if it includes the non-discretionary items listed above, is higher than “reported” inflation and the graph below is actually worse than it appears.”

“But this is nothing new as corporations have failed to ‘share the wealth’ for the last couple of decades.”

Read: There Will Be No Economic Boom – Part 2

Buybacks Run Amok

“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.”

Read: BTFD or STFR

The Illusion Of Prosperity

“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.”

Read: The Debtor’s Prism

The Average Not The Rule

“The chart below shows the S&P 500 as compared to annualized returns and the average of market returns since 1900.  Over the last 118 years, the market has NEVER produced a 6% every single year even though the average has been 6.87%. 

However, assuming that markets have a set return each year, as you could expect from a bond, is grossly flawed. While there are many years that far exceeded the average of 6%, there are also many that haven’t. But then again, this is why 6% is the ‘average’ and NOT the ‘rule.'”

Read: The Simple Math Of Forward Returns

Borrowing From The Future

As I discussed in “Sex, Money & Happiness:”

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’

However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $7000 annual deficit that cannot be filled.”

“In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates and lax lending standards put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.”

Read: Is Ballooning Debt Really Inflationary

Always Optimistic

“Since the end of 2014, investors are paying twice the rate of earnings growth.”

“No matter how you look at the data, the point remains the same. Investors are currently overpaying today for a stream of future sales and/or earnings which may, or may not, occur in the future. The risk, as always, is disappointment.”

Read: Q1-Earnings Review – Risk To Estimates

Yields Tell The Story

“As shown, when the spreads on bonds begin to blow out, bad things have occurred in the markets and economy.”

“For the Federal Reserve, the next “financial crisis” is already in the works. All it takes now is a significant decline in asset prices to spark a cascade of events that even monetary interventions may be unable to stem.”

Read: The Next Crisis Will Be The Last

Economic Realities

“Unfortunately, as much as we would like to believe that Navarro’s comment is a reality, it simply isn’t the case. The chart below shows the 5-year average of wages, real economic growth, and productivity.”

“Notice that yellow shaded area on the right.  As I wrote previously:

‘Following the financial crisis, the Government and the Federal Reserve decided it was prudent to inject more than $33 Trillion in debt-laden injections into the economy believing such would stimulate an economic resurgence.” 

Read: The Mind Numbing Spin Of Peter Navarro


“There are two other problems currently being dismissed to support the ‘bullish bias.’

The first, is that while investors have been chasing returns in the ‘can’t lose’ market, they have also been piling on leverage in order to increase their return. Negative free cash balances are now at their highest levels in market history.”

“Yes, margin debt does increase as asset prices rise. However, just as the ‘leverage’ provides the liquidity to push asset prices higher, the reverse is also true.

The second problem, which will be greatly impacted by the leverage issue, is liquidity of ETF’s themselves. 

When the ‘robot trading algorithms’  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.”

Read: The Risk Of Algo’s

Simple Method Of Risk Management

“The chart below is $1000 invested in the S&P 500 in 1997 on a capital appreciation basis only. The reddish line is just a ‘buy and hold’ plot while the blue line is a ‘switch to cash’ when the 200-dma is broken. Even with higher trading costs, the benefit of the strategy is readily apparent.”

“To Ben’s point, what happens to many investors is they get ‘whipsawed’ by short-term volatility. While the signal gets them out, they ‘fail’ to buy back when the signal reverses.

‘I just sold out, now I’m supposed to jump back in? What if it crashes again?’

The answers are ‘yes’ and ‘it doesn’t matter.’ That is the just part of the investment strategy. 

But such is incredibly hard to do, which is why the majority of investors fail at investing over time. Adhering to a discipline, any discipline, is hard. Even ‘buy and hold,’ fails when the ‘pain’ exceeds an individuals tolerance for principal loss.”

Read: Selling The 200-Day Moving Average

Debt Bubble

“Rising interest rates are a “tax.” When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.”

