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Monthly Archives: October 2017

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

Part I – “Buy & Hold” Can Be Hazardous To Your Wealth

Part II – Why Crashes Matter & The Saving Problem

Valuations & Forward Returns

“Part III” of this series will discuss the issue of valuations, the impact on forward returns as it relates to investment outcomes, and withdrawal rates in retirement.

As discussed previously:

“Investors do NOT have 90, 100, or more years to invest. Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have 30-35 years to reach their goals. If that stretch of time happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are massively diminished.”

But what drives those12-15 year periods of flat to little return? Valuations.

In this article, we focus on the Shiller Cyclically Adjusted Price to Earnings Ratio or CAPE. This technique differs from most other price-to-earnings ratios as it takes a longer term view by using ten-year average of earnings. The graph below shows how this compares over time.

What is clear, and unarguable, is that when valuations are elevated, future returns on investments decline. There are two ways in which the ratio can revert back to levels where future returns on investments rise. 1) Prices can rapidly decline, or 2) Earnings can rise significantly while prices remain flat. Historically, and as shown above, option 2) has never been a previous outcome.

One great thing about valuations, such as CAPE, is that we can use them to help us form expectations around risk and return. The graph below shows the actual 30-year annualized returns that accompanied given levels of CAPE.

While it is crystal clear, as evidenced by the graph, as valuations rise future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay today for an asset, future returns must, and will, be lower.

Math also proves the same. Capital gains from markets are primarily a function of market capitalization, nominal economic growth plus the dividend yield. Using the Dr. John Hussman’s formula we can mathematically calculate returns over the next 10-year period as follows:

(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1

Therefore, IF we assume that

  • GDP attains, and maintains, 4% annualized growth starting immediately, AND
  • There are NO recessions, AND
  • Current market cap/GDP stays flat at 1.25, AND
  • The current dividend yield of roughly 2% remains,

We would get forward returns of:

(1.04)*(.8/1.25)^(1/30)-1+.02 = 4.5%

But there’s a “whole lotta ifs” in that assumption.

More importantly, if we assume that inflation remains stagnant at 2%, as the Fed hopes, this would mean a real rate of return of just 2.5%.

This is far less than the 8-10% rates of return currently promised by the Wall Street community. It is also why starting valuations are critical for individuals to understand when planning for the accumulation phase of the investment life-cycle.

Let’s take this a step further. For the purpose of this article, we went back through history and pulled the 4-periods where valuations were either above 20x earnings or below 10x earnings. We then ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis.

At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was actually not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “” crash. It was the post-WWII bull market that ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.

Conversely, at 20x earnings, the best performing period started in 1900 which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)

The point to be made here is simple and was precisely summed up by Warren Buffett:

“Price is what you pay. Value is what you get.” 

This idea becomes much clearer by showing the value of $1000 invested in the markets at both valuations BELOW 10x trailing earnings and ABOVE 20x. I have averaged each of the 4-periods above into a single total return, inflation-adjusted, index, Clearly, investing at 10x earnings yields substantially better results.

Not surprisingly, the starting level of valuations has the greatest impact on your future results.

But, in investing, getting to your destination is only half of the journey.

Starting Valuations Are Critical To Withdrawal Rates

Valuations have even a bigger, and vastly more critical, impact on the outcomes of withdrawal rates during retirement. Michael Kitces wrote an article discussing the withdrawal rate in retirement (Why Most Retirees Will Never Draw Down Their Retirement Portfolio) where he laid out a typical example of a retirement portfolio during the distribution phase of retirement.

“Given the impact of inflation, it’s problematic to start digging into retirement principal immediately at the start of retirement, given that inflation-adjusted spending needs could quadruple by the end of retirement (at a 5% inflation rate). Accordingly, the reality is that to sustain a multi-decade retirement with rising spending needs due to inflation, it’s necessary to spend less than the growth/income in the early years, just to build enough of a cushion to handle the necessary higher withdrawals later!

For instance, imagine a retiree who has a $1,000,000 balanced portfolio, and wants to plan for a 30-year retirement, where inflation averages 3% and the balanced portfolio averages 8% in the long run. To make the money last for the entire time horizon, the retiree would start out by spending $61,000 initially, and then adjust each subsequent year for inflation, spending down the retirement account balance by the end of the 30th year.”

Before we get into the variability of returns and starting market valuations, I want to dig deeper into Kitces’ premise above by looking at the impact of inflation-adjusted returns and taxation.

The first chart below expands on Kitces’ chart above by adjusted the 8% return structure for inflation at 3% and also adjusting the withdrawal rate up for taxation at 25%.

By adjusting the annualized rate of return for the impact of inflation and taxes the life expectancy of a portfolio grows considerably shorter. However, the other problem, as first stated above, is there is a significant difference between 8% annualized rates of return and 8% real rates of return. 

When we adjust the spend down structure for elevated starting valuation levels, and include inflation and taxation, a much different, and far less favorable, financial outcome emerges – the retiree is out of money not in year 30, but in year 18.

So, with this understanding let me return once again to those that continue to insist the “buy and hold” is the only way to invest. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually in a mattress.

The red line is 10% compounded annually. While you don’t get compounded returns, it is there for comparative purposes to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The shortfall between the promised 10% annual rates of return and actual returns are shown in the two shaded areas. In other words, if you are banking on some advisor’s promise of 10% annual returns for retirement, you aren’t going to make it.

I want you to take note of the following.

When investing your money at valuations above 20x earnings, it takes 22-years before it has grown more than money stuffed in a mattress. 

Why 22 years? 

Take a look at the chart below.

Historically, it has taken roughly 22-years to resolve a period of over-valuation. Given the last major over-valuation period started in 1999, history suggests another major market downturn will “mean revert” valuations by 2021.

The point here is obvious. Valuations are the ultimate arbiter of future returns. Whether you are in the first half of the investment cycle, or the last, the single most important factor to your long-term success is at “what valuation level” did you start your journey?

On May 24, 2018, Paul La Monica penned an article for CNN Money entitled Companies have spent a stunning $2 trillion on mergers so far this year.  The article notes that in 2018 merger activity has hit a feverish pitch fueled by “healthy balance sheets and strong share prices.” While somewhat true we think it is important to tell the whole story.

We have written numerous articles describing how cheap money and poorly designed executive compensation packages encourage corporate actions that may not be in the best interest of longer-term shareholders or the economy. The bottom line in the series of articles is that corporations, in particular shareholders and executives, are willing to forego longer term investment for future growth opportunities in exchange for the personal benefits of short-term share price appreciation. Buybacks and mergers, both of which are fueled by the Federal Reserve’s ultra-low interest rate policy have made these actions much easier to accomplish.

On the other hand, corporate apologists argue that buybacks are simply a return of capital to shareholders, just like dividends. There is nothing more to them. Instead of elaborating about the longer term ill-effects associated with buybacks or the true short-term motivations behind many mergers, the powerful simplicity of the following two graphs stands on their own.

The first graph, courtesy Meritocracy, shows how mergers tend to run in cycles. Like clockwork, merger activity tends to peak before recessions. Not surprisingly, the peaks tend to occur after the Federal Reserve (Fed) has initiated a rate hike cycle. The graph only goes through 2015, but consider there has been $2 trillion in mergers in 2018, and its only June.

The following graph shows how corporate borrowing has accelerated over the last eight years on the back of lower interest rates. Currently, corporate debt to GDP stands at levels that accompanied the prior three recessions.

There is a pattern here among corporate activities which seems similar to that which we see in investors. At the point in time when investors should be getting cautious and defensive as markets become stretched, they carelessly reach for more return. Based on the charts above, corporate executives do the same thing. The difference is that when an investor is careless, his or her net worth is at risk. A corporate executive on the other hand, loses nothing and simply walks away and frequently with a golden parachute.

Being a good steward of wealth is most difficult when everyone else is chasing the bubble. Corporate executives are no exception. Their actions may seem harmless as the economy is growing and the market steadily rises, but the last two recessions demonstrate that the wreckage of poor corporate decision-making falls mostly on workers and investors in the guilty companies. This time will be no different; the only question is how much higher does the Fed need to boost interest rates before the consequences of their actions become obvious?

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

Economy & Fed


Most Read On RIA

Research / Interesting Reads

“ The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.” – Seth Klarman

Questions, comments, suggestions – please email me.

Blaise Pascal, a brilliant 17th-century mathematician, famously argued that if God exists, belief would lead to infinite joy in heaven, while disbelief would lead to infinite damnation in hell. But, if God doesn’t exist, belief would have a finite cost, and disbelief would only have at best a finite benefit.

Pascal concluded, given that we can never prove whether or not God exists, it’s probably wiser to assume he exists because infinite damnation is much worse than a finite cost.

When it comes to investing, Pascal’s argument applies as well. Let’s start with an email I received this past week.

“The risk of buying and holding an index is only in the short-term. The longer you hold an index the less risky it becomes. Also, managing money is a fool’s errand anyway as 95% of money managers underperform their index from one year to the next.”

This is an interesting comment as it exposes two primary falsehoods.

Let’s start with the second comment “95% of money managers can’t beat their index from one year to the next.” 

One of the greatest con’s ever perpetrated on the average investor by Wall Street is the “you can’t beat the index game.” It is true that many mutual funds underperform their index from one year to the next, but this has nothing to do with their long-term performance. The reasons that many funds, and investors, underperform in the short-term are simple enough to understand if you think about what an index is versus a portfolio of invested capital.

  1. The index contains no cash
  2. It has no life expectancy requirements – but you do.
  3. It does not have to compensate for distributions to meet living requirements – but you do.
  4. It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
  5. It has no taxes, costs or other expenses associated with it – but you do.
  6. It has the ability to substitute at no penalty – but you don’t.
  7. It benefits from share buybacks – but you don’t.
  8. It doesn’t have to deal with what “life” throws at you…but you do.

But as I have addressed previously, the myth of “active managers can’t beat their index” falls apart given time.

Larry Swedroe wrote a piece just recently admonishing active portfolio managers and suggesting that everyone should just passively invest. After all, the primary argument for passive investing is that active fund managers can’t beat their  indices over time which is clearly demonstrated in the following chart.”

“Oops. There are large numbers of active fund managers who have posted stellar returns over long-term time frames. No, they don’t beat their respective benchmarks every year, but beating some random benchmark index is not the goal of investing to begin with. The goal of investing is to grow your ‘savings’ over time to meet your future inflation-adjusted income needs without suffering large losses of capital along the way.”