Read: Coming Collision Of Debt & Rates

Not What It Seems

“In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates, and lax lending standards, put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.”

“As I recently discussed with Shawn Langlois at MarketWatch:

With a deficit between the current standard of living and what incomes, savings and debt increases can support, expectations of sustained rates of stronger economic growth, beyond population growth, becomes problematic.

For investors, that poses huge risks in the market.

While accounting gimmicks, wage suppression, tax cuts and stock buybacks may support prices in the short-term, in the long-term the market is a reflection of the strength of the economy. Since the economy is 70% driven by consumption, consumer indebtedness could become problematic.”

Read: Bull Markets Actually Do Die Of Old Age

Employment Illusion

“Why are so many people struggling to find a job and terminating their search if, as we are repeatedly told, the labor market is so healthy? To explain the juxtaposition of the low jobless claims number and unemployment rate with the low participation rate and weak wage growth, a calculation of the participation rate adjusted unemployment rate is revealing.

When people stop looking for a job, they are still unemployed, but they are not included in the U-3 unemployment calculation. If we include those who quit looking for work in the data, the employment situation is quite different. The graph below compares the U-3 unemployment rate to one that assumes a constant participation rate from 2008 to today. Contrary to the U-3 unemployment rate of 4.1%, this metric implies an adjusted unemployment rate of 9.1%.”

Read: Viewing Employment Without Rose Colored Glasses

Retirement Crisis

“The chart below is the S&P 500 TOTAL return from 1995 to present. I have then projected for using variable rates of market returns with cycling bull and bear markets, out to 2060. I have then run projections of 8%, 7%, 6%, 5% and 4% average rates of return from 1995 out to 2060. (I have made some estimates for slightly lower forward returns due to demographic issues.)”

“Given real-world return assumptions, pension funds SHOULD lower their return estimates to roughly 3-4% in order to potentially meet future obligations and maintain some solvency.

It is the same problem for the average American who plans on getting 6-8% return a year on their 401k plan, so why save money? Particularly when the mainstream media, and financial community, promote these flawed claims to begin with.”

Read: Retirees Face A Pension Crisis Of Their Own

How Long To Get Back To Even

The chart below shows the total real return (dividends included) of $1,000 invested in the S&P 500 with dollar cost averaging (DCA). While the periods of losing and recovering are shorter than the original graph, the point remains the same and vitally crucial to comprehend: there are long periods of time investors spend getting back to even, making it significantly harder to fully achieve their financial goals. (Note the graph is in log format and uses Dr. Robert Shiller’s data)”

“The feedback from Josh, Dan and others expose several very important fallacies about the way many professional money managers view investing.

The most obvious is that investors do NOT have 118 years to invest.”

Read: Myths Of Stocks For The Long-Run

These are some of our favorite charts and we hope you find them useful and insightful. Please send us any comments, suggestions, or your favorite charts to us for consideration.

Submitted by David Robertson, CFA
Via Arete Asset Management

The late stages of any economic cycle provide fertile ground for divergent opinions. Some recent positive numbers, for example, can be viewed as reflective of underlying strength but they can also be viewed as an indication of overheating and ultimately higher inflation.

What is unique to this cycle is that it is also accompanied by massively divergent beliefs regarding what the end game looks like. While some investors harbor doubts about whether markets can keep going up, others harbor doubts about whether many existing financial, economic, and political institutions serve a useful purpose. As a result, one must answer a seemingly stupid question in order to evaluate investment strategy: What does it even mean to invest?

To be sure, markets delivered good news in the quarter. Major indexes recovered their mojo under the power of good economic strength, strong sentiment and low unemployment. Sentiment, especially for small caps, hit record highs which served as an expression of joy and relief about trends in taxes and regulation, among other things. Such good news was tempered, however, by Fed tightening and geopolitical concerns. Warning signals were especially flashing in emerging markets.

Indeed, there are plenty of signs that market activity is getting stretched. For example, the Financial Times quoted distressed debt investor Jason Mudrick [here] arguing that “the roaring economy” is “just not sustainable” He went on to say, “My job is not to predict exactly when [the turn in the cycle] happens but to have the platform ready when it does.” As a result, he is planning ahead by marketing a second distressed debt fund to take advantage of the fallout when the market turns.

Respected strategist David Rosenberg provided a very blunt assessment:

“Cycles die, and you know how they die? … Because the Fed puts a bullet in its forehead.”

He went on to quantify the risk:

We are seeing a significant shift in the markets. The Fed was responsible for 1,000 rally points this cycle so we have to pay attention to what happens when the movie runs backwards.”

While the prospect of a meaningful decline in the market is unpleasant, there is something more going on. Perhaps nowhere is this captured better than with the trajectory of corporate debt. As the FT reports [here], “Debt is the legacy of the global financial crisis. Over the past decade of ultra low and negative interest rates, companies have more than doubled their outstanding amount of bonds and loans.”

Further, that massive increase in debt was not only accepted by credit markets, but applauded. As reported [here], “What is startling is that investors are not running scared. Instead, demand for risky debt is so high that the spread between safe and hazardous corporate debt … is a wafer-thin 50 basis points. In 2012 it was 200 bp.”

As market commentator John Mauldin notes, the explosion in debt is hardly confined to corporations. He reports,

“As of 2014, total global debt had risen to $199 trillion, growing some $57 trillion in just the previous seven years, about $8 trillion a year.” Further, “Since that 2014 report was published, global debt rose by $17 trillion through 3Q 2016.” As a result of debt growth outpacing economic growth, “Global debt-to-GDP is now 325%.” He concludes, “All that debt cannot be repaid under current arrangements, nor can those promises ultimately be kept … At some point, we’re going to have to deal with these issues and restructure everything.”

On top of these issues, a self-sustaining feedback loop is making things even worse. As Chris Cole described [here] “Well, post 2009 something really unique happened, and that volatility as a yield instrument selling it out of the money put options on the S&P and collateralize it, began to outstrip on a yield basis what you were getting in corporates. And all of a sudden, everyone jumped into vol.” In other words, artificially suppressed yields in credit markets prompted a desperate search for yield which was found in the (ultimately dangerous) strategy of shorting volatility.

As noted, “the volume of short positions in the Vix volatility index has climbed to the highest since late January”. Chris Cole captured the feeling well [here] when he said, “And to me, it’s giving rise to things like ramping up exposure. Like, there’s just– you feel it. There’s a desperation and a resignation that says, you can never sell anything. You know, I can’t explain it. I don’t know, but — It’s career risk.”

The same career risk has bled over into advisory and fund management businesses too. As the FT reports,

“The Bank of America Merrill Lynch monthly fund manager survey, which polls investors managing $541bn of assets, showed in June that equity investors had returned to being overweight US equities for the first time in 15 months.” As the FT goes on to say, “Now it appears many are throwing in the towel just when the real warning signs of overexuberance in parts of the market are becoming more apparent.”

Career risk is a phenomenon that is very hard for many investors to see or appreciate. The lesson that many market participants have learned over the last several years is that regardless of signals to the contrary, you can’t afford to be out of the market for any period of time. Needless to say this is a bad lesson to learn and creates systemic risk for the market. It is also deceptive, however, because it creates the appearance that market participants are enthusiastic about prospects.

In addition to cracks developing in the economic cycle and the debt super-cycle, there are also signs that fundamental financial and economic institutions are getting stretched. For example, Michael Gove, secretary of state for the environment in the UK, recently gave a speech on the state of capitalismin which he captured much of the zeitgeist of the times. In it, he acknowledged

“…the failure of our current model of capitalism to deliver the progress we all aspire to.”

Many developed economies have been struggling with productivity wage growth for years, but it has only been fairly recently that these failures have received much attention. Indeed, the economy is rife with examples of cronyism, rent-seeking, and market dominance that undermine the benefits of capitalism. Adam Smith himself worried “that markets were prone to being hijacked by rent-seekers and that companies could become tools of oppression.