It isn’t just mutual funds that regularly outperform their respective benchmarks but also hedge funds, private managers and numerous individual investors that put in the necessary time, work and effort.

But, I will admit that today, more than ever, the game is stacked against the average investor as high-speed trading takes advantage of retail investor online order flows. The proprietary trading desks, who have access to massive pools of capital, can push markets on an intra-day basis while computerized programs execute orders based on data flows. It has truly become the battle of “David and Goliath” with Wall Street armed with better technology, more resources, more information, teams of people dedicated solely to a single outcome versus – you and your computer. One can certainly understand why many individuals have given up trying to manage their investments.

But therein lies the huge conflict of interest between Wall Street and you. They need your money flowing into their products so they can charge fees. Wall Street is a business and, for them, business is good, and very profitable, as long as investors buy into the game that investing is the ONLY way to grow “rich.”

However, as investors, we must abandon the idea of chasing some random benchmark index, which really has very little to do with our own personal investing goals, and focus on the things that will make us wealth over time: spend less, save more, reduce debt (increase cash flow), grow our “human capital,” (earning power), invest and avoid major losses.

Investing and avoiding major losses brings us to the first point of the email which is “stocks become less ‘risky’ over time.”

Stocks Become Less “Risky” Over Time?

This idea suggests the “risk” of the loss of capital diminishes as time progresses.

First, risk does not equal reward. “Risk” is a function of how much money you will lose when things don’t go as planned. The problem with being wrong is the loss of capital creates a negative effect to compounding that can never be recovered. Let me give you an example.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.


The “power of compounding” ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe. 

The problem with following Wall Street’s advice to be “all in – all the time” is that eventually you are going to dealt a bad hand. By being aggressive, and chasing market returns on the way up, the higher the market goes the greater the risk that is being built into the portfolio. Most investors routinely take on more “risk” than they realize which exposes them to greater damage when markets go through a reversion process.

How do we know that risk increases over time? The cost of “insurance” tells us so. If the “risk” of ownership actually declines over time, then the cost of “insuring” the portfolio should decline as well. The chart below is the cost of “buying insurance (put options) on the S&P 500 exchange-traded fund ($SPY).

As you can see, the longer a period our “insurance” covers the more “costly” it becomes. This is because the risk of an unexpected event that creates a loss in value rises the longer an event doesn’t occur.

Furthermore, history shows that large drawdowns occur with regularity over time.

Byron Wien was asked the question of where we are in terms of the economy and the market to a group of high-end investors. To wit:

“The one issue that dominated the discussion at all four of the lunches was whether or not we were in the late stages of the business cycle as well as the bull market. This recovery began in June 2009 and the bull market began in March of that year. So we are more than 100 months into the period of equity appreciation and close to that in terms of economic expansion.

Importantly, it is not just the length of the market and economic expansion that is important to consider. As I explained just recently, the “full market cycle” will complete itself in due time to the detriment of those who fail to heed history, valuations, and psychology.

“There are two halves of every market cycle. 

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’ The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.

With valuations currently pushing the 2nd highest level in history, it is only a function of time before the second-half of the full-market cycle ensues.

That is not a prediction of a crash.

It is just a fact.”

But as Mr. Pascal suggests, even if the odds that something will happen are small, we should still pay attention to that slim possibility if the potential consequences are dire. Rolling the investment dice while saving money by skimping on insurance may give us a shot at amassing more wealth, but with that chance of greater success, comes a risk of devastating failure.

Winning The Long Game

In golf, there is a saying that you “drive for show and putt for dough” meaning that it is not necessary to be able to drive a golf ball 300 yards down the center of the fairway – it is the short putting, measured in feet, which will win the game. In investing, it is much the same – being invested in the market is one thing, however, understanding the “short game” of investing is critically important to winning the “long game.”

When valuations rise to rarely seen levels, and the associated risks of a major drawdown increase exponentially, focus on managing the “risk” of the portfolio rather than chasing “returns.”

Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:”

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

But it was Howard Marks who summed up our philosophy on “risk management” well when he stated:

“If you refuse to fall into line in carefree markets like today’s, it’s likely that, for a while, you’ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed. It may not happen this time, but I’ll take that risk.” 

Clients should not pay a fee to mimic markets. Fees should be paid to investment professionals to employ an investment discipline, trading rules, portfolio hedges and management practices that have been proven to reduce the probability a serious and irreparable impairment to their hard earned savings.

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

Personally, I choose to “believe” as I really don’t like the sound of “eternal damnation.” 

Do stocks get less risky the longer you own them? Most financial advisors say Yes; if you’ve got the time, you should own stocks. That’s because although nobody knows what the stock market will do over any one-year period, the market seems to go up over time — and at a rate that has overcome inflation by around 6-7 percentage points. History shows the longer the time period, the higher the chance of producing a positive return. So it’s foolish to own stocks for a one-year period, but also foolish not to own them if you’ve got, say, a decade or longer as a time horizon.

The problem is that a 60-year old planning to retire in five years doesn’t have a long period of time anymore. The typical advisor and the entire financial services business will argue that this hypothetical person does indeed have a long period of time because he will likely not die at 65. That person’s assets must see him through what could be a 30-year retirement. And that’s why most target date funds continue to have significant stock exposure on the date of retirement. The Vanguard Target Retirement 2020 Fund, for example, has 52% of its portfolio is stocks currently, according to Morningstar.

But increased longevity isn’t the final argument regarding asset allocation in retirement either. Last night, my colleagues, Richard Rosso and Danny Ratliff, and I interviewed Professor Zvi Bodie of Boston University who argues that the “stocks for the long run” argument can be misleading. Bodie decried the significant stock exposure that target date funds have at retirement, and argued that investors aren’t guaranteed to earn long term stock market historical averages by increasing their time frames. (Bodie says the same thing in this interview\ starting at 2:10). Not every 10- or 20-year period produces returns well in excess of inflation. the “risk premium” that stock are supposed to deliver over other asset classes is sometimes absent altogether. That means if someone has saved enough money to generate the income they need in retirement, one runs the risk of ruining that retirement plan by holding an excessive amount of stocks, whose value can decline significantly. After all, we’ve had two periods over the last 18 years where stocks have declined by 50%. One of those “drawdowns” lasted over two years and one period lasted for a little over one year.

Even if stocks do outperform bonds, the volatility they impose on an investor drawing income from investments can be catastrophic. Below is a chart of three hypothetical retirement scenarios beginning in 2000 and running through 2017. They represent a $500,000 retirement savings account invested in different allocations from which a retiree spends 4% in the first year and grows the initial withdrawal amount by 4% each year thereafter (the so-called 4% retirement income rule). The different allocations are a 30%/70% mix of stocks and bonds, a 60%/40% mix and a 100% stocks portfolio. We use the S&P 500 Index, including dividends, to represent stocks and the Bloomberg Barclay’s U.S. Aggregate Bond Index to represent bonds.

Over this period of time, stocks delivered a 5.4% annualized return, while bonds delivered a 5.1% annualized return. But, although stocks beat bonds marginally, increasing a retiree’s exposure to them didn’t help. The most conservative portfolio was the only one that kept the retiree’s assets intact after distributions. A balanced portfolio eroded the assets and a 100% stock portfolio eroded the assets spectacularly, despite the slight outperformance of stocks on an compounded annualized basis.

This illustration displays “sequence of return risk” well. The better performing asset on a compounded annualized basis was too volatile to keep the retiree’s portfolio intact. Losses came at the beginning of the distribution period so that the combination of losses and distributions in the first few years depleted the portfolio to the extent that a stock market rebound couldn’t elevate it adequately again.

Of course, stocks often beat bonds more resoundingly than they did from 2000 through 2017, though, again, not always. The illustration picks an unusually bad period when the stock market suffered two massive declines. That tends to harm a portfolio in distribution considerably. But investors should think in terms of worst-case scenarios, not just long-term averages.

Furthermore, investors should take starting valuations into consideration when contemplating various scenarios and their likelihoods. While the Shiller PE (current price relative to the past decade’s average, real earnings), for example, is lousy at forecasting crashes and short term returns, it’s pretty good at forecasting the next decade’s worth of returns. And because it has this longer term forecasting ability, it can be useful to retirees as financial planner Michael Kitces shows (here and here).

Currently, the Shiller PE is elevated at 32. Its long term historical average is less than 17. Perhaps a “new normal” for the metric is 20 or even 22, since companies are more profitable now than they were in the past. But even a new normal doesn’t make stocks appear cheap or future returns robust. That means, with stock return prospects so low, investors embarking on retirement probably shouldn’t have more than half their assets in stocks, and many should consider having considerably fewer than half their assets in stocks. In other words, the typical target date fund allocation may not be appropriate for many retirees.

Despite a challenging start to the year and recent turmoil in some European bond markets, U.S. fixed income markets perked up in May with five of the seven primary fixed income sectors posting positive monthly returns. Investment grade municipals were the best performing sector returning 1.15% for the month followed by U.S. Treasuries, the aggregate index and securitized bonds. The table below, sorted by May’s performance, highlights returns over varying time frames as well as their current yields.

Data Courtesy Barclays

Mid-way through May, 10-year U.S. Treasuries rose sharply by 16 basis points from 2.95% to 3.11% and importantly surpassed the heavily followed 2014 taper tantrum highs of 3.05%. But those levels would not hold and a month-end rally, initially inspired by rather dovish FOMC minutes, helped the 10-year close the month at a yield of 2.85%. All the while U.S. credit spreads were relatively well-behaved mostly ignoring problems in other parts of the world. In particular and worth following going forward, political turmoil in Italy resulted in a stunning increase in Italian yields (Ten-year BTP 1.70% to 3.10%). This likely produced some anxiety in riskier sectors which seems to be the primary reason for the small monthly loss in high-yield credit.

The emerging markets (EM) were down 73 basis points for the month and are posting a 3.23% loss year-to-date. New sanctions imposed by the U.S. on the Venezuelan government aimed at choking off funding for the Maduro regime coupled with an emergency 300 basis point rate hike in Turkey raises the risk of EM mutual fund outflows, broad-based weakness and further losses.

Despite the small loss for the month, U.S. High Yield remains the best performing sector year-to-date as the domestic focus of the high yield market remains supported by sound U.S. economic conditions and a favorable corporate fundamental backdrop. The chase for yield is certainly helping as well. Nevertheless, the high yield sector is the most leveraged segment of the fixed-income market. Therefore, sensitivities to economic conditions and interest rates have the potential to spur volatility for junk bonds.

It may be somewhat surprising to see high yield debt outperform investment grade corporate bonds in a period of tightening liquidity but so far, financial conditions have not deteriorated very much. Additionally, as the chart below illustrates, high yield spreads historically do not show a consistent pattern of widening relative to investment grade during rate hike cycles. Based on the last 25 years, junk spreads more often underperform after the terminal Fed Funds rate has been achieved for the cycle.

Data Courtesy Barclays and St. Louis Federal Reserve

The suicide deaths of celebrities like Anthony Bourdain and Kate Spade has brought an uncomfortable and tragic attention to a growing problem. According to a recent report by the Centers for Disease Control and Prevention, rates of death by suicide in the U.S. have risen by close to 25% over the last 20 years.

We’re not here to debate how and why. It’s not our area of expertise. However, suicide is a choice. Not a good choice. Suicide doesn’t know age, success, color, social status. Suicide knows demons. When they overwhelm, you listen.

Coming from a family where suicide and depression runs deep, to this day I wonder if I should have saved my mother the third time she tried to take her life. I needed 6 months absence from junior high school to care for her.

Before a person takes a horrible step, before you would make the choice, look for divine intervention. Search for a message, a sign, anything. That it’s not your time.

As I work on a few big projects, one being a book with business partner and individual I greatly respect, Lance Roberts, I try my best to listen to what I usually ignore. The divine intervention reaches to me through the tall pines that surround my house. When I assist someone overcome a money obstacle, I consider it divine intervention, too.

I firmly believe divine intervention was involved when I saved my mother for the third time.

She never attempted suicide again, but her existence was far from happy. So occasionally, I wonder.

Was saving her the best choice?

In your life, many questions will remain unanswered.

“You just learn to live with open circles, I guess.”

Lucas McCain delivers these words in my screenplay to bring the 50s western, “The Rifleman,” to the big screen.

Many of us must don’t learn to close open circles when it comes to poor financial decisions. Even the worst money habits can be turned around, changed for the better. It doesn’t take much effort to identify poor financial paths and initiate small steps to turn the tide.

The tragic events over the last two weeks reminded me of an incident that occurred when I was a boy. It was back then I realized that minutes can slow down and feel like forever.

Here are some lessons I learned back in 1976.

“Another nine minutes. She’d be dead.”

I wonder what he meant.

Almost 4 decades ago.

As memories fade leaving pin-hole punctures wrapped in thick haze of distant moments, there remain a few clear snapshots left in my head of what happened that August morning.

You know. Nine minutes that border life and death.

So specific. So odd.

Her body was glowing cold. Dressed in the previous day’s outfit. Low faded jeans, bell bottom style. Shoes. A floral halter top circa 1976.

Tight in a fetal position. Her head and neck awkwardly stuck between the bottom shelf of the refrigerator and a crisper bin.

The paramedic pulled 92-pounds of stiff limbs from a cold cage. He heaved her to the linoleum kitchen floor as easy as a person tosses a used candy wrapper.

She was solid.

An overdose of pills and booze.

I was certain it was rigor mortis. I’d witnessed enough of it spending time staging G.I. Joe adventures in the plush red-draped lobby of the neighborhood funeral parlor owned by my best friend Joey.

But she wasn’t dead.

The paramedic said in nine more minutes things would have been different.

But how did he know?

I looked up at the kitchen clock. He said those words with such confidence. Who was I to doubt him?


In nine more.

Game over: 3:00am.


May not be full release of the mortal coil but some kind of game changer is imminent.

As you read this a thousand of your skin cells just died.

A cancer you don’t know about yet grows larger.

The love of your life is about to enter your space.

You’re on track for an encounter with a jerk or the greatest inspiration you ever met.

A phone call away from a life-changer. A drive. A walk. A run. A jog.

You just made a purchase of something you really don’t need.

A fall. A rise.

Minutes humble you. Not years. Years mellow you. Minutes keep the receptors open. Allow the flood of your life and the lives of others to fill where you stand. The next move you make can change your world whether you want it to or not.


Never question why a challenge, a person, an illness, an opportunity, a setback, gets thrown in your groove. The intersection came upon you from a source you’ll never be able to explain or completely understand. It’s a waste of time to trace what lead you here but worth the minutes to live the steps you’re taking now.

Signs are all around if you just let go of skepticism, lessen the noise. Whose life remains in the balance once you open your eyes, mind and heart to the signs? When a change places a purpose in the road, your brain will hum endlessly until you follow it and hum the tune every day.


I can write the best 250 words of my life in 9 minutes. I can watch my pup Rosie monitor the neighborhood from the open blinds in the living room and ponder how happy I am to have adopted her from the animal shelter.

Greatness is defined by the whispers of time. In the small of actions that move and make you stronger, life is lived large. It’s when greatness appears.

Greatness is not earned through the validation of others. It comes when you recognize and develop talents you’ve had since youth.

When you positively affect one life, you’ve earned prominence.

We answer money questions, bust Wall Street myths, set lives on the right financial path every day. If we affect one life positively, help one individual meet a retirement goal, we’ve accomplished a noble mission.

Like a paramedic who believed he was nine minutes early. Able to save a life.

An unassuming master of greatness.


How many people do you know who died long ago?

You see them daily. They live in a perpetual fetal position. Stiff. Lifeless. Nine minutes closer to a dirt nap.

They work little corporate jobs, have little middle managers who define their big fates. They don’t have time to bask in their kids or the live life stories that add richness.

My former regional manager at Charles Schwab, told me “you don’t need to see your kids play baseball or attend dance recitals. You need to be at work.”

Not for me: I pulled my head out of the fridge.

Do something in nine minutes every day that makes you glad to be here. Breathe deep. Take your life back. Start a book from our RIA Reading List. Nine minutes of reading a day. Observe what happens over a year based on only nine minutes of reading a day.


Yes, I know we live to complicate things in the financial services business. Complicated is designed to sell product you don’t need. Simplicity is the key to financial success. The best long-term asset allocations are those designed using low-cost investment vehicles along with rules to manage risk which include liquidating stocks to minimize the effects of the time required to break even and meet financial goals.

If I ask, you already know what your greatest money weakness is. Take nine minutes to write it out. Spend another nine to consider one specific action to improve.

Ask yourself: Are you happy right now? Where is resistance coming from? Are you working for a future that never appears? When the future is the present do you look ahead to another future? In the silent noise that vibrates in the back of your head is there regret? Anxiety? Look inside yourself for answers. Others can’t be blamed. They’re not the cause. You’ll never discover truth if you’re not accountable.

In nine minutes can you write nine reasons why you feel the way you do? That’s the flow of your life. The time that bridges big events is where flow is discovered. Or changed, re-directed, improved.

Your choice.

We alternated nights in the only bed. Mom and I.

Monday couch (no sleep), Tuesday bed (sleep). There was a full-length mirror in our three-room walk up. I recall dad cursing, fighting to secure the clunky structure to the hall-closet door.

At the right angle the mirror provided a clear view of the kitchen. From the bedroom you could observe everything. The present events. Now I understand how it saw the future too.

Since mom always seemed to gravitate to the kitchen late at night, the reflection in the mirror of her pacing back and forth was not uncommon. I was a light sleeper. My habit was to wake, look in the mirror, turn away to the darkness of the wall. Many nights I was forced to get up and close the bedroom door, so I couldn’t see what was going on in the rest of the apartment.

10pm: Wake up. Glance in mirror. Observe kitchen. Fridge door open. More beer for mom I was sure. 12:02am: Wake up. Look in mirror. See kitchen. Fridge door open? Heavy drinking binge. Turn. 2:16 am: Wake up. Turn. Look in mirror. See kitchen. Fridge door ajar. Again? Still?


I was mad. So mad. I got up to see what was going on. Mom half on the floor. On her side. Tangled in the extra-long, engine-red cord of a dead Trimline phone. Her head inside the bottom shelf of the fridge. I touched her shoulder. Felt the freeze of her body.


I happened to glance at that damn kitschy cat clock. Waggy tail. Shifting eyes.

Tick. Tail. Tick. Tail. Eyes right. Eyes left.

Never forgot 2:18. Plastic cat eyes.

Taunting me.

A human accordion. She wouldn’t unfold. Still breathing. Shallow. I noticed the slight movement of a tiny chest. Up and down. Slow. Mouth open. Tongue shriveled. Lips colorless. Light blue.

I was in a panic. Half asleep. My mind reeling.


Cat eyes away.

Suddenly calm, I sat on the floor. Staring at her.


I watched mom’s chest go choppy. Still. Move. Move. Nothing.

Cat tail. Swing left. Right.

Extended on the exhale. Awaiting permanent stillness. Hoped for it. 2:22.

Crossroad. Intersection.

Whatever you call it. The power to make a decision that would change all. Slowed down everything. An inside voice, one I never heard before. Kept asking. Slightly teasing. The repetition of the question felt forbidden. But continued. Cat tick-tock.

A thousand pounds tied to a melamine tail.

Live or die? Choose. Now. No time left.


In nine minutes. Decide.

Go on the way you have been.

Or live.



Fiscally-fit people wait before making a purchase, especially a significant one. Waiting lessens the impulse to part with money for something you don’t need. Wait nine minutes. Then nine hours. Nine days. If you still want the item, buy it. Most likely the heat will pass. Your desire will grow cold.

The epidemic of suicide is real. And spreading. If you know of someone in crisis, reach out. The National Suicide Prevention Hotline is 1-800-273-8255.

As we detailed in this past weekend’s newsletter:

“…[the expected] breakout did occur and pushed prices to the first level of resistance which resides at the late February highs.”

“…there is a significant amount of overhead resistance between 2780 and 2800 which may present a challenge in the short-term to a further advance. However, I suspect any weakness next week will likely provide a decent opportunity to increase equity exposure modestly. 

This idea aligns with the updated ‘pathway analysis’ from last week.”

“We had previously given pathway #1, #2a and #2b a 70% probability of coming to fruition. The tracking of pathway #1 also negates pathway #3 entirely for now. 