Perhaps no group has experienced the negative consequences as much as the millennials. As noted,

“Older millennials entered the workforce in the mid-2000s, and many lost jobs after the 2008 crisis. They were also caught by rapid inflation in house prices as interest rates fell and remained low. The milestones of leaving home, getting a job, marrying and having children have been delayed — 45 per cent of 18 to 34-year-old Americans had done all four in 1975, but only 24 per cent had in 2015.”

Not surprisingly, such experiences have caused millennials to become “disenchanted with their lot.” As one indication of this, “A UK Resolution Foundation study found that pessimists outweighed optimists by two to one when they were asked about their chances of improving on their parents’ fortunes.” Further, “A Pew study in 2014 found that only 19 per cent of millennials believed that others could be trusted, compared with 40 per cent of boomers and 31 per cent of the generation Xers.” As Keith Niedermeier, professor at the Wharton business school, summarizes, “This generation is incredibly sceptical of governments and big corporations.”

So what does all of this say about the market environment? It says that there is a much bigger game in play than fluctuations in the economy or twists and turns in the market. In order to fully appreciate this, however, it helps to establish some context by going back to first principles. We need to think about what it means to invest.

One reasonable definition of investing, in a general sense, is “to devote (one’s time, effort, or energy) to a particular undertaking with the expectation of a worthwhile result.”

A recent report, “Future state of the investment professions”, from the CFA Institute e], makes a similar point that investing should serve a valuable role in society. The report notes, “the core purposes of the investment industry lie in two overlapping areas.” One is wealth creation which involves “Mobilizing capital for jobs and growth,” and another is savings and investments which involves “Deploying investment services for wealth and risk management.”

So far so good. The problem is that many of the trends and practices endemic to today’s business environment fail on one or both counts. Loose monetary policy, excessive debt growth, and economic rent-seeking do little to “mobilize capital for jobs and growth”. Further, what little might be accomplished from such policies only benefits the short term at the expense of the long term and as such, is antithetical to the practice of investing.

The investment industry itself has also largely failed this test. The CFA Institute report reveals that only “11% of investment leaders describe the impact of the investment industry as very positive for society today.” A key reason for this weak result is that the industry has been much more focused on creating profitable “products” than in “deploying investment services for wealth and risk management”.

The result is a rising and widespread degree of financial insecurity. Retiring investors are affected, as Chris Cole noted, “But what we’ve done is we’ve taken the tail risk from the present, and we’ve shifted it to the future on the retiring generation. They’re going to bear the brunt of this.” Millennials and Xers are affected by being rightly skeptical of government promises.

As a result, the exercise of wealth and risk management has become very far removed from the original purpose of investing and will have to adapt in order to become more socially useful. In a world vulnerable to major shocks and fraught with insecurity, what absolutely won’t work is assuming that you just need to accumulate enough money.

For one, the expected returns on financial assets are unlikely to be sufficient to provide an adequate nest egg for many investors. As Mauldin comments,

“I believe that diversifying among asset classes will simply diversify your losses during the next global recession.”

For another, all of the evidence suggests that the assumption of having a fairly stable environment as a basis for planning retirement is wrong. High and growing levels of debt substantially increase the prospects of both inflation and deflation down the road, but well within investment planning horizons. Further, high and growing skepticism of government and big business increases the prospects of extreme and unexpected political outcomes.

Some proactive investors are trying to find forms of investment that are more sustainable. For example, InvestmentNews identifies impact investing as “the act of purposefully making investments that help achieve certain social and environmental benefits while generating financial returns”. The story also reports that “A large majority of affluent millennials (77%) and Generation X investors (72%) have made an impact investment,” which contrasts with “just 30% of affluent donors from the baby boomers and older generations.”