More importantly, the market is sitting at the critical juncture of either a continuation of pathway #1 toward all-time highs or a correction of some sort to retest support and confirm this past week’s breakout. A corrective retest that provides a better entry point to increase exposure is the most preferable of outcomes.”

While we will increase our equity exposure in portfolios, cautiously and moderately, it does not mean we no longer appreciate the risk in the markets, or to investment capital.

Risks To Our View

As we discussed this past weekend, the risks to our view, both in the short and intermediate-term, remain.

  1. The Fed will hike rates next week, however, their press conference will be closely watched for more “hawkish” undertones.
  2. Next week, the Trump Administration will announce $50 billion in “tariffs” on Chinese products. The ongoing trade war remains a risk to the markets in the short-term. 
  3. Any unexpected “back-of-the-napkin” policy the White House takes which surprises the market.
  4. Ongoing liquidity concerns with respect to Italy or Deutsche Bank.

On Monday, the market shrugged off the “back-of-the-napkin” trade policy and backlash by the Administration towards Canada’s Prime Minister Justin Trudeau following the G-7 Summit. However, there is still a growing risk that “trade policy” will have a more detrimental impact to U.S. companies in the months ahead.

There is also risk in the optimism over Trump’s “mano-a-mano” meeting with Kim Jung Un on the issue of a “nuclear-free North Korea.” While the pair signed an agreement yesterday “committing” to denuclearization, it was actually little more than an agreement to have more summits.

The markets had already priced in much of the current events with the recent run up, so an agreement to have more summits left markets a bit “underwhelmed” this morning.

The biggest risk to our more optimistic market view remains the Fed, global Central Bank liquidity support, and monetary policy. Bank of America, via ZeroHedge, provided additional support to our view of the “end of liquidity” which will become more aggressive this year.

“In our view, the ECB has decided to announce in June how QE will end for three reasons. The QE program will end for sure this year, because of technical constraints, so there is no reason to keep the uncertainty and give a false impression that extending QE to 2019 remains an option.

Following the market turmoil from Italy last week, the ECB has strong incentives to make it clear that QE is about to end, also sending a message to the new government in Italy that they should not count on QE support if they want to loosen fiscal policies. And recent headlines on the ECB drop of BTP purchases in May makes the QE program politically more controversial. This suggests that the end of QE has nothing to do with the intended ECB monetary policy stance or the latest economic developments and outlook ahead. We would expect the ECB to emphasize that rate hikes ahead will be strictly data dependent.”

With the FOMC hiking rates this coming week, and accelerating its “balance sheet normalization” by increasing its roll-offs from $30 to $40 billion a month, the proverbial “global liquidity punch bowl” is now being more aggressively removed. This is akin to removing the trampoline with the jumper currently at their apex.

With global economic growth slowing, trade war risks rising, and liquidity being extracted, there is a rising possibility that tighter global monetary policy will lead to a credit-driven event. This is particularly the case given the rate at which corporations have been gorging themselves on cheap debt to take cash out of their balance sheets for the benefit of their executives and shareholders. Steven Pearlstein via the Washington Post:

“Now, 12 years later, it’s happening again. This time, however, it’s not households using cheap debt to take cash out of their overvalued homes. Rather, it is giant corporations using cheap debt — and a one-time tax windfall — to take cash from their balance sheets and send it to shareholders in the form of increased dividends and, in particular, stock buybacks. As before, the cash-outs are helping to drive debt — corporate debt — to record levels. As before, they are adding a short-term sugar high to an already booming economy. And once again, they are diverting capital from productive long-term investment to further inflate a financial bubble — this one in corporate stocks and bonds — that, when it bursts, will send the economy into another recession.

Welcome to the Buyback Economy. Today’s economic boom is driven not by any great burst of innovation or growth in productivity. Rather, it is driven by another round of financial engineering that converts equity into debt. It sacrifices future growth for present consumption. And it redistributes even more of the nation’s wealth to corporate executives, wealthy investors and Wall Street financiers.”

“As the accompanying chart indicates, over the past decade, net issuance of public stock — new issues minus buybacks — has been a negative $3 trillion. This reduction in the supply of public shares in American companies, coupled with an increased global demand for them, goes a long way toward explaining why stocks are now priced at 25 times earnings, well above their historical average.”

This is a problem that provides our biggest concern currently. As I noted last week:

“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.

This is THE story we will most likely be discussing in the future even while the mainstream media suggests “no one could have seen it coming.” 

It’s Confusing

This is where it gets confusing.

“Why are you increasing equity risk in portfolios, if you are certain the markets are going to break?”

It’s a great question from a reader over the weekend.

As portfolio managers we face two great challenges – making investments in the short-term to capitalize are market movements (or suffer career risk from underperformance) and managing long-term capital destruction risks which will occur from overvalued and extended bull markets.

Our investment discipline is designed to manage both ends of the spectrum. Our technical analysis, as we discuss each week, drives shorter-term portfolio actions (weeks to months), with fundamental analysis driving asset allocation and portfolio weighting decisions (months to years.)

Are we certain the markets are going to experience a severe “mean reverting event?” 



We have no idea.

This is specifically why we don’t make absolute predictions about where markets are headed. We are not psychics, fortune-tellers, or imbibed with any prescient gifts. As such, we must we focus, and rely, on our assessment of the current possibilities versus probabilities based on an accumulation of evidence (hence our pathway analysis as shown above.)

We will make right “calls” and wrong ones. Such is the nature of investing. We just focus on trying to right more often than we are wrong.

This is why we share our analysis with you each week.

Writing forces us to consolidate our views, have an opinion, and make informed decisions. Having a record of our decision-making process forces us to be accountable to ourselves and our clients. 

Even if you don’t publish your own views and ideas, we encourage you to write them down, review them on a regular basis, and compare them to your portfolio actions. A written record informs you of what you have done right, and wrong. It also keeps you honest about your assessment of risk, reduce emotional responses to short-term market volatility, and focus your investing behavior toward your goals.

You will be a better investor for it.

“Consensus is something everyone agrees to, but no one believes in.” – Margret Thatcher

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

Crashes Matter A Lot

In Part I – Buy and Hold can be Hazardous to your Wealth, we showed how the stock markets tend to cycle between growth and decline. Passive, “buy and hold” investors who hold their investments through the cycles are likely to endure long periods of time in which they are recovering losses and not compounding their wealth. As discussed, falling into this age-old trap for a decade or longer violates Warren Buffett’s two golden rules of investing:

  1. Don’t Lose Money
  2. Refer To Rule #1

In “Part II” of this series, we will discuss why avoiding major market corrections is so important. We also dive into a related topic, the “savings problem.”

As noted previously, many of those who promote “buy and hold’ type philosophies often claim that those who dollar cost average (DCA) on a regular basis endure much shorter periods recovering previous losses. While they are partially correct, as recovery periods from losses are shorter, evidence clearly shows few individuals actually invest that way.

As discussed previously, investors do NOT have 90, 100, or more years to invest. Given that most investors do not start seriously saving for retirement until the age of 35, or older, that leaves 30-35 years for them to reach their goals. If that stretch of time happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are massively diminished.

Let’s walk through an example showing why avoiding “mean reverting events” matters.

Bob is 35-years old, earns $75,000 a year, saves 10% of his gross salary each year and wants to have the same income in retirement that he currently has today. In our forecast, we will assume the market returns 7% each year (same as promised by many financial advisors) and we will assume a 2.1% inflation rate (long-term median) to help determine his desired retirement income.

Looking 30 years forward, as shown below, when Bob will be 65, his equivalent annual income requirement will be approximately $137,000 as shown below.

Understanding the relevance of this simple graph is typically problem number one for investors. Many savers fail to realize that their income needs will rise significantly due to inflation. In Bob’s case, $137,000 is the future equivalent to his current $75,000 salary assuming a modest 2.1% rate of inflation. If the double-digit inflation rate of the 1970’s were to reappear, Bob’s income needs would be significantly higher, and a larger lump sum of savings would be required to generate that higher level of income.

In this case, to meet his $137,000 retirement income goal and keep his wealth intact, Bob will need to amass a portfolio over $4.5 million. The figure is based on a 3% withdrawal rate matching the long-term Treasury yield.

(The graph excludes social security, pensions, etc. – this is for illustrative purposes only.)

In this analysis, we give Bob a big advantage and assume that he has been a diligent saver and has accumulated a nest egg of $100,000 to jump-start his savings adventure. Furthermore, we start his investment period in 1988 following the 1987 crash. Bob’s first 12 years of investing was one of the greatest periods to be in U.S. equities.

As stated, we are giving Bob every benefit we can.

With the example set, let’s run an analysis to determine if “buying, holding and dollar cost averaging” into the S%P 500 will get Bob to his retirement goal.

To answer this question, the chart below shows the difference between two identical accounts.

  • Each started at $100,000, each reflects $625/month contributions (DCA)
  • Both were adjusted for inflation and include dividends. (Total Return)
  • The blue dotted line shows the amount of money Bob requires to meet his retirement goal in 30-years.
  • The gold line is the “buy and hold” strategy using the S&P 500 index.(Passive)
  • The blue line utilizes a simple switching strategy that goes to “cashwhenever the S&P 500 declines below the 12-month moving average. (Active)
  • The blue and red shaded areas show the deviation of the S&P 500 above and below the 12-month moving average.


Had Bob followed a buy and hold strategy he would have turned his $100,000 investment into a respectable $1.7 million nest egg.

While such a sum is certainly nothing to scoff at, when Bob applies his 3% withdrawal rate, his annual income will fall to just $51,000 per year. Not only is this less than he was making 30-years ago, it is far short of the $137,000 income needed.

What clearly impacted his progress was the recovery periods following the crashes of 2000 and 2008.

The obvious advantage of the actively managed portfolio is the avoidance of the major drawdowns which allowed it to effectively compound over the expected time frame. Not only did his initial $100,000 investment grow to $5.75 million, which exceeded his required retirement objective, at 3% interest it generated more than enough to meet his $137,000 income goal.

There is an important point to be made here. The old axioms of “time in the market” and the “power of compounding” are true, but they are only true as long as principal value is not destroyed along the way. The destruction of the principal destroys both “time” and “the magic of compounding.”

Or more simply put – “getting back to even” is not the same as “growing.”

While those selling passive strategies throw out the “you can’t time the market” argument, the simple truth is you can. Even the simple rule, as we applied, can be followed with little effort. The problem, however, isn’t the strategy, it is the investor. The biggest detraction from successful investing over the long-term is ourselves. Our emotional and behavioral biases consistently plague our investment decision making from the “fear of missing out,” to “herding,” “recency bias,” and many others are all inherent traits that we will discuss in an upcoming chapter. However, managing risk, and avoiding major mean reverting events, is quite achievable with a good bit of discipline and patience.

Crashes matter, and the time spent recouping those losses is likely to stop you from meeting your goals.

The Other Big Problem For Dollar Cost Averaging

In Bob’s example, we assumed dollar cost averaging. Today, there is little evidence individuals are actively saving adequately for their retirement.

We could fill pages with study after study, but you get the idea. The reality is that about 80% of Americans currently CANNOT save adequately for retirement because of the tremendous costs associated with raising children, mortgages, debt payments, food, energy costs and health insurance. For many, these costs exceed their disposable income. As shown below, even with a sharp ramp-up in consumer credit, there is still a nearly $7000 deficit between the required standard of living and what incomes and debt combined can fill.

This goes a long way in explaining why the majority of Americans are NOT saving for their retirement. While Josh Brown was correct that individuals add to their company plans on a regular basis, the reality is that most “Americans” do not invest at all.

“Americans do most of their saving for retirement at their jobs, though many private sector workers lack access to a workplace plan. In addition, many workers whose employers do offer these plans face obstacles to participation, such as more immediate financial needs, other savings priorities such as children’s education or a down payment for a house, or ineligibility. Thus, less than half of non-government workers in the United States participated in an employer-sponsored retirement plan in 2012, the most recent year for which detailed data were available.

But even if they don’t have access to a plan, they are surely investing in the stock market on their own, right? Not really.

“Among filers who make less than $25,000 a year, only about 8% own stocks. Meanwhile, 88% of those making more than $1 million are in the market, which explains why the rising stock market tracks with increasing levels of inequality. On average across the United States, only 18.7% of taxpayers directly own stocks.”

With the vast amount of individuals already vastly under-saved, the next major correction will reveal the full extent of the “retirement crisis” silently lurking in the shadows of this bull market cycle.


Markets stand at valuations that offer very little return yet historically large risks. In the past, every market environment like the current one was met with a major correction that took years for investors to recover from. While we do not know when such a move lower will start, make no mistake markets have not suddenly become immune from “mean reversion.”

We do not advocate you sell all of your stocks. We just hope you consider the risk/return proposition and invest with a strategy which aims to avoid major losses.

We end with a paragraph from Andrew W. Lo from his book Adaptive Markets: Financial Evolution at the Speed of Thought

“In this respect, we can think of markets as being bipolar- they can seem ordinary on most days, but once in a while, a dark mood settles over the market, and prices drop precipitously in response to the most innocuous news. When we compute an eighty-eight year average, the impact of these periodic slumps may not be very great, but the problem for investors is they do not get to earn the eighty-eight year average. Long-term averages can hide many important features of the financial landscape, especially when the long-term average is so long that it includes radically different financial institutions, regulations, political and cultural mores and investor populations. A river may have an average depth of only five feet, but that doesn’t mean it can be crossed safely by a six-foot hiker who can’t swim.

How an advisor should talk to clients and what rhetoric leads to big sales are often at odds. It can be death to an advisory business if the advisor is negative. Clients tend to want reassurance from an optimistic advisor. That’s why economist Andrew Smithers refers to broker happy talk asstockbroker economics.”

The two rules of stockbroker economics are:

1. All news is good news, and;

2. It’s always a good time to buy stocks.

On the role of news, a strong economy fills clients will all the optimism and willingness to buy that they need. A weak economy simply prompts a broker to say that falling interest rates and future rising profits are good for stocks, never mind that profits and prices had only moved in tandem 54% of the time when Smithers wrote his 2006 article. On the second rule, nothing has succeeded as well as what Smithers calls the “bond yield ratio,” another name for which is the “Fed Model.” That model compares bond yields to the earnings yield of the stock market (the reciprocal of the P/E ratio or E/P). This ratio worked from 1977 to 1997, but didn’t from 1948 to 1968. Using the full dataset shows no relationship between bond yields and earnings yields, according to Smithers.

Other forms of nonsense used to support the second rule include using a current P/E ratio to appraise stocks. Of course, a current P/E ratio has little ability to forecast long-term returns. It sometimes shows stocks are expensive when they are actually cheap, and vice versa.

A third piece of nonsense that Smithers doesn’t mention is the assertion that all forecasting is bunk. While forecasting next year’s returns might be bunk, metrics like the Shiller PE and Tobin’s Q have strong records in forecasting future long-term returns. Even if the Shiller PE has been elevated for the past 25 years, the S&P 500 Index has delivered tepid returns (5.4% annualized) from 2000 through 2017 with the entirety of that return occurring only in the last 5-years.

All of this means the first rule for investors judging their advisors is whether their advisors engage in too much happy talk – especially about future returns. If an advisor says a balanced portfolio should deliver a 7% annualized return for the next decade with starting 10-year U.S. Treasury yields at 3% and stocks at a 32 CAPE, be wary.

Second, investors should avoid advisors who avoid making forecasts to the point where they disparage anyone who does. That’s because it’s not hard to make a bond forecasts. With high-quality bonds, yield-to-maturity will get you close to the total return. Although stocks are harder, the Shiller PE can help. And, the more it’s stretched by historical standards, the more accurate it gets. No advisor should be dogmatic about pinpointing future returns; anyone who thinks they can be precise is crazy. But it’s also outlandish to expect long term historical returns from the stock market when valuations are as stretched as they are today. Stock market forecasts are hard, but don’t let your advisor squirm out of them completely.

Making a forecast is also necessary for constructing a financial plan. And, while it’s true that an accurate forecast doesn’t have to be available just because advisors and clients need one, decade-long projections are easier, if imperfect, than guessing what next year’s market move might be. When the Shiller PE stretches to more extreme levels, low future returns become more likely. So, when you hear an advisor making fun of something, that should raise warning flags.

We think advisors with integrity aren’t afraid to tell clients stocks are expensive even when it might hurt the advisor’s business. An advisor constructing a financial plan owes you an honest assessment of future returns. Currently, the Shiller PE is at 32. And while nothing is impossible, it’s very unlikely that stocks will deliver more than a 2% real annualized return for the next decade.

Third, consider if your advisor goes beyond the risk questionnaire he gives you. Nearly every financial advisory firm has a risk questionnaire that it gives to prospects and clients. The questionnaire often has many questions about how much risk the investors think they can handle and what portion of their assets they’d like to put at risk in exchange for possibly getting a higher return than a low risk investment will deliver. But risk questionnaires ask about percentages, and most people don’t think in percentages. Consider if your advisor asks you how you might feel if you opened up your statement and your account was down by a certain dollar amount. That’s more meaningful than a percentage question. Consider it a positive thing if your advisor pursues this line of questioning a bit, including asking you how you felt and how you reacted to the market plunge in 2008.

Risk often boils down to how much of a portfolio decline a client can tolerate before selling out, and everyone has a point at which they sell. This is important because it shows how investors do themselves damage. The tendency should be to buy stocks when they get cheaper, not sell them. But investors rarely think of buying when the prices of their holdings are declining.

Advisors have other ways of trying to train clients about how to treat price declines in their portfolios. Many advisors focus on long–term asset class returns, trying to persuade investors that they can overcome declines if they have the willpower to stay the course and not be discouraged. Other advisors do the opposite, focusing on how severe declines can be and trying hard to get clients into allocations that they can live with at the outset and to prepare them for the difficulty that lies ahead in the inevitable downturns.

The advisors who emphasize long term returns often come close to shaming clients into owning stocks. In my experience, such has made some clients feel inadequate for not wanting to assume more risk – or have encouraged clients to take more risk than they would have for fear of being deemed inadequate in the eyes of the advisor. Make sure your advisor isn’t shaming you into owning more stocks than you can handle.

At Clarity Financial, we focus on the growth of savings and on the minimization of emotional duress that can lead to poor investment decision-making.

Last year, I penned an article discussing the primary problems with Social Security. To wit:

“According to the June 2017 snapshot from the Social Security Administration, nearly 61.5 million people were receiving a monthly benefit check, of which 68.2% were retired workers. Of these 41.9 million retirees, more than 60% count on their Social Security to be a primary source of income.

Of course, that dependency ratio is directly tied to financial insolvency of the vast majority of Americans.  According to a Legg Mason Investment Survey, US baby boomers have on average $263,000  saved in defined contribution plans. But that figure is less than half of the $658,000 they say they will need to retire. As noted by GoBankingRates, more than half of Americans will retire broke.”

“This is a huge problem that will not only impact boomers in retirement, but also the economy and the financial markets. It also demonstrates just how important Social Security is for current and future generations of seniors.

Of course, the problem is that according to the latest Social Security Board of Trustees report issued last month, those benefits could be slashed for current and future retirees by up to 23% in 2034 should Congress fail to act. Unfortunately, given the current partisan divide in Congress, who have been at war with each other since the financial crisis, there is seemingly little ability to reach any agreement on how to put Social Security on sound footing. This puts those “baby boomers,” 78 million Americans born between 1946 and 1964 who started retiring last year, at potential risk in their retirement years. 

While the Trustees report predicts that asset reserves could touch $3 trillion by 2022, implying the program is expected to remain cash flow positive through 2021, beginning in 2022, and each year thereafter through 2091, Social Security will be paying out more in benefits than it’s generating in revenue, resulting in a $12.5 trillion cash shortfall between 2034 and 2091. That is a problem that can’t be fixed without internal reforms to the pension fund due specifically to two factors: demographics and structural unemployment.”

I was reminded of this discussion by a recent note from the Committee For A Responsible Federal Budget which updated the rather dire situation of the Social Security system.