Similar ideas are reported by Michael Shuman in his book, Local dollars, local sense: How to shift your money from Wall Street to Main Street and achieve real prosperity. Shuman calls out the fact that “Americans are systematically overinvesting in Wall Street and underinvesting in Main Street” and calls that gap a “huge market failure”. He then reports: “A growing body of evidence suggests that local businesses are the key to economic prosperity, especially job creation.”

Shuman does an especially nice job of illustrating the human aspects of economic exchanges: “But what truly has become ridiculous is continuing to pour our hard-earned dollars, month after month, into global businesses and stock market casinos that increasingly bear no relationship to our own prosperity. Real prosperity must begin at home.”

He summarizes by saying, “I’m just sick and tired of my hard-earned dollars going to buy the equities of companies that I do not know [and] do not agree with …” By contrast, he describes the situation with cooperatives: “There’s real business value in being able to look your customers in the eye and say, You can trust us, because you own us, and we’re in business to do nothing other than act in your best interest.”

These ideas may sound too “touchy-feely” for died-in-the-wool free markets economists and finance purists, but they are well supported. For instance, the FT reports that institutional investors are increasingly “grappling with the ethics of how … returns are delivered”. Specifically, the Washington and Wisconsin state pensions have “questioned their allocation to KKR, the private equity titan” in response to “the ugly liquidation” of Toys R Us that “may see 30,000 ordinary workers lose their jobs without severance pay.” In addition, Adam Smith himself noted, “Markets constitute a socially constructed and evolving order that exists and must exist not by divine right but because it serves the public good.”

Smith also described hot to go about serving the public good:

“What matters is not the largely empty rhetoric of ‘free markets’, but the reality of effective competition. And effective competition requires mechanisms that force companies to internalise their own costs and not push them on to others, that bear down on crony capitalism, rent extraction, ‘insider’ vs ‘outsider’ asymmetries of information and power, and political lobbying.”

One really important message from this is that the system of capitalism may have some weak points that need to be managed, but it is not inherently flawed. Michael Gove acknowledged this when, despite his criticism, he also commended capitalism as “the most successful wealth-creating machine the world has seen”. This should be remembered especially in the context of political temptations to address undesirable symptoms by reallocating wealth. Because such approaches don’t actually solve underlying problems, they are harmful economically and therefore not sustainable.

Combined with the CFA Institute report’s definition of investing, these ideas establish some useful standards by which to judge investment strategies. For example, how well does passive investing hold up to these criteria? Certainly low costs advance the goal of wealth management. But then with purely passive strategies there is no explicit effort at risk management so that counts against. Further, the idea of allocating capital purely on the basis of size rather than with the intent to “mobilize capital for jobs and growth” also counts against. Nor does passive investing have any effective means by which to subdue crony capitalism, rent extraction, or political lobbying; if anything it promotes such behavior by being complicit. By these criteria, passive investing appears to be more a part of the problem than part of the solution.

The bad news in all of this is that for the vast majority of us there really is no longer any meaningful sense of financial security through our retirement years. While this may feel painful for some, it is really just an “eyes wide open” admission of what has been developing for some time. The good news is that a clear diagnosis allows for much more productive responses. Further good news is that just because some financial constructs are not sustainable doesn’t mean the end of the world. After all, there will be a time when financial assets are attractive again and in the meantime, there will be plenty of other worthwhile things in which to invest our time, effort, and energy.

If you own an individual stock, can you say how much revenue its underlying business realized last year? Can you say what its operating margin was? Can you say what its earnings-per-share were? Can you compare those three metrics from last year to the past five years?  And if you don’t know any of these metrics, should you really own the stock?

Lately I’ve met with investors – if you can call them that — who own individual stocks, but can’t answer any of these questions about the stocks they own. They know something about how the stock has performed, but they know almost nothing about the underlying business. Perhaps they know the industry the business is in because they work in that industry or because they are otherwise enamored of the business – Tesla and electric cars! — but they don’t know how a lot of the revenue is generated, what might sustain it, what might threaten it, etc… Being enamored of a business or industry doesn’t mean you understand it. And just because a business or an industry is new doesn’t mean you have a good way to judge how profitable it will be. Airline travel has changed people’s live, but up until recently, when a few major carriers decided to divvy up routes and keep competition at bay, the airline industry has burnt through an astounding amount of capital.