“The Trustees for Social Security released their annual report today. As they have for many years, their projections show that the Social Security program faces a large and growing funding imbalance that must be addressed promptly to prevent across-the-board benefit cuts or abrupt changes in tax or benefit levels. This year’s report shows:

  • Social Security Will Run Permanent Deficits. For the first time since 1982, the program will spend more than it raises in revenue and collects in interest. The gap will total $900 billion over a decade. On a cash-flow basis, Social Security will run a deficit of $85 billion this year and $1.7 trillion over the next decade.
  • Social Security Faces Large Long-Term Imbalances. The Trustees estimate Social Security faces a 75-year shortfall of 2.84 percent of payroll (1.0 percent of GDP), growing to 4.32 percent of payroll (1.5 percent of GDP) by 2092. That means payroll taxes will need to be increased by 22 percent or scheduled benefits cut by a sixth (or some combination) to ensure 75-year solvency; ultimately, taxes will need to be increased by a third or benefits reduced by 26 percent.
  • Social Security Will Be Insolvent by 2034. The Trustees project depletion of the Disability Insurance trust fund by 2032 and the Old-Age & Survivors Insurance trust fund by 2034. On a theoretical combined basis, the trust funds will run out by 2034 – the same as last year’s projections. At the time of insolvency, all beneficiaries will face a 21 percent across-the-board benefit cut.
  • The Problem Is Similar To Last Year, But Has Deteriorated This Decade.  Social Security’s 75-year shortfall rose from 1.92 percent of payroll in 2010 to 2.83 percent last year and 2.84 percent this year. The 2034 insolvency date is the same as projected last year, but three years earlier than projected in 2010.
  • Lawmakers Should Start Making Changes Now. Social Security insolvency is not that far away – when today’s 51-year-olds reach the normal retirement age and today’s youngest retirees turn 78. Waiting 16 years to act would mean any tax hikes or benefit cuts have to be 35 to 40 percent larger.

Protecting Social Security’s solvency is vitally important for the country’s overall fiscal outlook and the 86 million beneficiaries who will be on the program when the trust funds are exhausted in 2034. Swift action is needed to prevent seniors, surviving dependents, and people with disabilities from facing abrupt cuts in just a few years.”

Here are the only two charts you need to see to understand the overarching problem.

As stated above, the biggest problem for Social Security is that it has already begun to pay out more in benefits than it receives in taxes. As the cash surplus is depleted, which is primarily government I.O.U.’s, Social Security will not be able to pay full benefits from its tax revenues alone. It will then need to consume ever-growing amounts of general revenue dollars to meet its obligations–money that now pays for everything from environmental programs to highway construction to defense. Eventually, either benefits will have to be slashed or the rest of the government will have to shrink to accommodate the “welfare state.” It is highly unlikely the latter will happen.

Demographic trends are fairly easy to forecast and predict. Each year from now until 2025, we will see successive rounds of boomers reach the 62-year-old threshold. There are several problems that no one wants to address:

  • Each boomer has not produced enough children to replace themselves which leads to a decline in the number of taxpaying workers. It takes about 25 years to grow a new taxpayer. We can estimate, with surprising accuracy, how many people born in a particular year will live to reach retirement. The retirees of 2070 were all born in 2003, and we can see and count them today.
  • In 1950, each retiree’s benefit was divided among 16 workers. Today, that number has dropped to 3-workers per retiree, and by 2025, it will reach–and remain at–about two workers per retiree. In other words, each married couple will have to pay, along with their own family’s expenses, Social Security retirement benefits for one retiree. 
  • In 1966, each employee shouldered $555 dollars of social benefits. Today, each employee has to support roughly $18,000 of benefits. The trend is obviously unsustainable unless wages or employment begins to increase dramatically and based on current trends that seems highly unlikely.

The entire social support framework faces an inevitable conclusion where no amount of wishful thinking will change that outcome. The ONLY question is whether our elected leaders will start making the changes necessary sooner, while they can be done by choice, or later, when they are forced upon us.

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

Economy & Fed


Most Read On RIA

Research / Interesting Reads

“ I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.” – Alan Greenspan

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.”

Each year, private equity powerhouse Bain & Company produces a comprehensive review of the private investments sector. Private investments are thriving because they generate returns that beat public stock market investments, which they have done over multiple time horizons in the past.

Institutional investors have noticed.  Private investment funds raised $700 billion in each of the past two years.  Per McKinsey, the assets of the private investment industry have hurtled above $5 trillion.   But the industry also has a problem; it is pulling in more capital than it can invest.  As of December 2017, almost 1/3 of the money that has been committed ($1.7 trillion) is sitting idle.  The largest single category of private investing is buyout ($600 billion), which focuses on buying companies, some of which are publicly-traded.

What could explain record inflows into an asset class that already is having trouble investing money quickly enough? Private equity investments can only continue to beat public equity investments if some combination of the following variables is present:

  1. Initial valuation is low enough
  2. After an investment or buyout, operations can be made more efficient/profitable
  3. Leverage is employed to magnify the gains from improved efficiency/profitability
  4. Exit valuation is high enough

Private equity firms can only have a direct impact on the second variable, while the first and fourth variables are set by markets (although, as will be shown, private equity bidding helps set market valuations).  The third variable is a function of the lending environment.

Looking at the first variable, valuations for deals done in late 2017 were at an all-time high, and 25% higher than in 2010-2013, as shown below.

The Bain study included a screening tool, attempting to predict how the wall of idle buyout cash might be invested, given today’s high valuations.

“To gauge the potential for public-to-private activity in the year ahead, we looked at the universe of U.S. public companies with enterprise value up to $50 billion (a level beyond which a take-private transaction becomes impractical). We identified close to 800 companies trading at multiples of nine times EBITDA or below, making them relatively attractive targets. Screening them further based on potential for revenue and margin expansion, we ended up with 72 US public companies that seem ripe for conversion. For large GPs eager to put big sums of capital to work, the public markets are likely to offer a fertile field in 2018.”

Summarizing, private equity buyout firms, which have plenty of dry powder and the motivation to use it (fees), are effectively setting a floor valuation for dozens of large U.S. public companies.  We have previously discussed how traditional central bank QE and corporate QE (buybacks), plus the high-frequency traders that front-run them, have boosted stock market valuations.  Private equity investors, lacking good investments in their traditional space, are yet another eager buyer waiting in the wings, although in contrast to the other types of buyers, there appears to be some constraint on the valuations they pay.   The main point is that equity prices do not operate in a vacuum.  Money can be created out of thin air by central banks, borrowed from the banking system, easily converted from one currency to another, or moved from one asset class to another.

High valuations can also be explained, at least partly, by the availability of plentiful leverage.  Although still below the high set in 2007, leverage multiples have been bumping up against a 6x limit that is thought to attract the scrutiny of banking regulators, as shown below.  If leverage is limited while valuations are rising, then more equity must be injected to get the deals done.  But a higher equity component in the capital structure reduces the IRRs that can be achieved on the equity.

The cost of leverage is yet another factor in successful private equity investing.  One big difference between 2007 and recent times is the level of interest rates.  A leveraged private equity deal can be financed at short-term interest rates or long-term interest rates.  Interest rates are much lower today for either type of borrowing, as shown below.  But if the Fed is to be believed, the direction of interest rates is higher in coming years, which would reduce the IRRs of private equity deals in the future, all other things equal.


There is a surplus of money aimed at the private investments sector, as evidenced by the fact that $1.7 trillion is now committed but not invested, and that number has been growing each year. Of the $1.7 trillion of dry powder, $600 billion is aimed at the buyout sector, which can only be successful with a combination of buying at a low valuation, financing buyout deals with cheap and plentiful leverage, wringing out operational efficiency gains, and selling at a valuation close to what it bought at.

Yet today, valuations are high, interest rates are rising, and leverage ratios are already at a regulatory limit.  In addition, the percentage of equity required to get deals done is rising, which lowers the IRRs that can be achieved in future deals.  Even with those headwinds, the Bain screen shows that dozens of large U.S. public companies could be bought out, which places a floor those companies’ stock prices.  Investors in private equity buyout funds appear to be placing great faith in the ability to create operational efficiencies and/or even higher valuations in the future. Come to think of it, so do investors in the U.S. stock market.

On Tuesday, I discussed the issue of what has historically happened to the financial markets when both the dollar and rates are rising simultaneously. To wit:

“With the 10-year treasury rate now extremely overbought on a monthly basis, combined with a stronger dollar, the impact historically has not been kind to stock market investors. While it doesn’t mean the market will “crash” today, or even next week, historically rising interest rates combined with a rising dollar has previously led to unexpected and unintended consequences previously.”

I wanted to reiterate this point after reading a recent comment from Jamie Dimon, CEO of JP Morgan, whom, as I have previously written about, makes rather “disconnected” statements from time to time.

“We’re probably in the sixth inning (of this economic cycle), and it’s very possible you’re going to see stronger growth in the U.S. I’ve heard people say, well, it’s looking like 2007. Completely untrue. There’s much less leverage in the system. The banks are much better capitalized.”

First, while he talks about banks being much better capitalized, the interesting question is:

“If banks are so well capitalized, why hasn’t FASB Rule 157 been reinstated?”

As I noted previously, FASB Rule 157 was repealed during the financial crisis to allow banks to mark bad assets to “face value” making balance sheets stronger than they appear. This served the purpose of reducing panic in the system, supported “Too Big To Fail” banks, and kept many banks in operation. But if banks are once again so well capitalized, leverage reduced and the economy firing on all cylinders – why is that repeal still in place today? And, if the financial system and economic environment are so strong, then why are Central Banks globally still utilizing “emergency measures” to support their economies?

Likely it is because economic growth remains tepid and banks are once again heavily leveraged as noted by Zero Hedge:

“It is by now well known that consolidated leverage in the system is at an all-time high, with both the IMF and the IIF calculating in April that total global debt has hit a new all-time high of $237 trillion, up $70 trillion in the past decade, and equivalent to a record 382% of developed and 210% of emerging market GDP.”

However, let me address the leverage issue from an economic standpoint. 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.

This leverage issue is more clearly revealed when we look at non-financial corporate debt and assets as a percentage of the gross-value added (GVA). Again, as above, rising rates have historically sparked a rapid reversion in this ratio which has generally coincided with the onset of a recession.

With leverage, both corporate and household, at historical peaks, the only question is how long can consumers continue to absorb higher rates?

While Mr. Dimon believes we are only in the “sixth-inning” of the current economic cycle, considering all of the economically sensitive areas which are negatively impacted by higher rates, one has to question the sustainability of the current economic cycle?

1) Rising interest rates raise the debt servicing requirements which reduces future productive investment.

2) Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. 

4) One of the main arguments of stock bulls over the last 5-years has been the “stocks are cheap based on low interest rates.”

5) The massive derivatives and credit markets will be negatively impacted. (Deutsche Bank, Italy, etc.)

6) As rates increase so does the variable rate interest payments on credit cards and home equity lines of credit. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a contraction in disposable income and rising defaults.

7) Rising defaults on debt service will negatively impact banks.

8) Many corporate share buyback plans and dividend payments have been done through the use of cheap debt, which has led to increased corporate balance sheet leverage.

9) Corporate capital expenditures are dependent on lower borrowing costs. Higher borrowing costs leads to lower CapEx.

10) The deficit/GDP ratio will rise as borrowing costs rise. 

You get the idea. Interest rates, economic growth, and credit are extremely linked. When it comes to the stock market, the claim that higher rates won’t impact stock prices falls into the category of “timing is everything.”  

If we go back to the first chart above, what is clear is that sharp increase in interest rates, particularly on a heavily levered economy, have repeatedly led to negative outcomes. With rates now at extensions only seen in 7-periods previously, there is little room left for further acceleration in rates before such an outcome spawns.

As Bridgewater just recently noted:

“Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive – reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half.”

Here are the things that you need to know:

1) There have been ZERO times when the Federal Reserve has embarked upon a rate hiking campaign that did not eventually lead to negative economic and financial market consequences.

2) The median number of months following the initial rate hike has been 17-months. However, given the confluence of central bank interventions, that time frame could extend to the 35-month median or late-2018 or early-2019.

3) The average and median increases in the 10-year rate before negative consequences have occurred has historically been 43%. We are currently at double that level.

4) Importantly, there have been only two times in recent history that the Federal Reserve has increased interest rates from such a low level of annualized economic growth. Both periods ended in recessions.

5) The ENTIRETY of the“bullish” analysis is based on a sustained 34-year period of falling interest rates, inflation and annualized rates of economic growth. With all of these variables near historic lows, we can only really guess at how asset prices, and economic growth, will fair going forward.

6) Rising rates, and valuations, are indeed bullish for stocks when they START rising. Investing at the end of rising cycle has negative outcomes.

What is clear from the analysis is that bad things have tended to follow sustained increases in interest rates. As the Fed continues to press forward hiking rates into the current economic cycle, the risk of a credit related event continues to rise.

For all the reasons currently prognosticated that rising rates won’t affect the “bull market,” such is the equivalent of suggesting “this time is different.”

It isn’t.

Importantly, “This Cycle Will End,”  and investors who have failed to learn the lessons of history will once again pay the price for hubris.

There are benefits of where the dollar is and there are costs of where the dollar is,” Mnuchin said during a panel discussion at the World Economic Forum in Davos, Switzerland. “It’s not a shift in my position on the dollar at all. It is perhaps slightly different from previous Treasury secretaries.” “We do support free and floating currencies reflective of the market” courtesy: Bloomberg 1/25/2018

The market’s interpretation of the quote above from U.S. Treasury Secretary Steven Mnuchin is on par with the title of the Bloomberg article: Mnuchin Defends Weaker Dollar Comments as ‘Clear,’ ‘Consistent.’

Despite the recent uptick, the dollar has been steadily declining since the presidential inauguration, and the positive and negative implications of the trend are becoming more evident to politicians, economists and investors. Many dynamics affect the value of the U.S. dollar, and libraries of books have been written on the topic. While we solidly grasp the traditional factors that affect the value of the dollar, we must also appreciate the aims and goals of central banks. These tend to receive less attention despite central banks’ direct and, at times, massive interventions in the currency markets.

In this piece, we review the traditional influences on the dollar to gain an understanding of why it has generally trended lower for the past year and a half. Further, we present our two cents as to what the biggest explanation of dollar weakness may be. The relative value of the dollar has major implications for all investments. A clearer understanding of what is influencing it can yield insight that many investors tend to overlook and enhance decision-making.

Factors Supporting Dollar Appreciation

Currently, the Fed Funds rate, as set by the Federal Reserve (Fed), stands at 1.75%. For many years after the financial crisis (December 2008 through December 2015), the target range was 0%-0.25%. In comparison, the targeted monetary policy rates in Japan and Europe, the currencies against which the dollar is most heavily weighted, are pinned below zero. The Fed Funds rate is expected to rise to at least 2.25% by year-end, with the Federal Open Market Committee (FOMC) telegraphing two more rate hikes this year. The Fed is also actively reducing their balance sheet with the pace of the reduction increasing throughout 2018. By the end of 2018, the Fed’s balance sheet is expected to fall 10%, or about $400 billion, from the peak reached in 2015. In comparison, the balance sheets of the central banks of Europe (ECB) and Japan (BOJ) are still on the rise, although the pace of growth is diminishing in both instances.

The Fed has been more aggressive than Europe and Japan in normalizing monetary policy due to a more resilient economy and higher inflation levels over the last few years. Comparatively higher interest rates in the U.S. should attract global investment and that demand should support the U.S. dollar. Consider the table below comparing economic growth, inflation and interest rates all of which argue for dollar strength.

Data Courtesy Bloomberg and St. Louis Federal Reserve

Another factor that should benefit the dollar is that global growth appears to be running at its strongest level since the 2008 financial crisis. Given that the dollar is the world’s reserve currency and most international trade is conducted in U.S. dollars, more economic activity naturally creates greater demand for dollars versus other currencies.

The dollar should be appreciating versus the euro and the yen based on the domestic and global economic data, comparative interest rates and respective monetary policies. Before presenting some of the important factors that are weighing on dollar strength, consider that the euro has appreciated 11% and the yen 7% versus the dollar since 2017.

Factors Supporting Dollar Depreciation

Despite the fundamentals supportive of a stronger dollar, there are a few factors working against dollar strength.

The newly passed tax reform is expected to add approximately $1.5 trillion to the deficit, and the continuing budget resolution (CR) will add $300 billion. These amounts are on top of rising Treasury debt forecasted to grow over $1.0 trillion annually for the foreseeable future. To put that in context, $1.0 trillion is on par with the emergency deficits of the financial crisis and two to four times those witnessed during the remainder of the 2000’s. Also potentially adding to the deficit are recent proposals for a trillion dollar infrastructure spending plan. For further insight on the arduous task of funding future deficits, we recommend reading Deficits Do Matter.

Deficits are inherently negative from a creditworthiness perspective, especially when they are rising quicker than economic growth. Therefore, a sharply rising deficit tends to be dollar negative. This presents the U.S. Treasury with a dilemma. On one hand, in order to cost-effectively fund the government’s $21 trillion of debt outstanding, the future growth of debt outstanding, and the outsized debt of corporations and individuals, Treasury officials will encourage the Fed to keep interest rates low. On the other hand, the amount of new supply of Treasury debt may require higher interest rates in order to attract buyers. Over the last few decades, as the debt burden has increased, the economic sensitivity to higher interest rates has increased markedly. The deterioration in the U.S. fiscal standing and the heightened probability of Fed intervention to manage rates either through traditional or unconventional policies seem likely to weigh negatively on the dollar.

While impossible to pinpoint the level at which rising interest rates could cause economic difficulties and recession-inducing stress, we are confident that the Fed will use everything in its monetary policy arsenal to avoid that outcome. This not only entails lowering the Fed Funds rate back to zero and restarting quantitative easing (QE) but may also include targeting negative interest rates. These monetary policy tools, especially when used in the extreme as we have seen since 2008, greatly debase the value of the dollar.  To wit consider the following headline from April 13, 2018 – (Fed Governor) “Rosengren sees risk of rates back at zero in future recessions.” It is quite possible the currency markets are looking forward.

In addition to the deteriorating fiscal situation and the likelihood that extreme monetary policy will be used to combat its consequences, it is increasingly apparent that President Trump, as echoed by the Treasury Secretary, appreciates the benefits of a weaker dollar. From an economic perspective, a weaker dollar makes U.S. manufactured goods cheaper to foreign buyers encouraging more production within the U.S. or, at a minimum, helps retain existing U.S. production. This helps to fulfill Trump’s promise to restore the U.S. manufacturing sector. A weaker dollar along with tariffs and other adjustments to global trade is a powerful incentive aimed at fulfilling those popular political promises.

Last April Trump made the following comments: “Look, there’s some very good things about a strong dollar, but usually speaking the best thing about it is that it sounds good . . . It’s very, very hard to compete when you have a strong dollar and other countries are devaluing their currency.” Need we remind you the midterm elections are right around the corner and holding the majority in Congress is vital if Trump is to have legislative success. Further in early 2019, Trump will begin campaigning for a possible second term and would no doubt like to have tangible evidence of progress in strengthening the manufacturing base and U.S. trade deficit reduction.

Our Two Cents

The logical conclusion would seem to be that dollar weakness stemming from concerns about increasing deficits and Trump’s economic goals are overshadowing the positive economic and monetary policy factors that should be driving the dollar higher. However, there is more to consider beyond these fundamental factors. Just as any currency may be influenced by internal dynamics, they are equally susceptible to external influence.

Japanese and European central banks are taking baby steps towards reducing their balance sheets and normalizing monetary policy. While these moves are small and almost meaningless compared to the extreme policies of the last ten years, they will eventually tighten financial conditions in those countries. Japan and many European countries have been dealing  with anemic economic growth and tottering in and out of recession for at least the last ten years. Japan’s malaise is now approaching 30 years. Based on the comments of their central bankers and politicians, they desperately want to foster current levels of growth and are apprehensive about any policy measure that may present a set-back. For instance, at the January 25th ECB policy meeting, ECB President Mario Draghi spoke of deflation risks disappearing and promising economic growth. After the relatively rosy economic outlook he reminded us, “If the outlook becomes less favorable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase the asset purchase program in terms of size and/or duration.” Bottom line, the ECB will quickly re-engage unconventional policies if they see any signs of slowing growth or deflation.

So the question becomes how to tighten monetary policy while maintaining accommodative monetary conditions. Such a task seems nearly impossible until you consider the role of the U.S. dollar in foreign nations. Many foreign companies and some nations borrow in U.S. dollars. They effectively convert the dollars borrowed to their home currency, and when the debt matures they purchase dollars with their home currency to pay off the dollar-denominated debt. In other words, foreign borrowers of dollars are effectively short the U.S. dollar. The cost of borrowing is the dollar-denominated interest rate plus the change in the exchange rate between the dollar and their home currency. If the dollar weakens over the life of the transaction (i.e., the change in the exchange rate is negative), the foreign issuer’s real cost of borrowing declines.