Keep the technicals in their place

Buying a stock without understanding the underlying business is one of the dangers of emphasizing 200-day moving price averages and other technical metrics. The academic evidence is in, and momentum is a legitimate “factor” that drives stock prices. But over-emphasizing technical statistics or stock price movements runs the risk of directing investors’ attention away from the performance of the underlying business. Technical statistics are very democratic – can we call them populist? — because they flatter everyone with a computer screen who can look at a stock price chart. The truth is they render owners of stocks into something other than investors because investors must be concerned with a stock’s underlying business at least as much as the stock.

Have you heard the phrase “the stock is not the business”? Well, ultimately, it is, and you will get destroyed if you don’t realize that. Just ask former Enron shareholders. An ironic thing about those who doubt the validity of the “fundamentals” of a business is that they don’t dispute why the stock of a bankrupt company is worthless. Nobody disagrees that if a company is bankrupt, the stock price should reflect the status of the underlying business. So why do they dispute that the price must relate to the business in every other circumstance but bankruptcy?

Some might say that technical analysis would have gotten you out of Enron before it went to zero. But a good fundamental analyst realizing that it was impossible to understand how Enron made money – that it was impossible to answer the fundamental question about Enron’s business (or the fact that Enron wasn’t a legitimate business) — would have avoided it altogether.

You’re up against stiff odds

If technicals distract you from the underlying business, studying the underlying business pits you against the best fundamental analysts.

Knowing the business doesn’t only mean knowing — without needing to consult the financial statements, because you’ve studied them already — what revenues, operating margins and earnings-per-share are. Far from it. Knowing the business also mean knowing what a company sells to achieve its revenues and earnings, and what the competitive threats are to those products and services. Do other companies sell the same kind of good or service? What makes the things your company sells better? Or what makes the stock underpriced based on the quality of its products and the future prospects for sales and earnings? Knowing the business also means understanding the financial health of the business. If it has debt, can it cover its interest payments comfortably?

If you own a stock, you are competing against investors who are studying financial statements and trying to assess the prospects of the underlying business as their full-time jobs. Warren Buffett reads 500 pages of financial statements everyday. You can score some trading victories without knowing anything about a stock’s underlying business, and, yes, sometimes analysts know so many details about the underlying business that they lose sight of its two or three most important drivers when evaluating what it’s worth. But how long can that game of trading things you know nothing about go on? Can you really compete with this folks studying the underlying business full-time, if you’re operating on a part-time basis?

Every stock purchase is an act of arrogance, says hedge fund manager, Seth Klarman. When you make your purchase, you’re saying that you know more than the market about what the stock is worth. You’re saying you know more than others whose study of the underlying business is their full-time job. If you’re an ordinary retail investor, why should you be able to compete with such people? The fact is, you shouldn’t, and your arrogance in making the purchase is almost certainly unwarranted.

Get a financial plan

Instead of trying to pick individual stocks, go see a financial adviser and get a financial plan. Get yourself on the road to saving steadily for the important goals in life – retirement and sending your kids to college. See a financial planner who can help you put a budget in place so that you control spending and have some money to save every pay period. Figure out a plan that gets you saving periodically, allocates your assets in a way that won’t force you to sell when markets swoon, estimates future returns in a realistic way, and lets  you know when you might be able to retire and what retirement might look like financially. All of these things are much more important than wasting time thinking about individual stocks.

Don’t let trying to figure out which stock to buy, when to buy it, and when to sell it, get in the way of the steady business of saving money for your long term goals. If you’re finished spinning your wheels trying to pick individual stocks, and you’re ready to see an adviser, click this link.