It is quite possible that the central banks, notorious for intervening in currency markets, are tightening or threatening to tighten monetary policy while easing financial conditions behind the scenes via currency manipulation. It is likely the Trump administration is on board with such a plan, as it can help make American exports more affordable and thus provide further impetus for the U.S. stock market. We also suspect that the Fed, given their desire to boost inflation, would not resist such a plan as a weaker dollar is inflationary as foreign goods become more expensive (often referred to as “imported inflation”).

As it relates to the Treasury Secretary’s comments and the impact of a weaker dollar, Ray Dalio, of Bridgewater Associates recently stated: Regarding Treasury Secretary Mnuchin’s comments about the administration’s weak dollar policy, I want to make sure that you understand what having currency weakness means – most importantly, it is a hidden tax on people who are holding dollar-denominated assets and a benefit to those who have dollar-denominated liabilities.”


We end with a word of caution: disorderly foreign exchange movements will change market conditions across many asset classes, mostly for the worse, but especially so if it occurs in the U.S. dollar.

So, you’ve decided to undertake comprehensive financial planning.

A properly designed financial plan will cover important elements like retirement savings, insurance analysis and estate review; a qualified planner will target and outline specific areas of strength and weakness along with flexible, realistic routes to each financial goal.

If you’re stressing over the process, how long it takes to get a plan together: Don’t. Yes, there’s a financial self-discovery period on your part and that will take effort and homework. However, a plan can be modular based on your most important concern first, then built on over time.

Let me be one of the first to say congratulations on your decision!

You must be serious about financial awareness. After all, there are none of the day-to-day highs and lows of the stock market.

No sizzle. So boring.

Financial planning doesn’t make headlines or capture the attention of media talking heads.

It flies under the radar.

And to that I say:

Thank goodness.

Consider financial planning the mundane sentinel which forms the foundation of money awareness. When plans are attached to goals or life benchmarks as I call them, they take on a life of their own as progress markers along the path to a successful financial life.

A plan is a complete diagnostic of money chemistry. And the numbers don’t lie.

At times, it’s is validation, other times, an awakening.

On occasion, a warning.

See? Perhaps planning is exciting (we’ll keep that between us. Our own little secret).

Now that I have your attention and you’re ready to go, I’ll share 4-hidden dangers for investors to heed.

Mistake #1: You depend on the wrong tools to get the job done.

Online publicly-available financial planning calculators are the junk food of finance posing as nutritious choices. I guess it’s better than nothing, however just because a planning calculator is available from a reputable firm like Vanguard or Charles Schwab surprisingly doesn’t make it worthy of consideration.

As a matter of fact, per a study, the efficacy of publicly-available retirement planning tools from 36 popular financial websites was challenged and results were extremely misleading.

These quick (worthless) financial empty-calories don’t provide enough input variables to provide a level of accuracy. Most egregious is the dramatic over-estimation of returns and plan success.

If you trust an online calculator to adequately plan for retirement or any other long-term financial life benchmark and feel confident in the output (most likely because it provided a positive outcome,) then you’re ostensibly setting yourself for dangerous surprises.

Avoid them. They’re not worth it. Best not to do any planning at all if it’s this route.

Mistake #2 – The plan is used to sell product.

Antoinette Koerner, a professor of entrepreneurial finance and chair of the finance department at the MIT Sloan School of Management, along with two co-authors, set out to analyze the quality of financial advice provided to clients in the greater Boston area.

They employed “mystery shoppers” to impersonate customers looking for advice on how to invest their retirement savings. Unfortunately, it didn’t work out too well.

Advisors interviewed tended to sell expensive and high-fee products and favored actively-managed funds over inexpensive index fund alternatives. Less than 8% of the advisors encouraged an index fund approach.

The researchers found it disconcerting how advisor incentives were designed to motivate clients away from existing investment strategies regardless of their merit. They found that a majority of the professionals interviewed were willing to place clients in worse positions to secure personal, financial gain.

So, let me ask:

“Would you rather have a comprehensive plan completed by a professional who adheres to a fiduciary standard where your financial health and plan are paramount, or a broker tied to an incentive to sell product?”

Brokerage firms are willing to offer financial plans at no cost. However, the price ultimately paid for products and lack of objectivity, is not worth a ‘free’ plan. It’s in a consumer’s best interest to find a financial partner who works on an hourly-fee basis or is paid to do the work, not based on investments sold.

Last month, I met with a gentleman whose comprehensive financial plan inspired most of this blog post. The financial plan completed by his advisor was fraught with conflicts of interest and mistakes I’ll expand upon. The plan was not designed for an individual who was about to “cross over,” as I define it.

In other words, the plan was not designed for an individual preparing to retire within 5 years and look to begin a lifetime income distribution strategy. Nothing about longevity assessment (which we do through analysis to help people plan realistically based on health habits and family history), zero about proper Social Security strategy including spousal retirement and survivor benefits maximization, nada about how or if he should take his pension, along with erroneous inflation rates.

What stood out was the recommendation of a sizable investment in a variable annuity.

I couldn’t understand why an annuity was recommended, especially a variable choice with an income rider that was not required. Based on my analysis, this successful earner, saver and investor had enough to meet joint fixed expenses for life based on pension and Social Security optimization alone.

Annuities are usually sold, not planned.

However, in this case a plan was purposely engineered to roll a lump-sum investment into a product that wasn’t needed. No other option for the pension was provided but to roll it over into an annuity without further investigation.

It felt like the plan was patchworked to conclude in a product sale. A variable annuity may have been suitable, but it certainly wasn’t in the highest and best or fiduciary interest of the prospective investor. Be careful out there. Get a second opinion from a registered investment adviser who offers a fiduciary level of care.

Mistake #3 – Beware of the inflation-scare method 

At Clarity we provide countless second opinions on financial plans; a trend that consistently emerges is the omnipotent annual 3% inflation rate. Regardless of the expense goal, even medical (which should be higher), the 3% blanket annual inflation rate in my opinion is left in as the default selection that never gets updated perhaps as a method to scare investors into managed product and possibly overweight stocks. Candidly, many financial professionals do not understand inflation.

When having a financial plan completed, consumers must be smarter about inflation rates and make sure their planners are knowledgeable when it comes tying applicable rates of inflation to each goal.

Keep in mind – inflation is personal to and differs for every household.

My household’s inflation rate differs from yours.

Thanks to an inflation project undertaken by the Federal Reserve Bank of Atlanta, there’s now a method to calculate a personal inflation rate. A smart idea is to compare the results of their analysis to the inflation factor your financial professional employs in retirement and financial planning. Instruct your adviser to complete an additional planning scenario which incorporates your personalized consumer price index and see how it affects your end results or outcomes.

The bank has undertaken a massive project to break down and study the elements of inflation along with the creation of a myCPI tool which captures the uniqueness of goods that individuals purchase.

Researchers estimate average expenditures using a calculation which incorporates various cross-demographic information including sex, age, income, education and housing status. The result is 144 different market baskets that may reflect a closer approximation to household’s personal cost of living vs. the average consumer. It’s easy to use and sign up for updates. Try it!

My personal CPI peaked in July 2008 at an annualized rate of 5.2%. Currently, it’s closer to 1.2%. For retirement planning income purposes, I use the average over the last decade which comes in at 2.3%.

The tool can help users become less emotional and gain rational perspective about inflation. Inflation tends to be a touchy subject as prices for everything must always go higher (which isn’t the case). I’ve witnessed how as a collective, we experience brain drain when we rationalize how inflation impacts our financial well-being. It’s a challenge to think in real (adjusted for inflation) vs. nominal terms.

I hear investors lament about the “good old days,” often where rates on certificates of deposit paid handsomely. For example, in 1989, the year I started in financial services, a one-year CD yield averaged 7.95%. Inflation at the time was 5.39%. After taxes, investors barely earned anything, but boy, those good old days were really somethin’ weren’t they?

We’re so-called inflation experts because it co-exists with us. It’s an insidious financial shadow. It follows us everywhere. We just lose perspective at times as the shadow ebbs and flows, shrinks and expands depending on our spending behavior. Interestingly, as humans, we tend to anchor to times when inflation hit us the hardest.

Worried about inflation in retirement? Let’s whittle down this myth of massive inflation in retirement. Decreased spending in retirement offsets price increases based on conclusions of multiple studies. For example, according to David Blanchett, CFA, CFP® Head of Retirement Research at Morningstar in his Working Paper titled “Estimating the True Cost of Retirement,”  the following holds true:

While a replacement rate between 70% and 80% may be a reasonable starting place for many households, when we modeled actual spending patterns over a couple’s life expectancy, rather than a fixed 30-year period, the data shows that many retirees may need approximately 20% less in savings than the common assumptions would indicate.

Real retiree expenditures don’t rise (or fall) in nominal terms simply as a function of broad-based inflation or expected health care inflation. The retirement consumption path, or “spending curve,” will be a function of the household-specific consumption basket as well as total consumption and funding levels.

When correctly modeled, the true cost of retirement is highly personalized based on each household’s unique facts and circumstances.”

A generic inflation rate used by most planners overstates the inflation risk most retirees will experience.

While at Clarity we use a 1.7% inflation rate in planning for most needs (except certain categories of healthcare, higher education and long-term care costs which we increase at 4.5% annually), a personalized rate for those who go through the myCPI is highly recommended.

According to an insightful myth-busting analysis by John Kador for, prices don’t inflate equally. Now if more financial professionals would get the picture and use the information for accurate planning purposes (let’s not hold our breaths).

Mistake #4 – Market return projections only for vampires

I am 100% confident that stocks always move higher in the long run.

I know for certain the Dow will reach 60,000. I probably won’t be alive to witness it, but I know it’s going to happen. I do. Markets are infinite. Unfortunately, humans are finite. Unless you’re a vampire, there are going to be times when you’ll battle through return headwinds or glide easy thanks to tailwinds. There will be extended periods (hopefully not yours), when dollar-cost averaging will seem like treading wealth through thick sludge. Other times, it’ll feel like your money is lithe and positive returns occur with minimal or zero effort.

As Lance Roberts states:

“The most obvious is that investors do NOT have 118 years to invest. Given that most investors do not start seriously saving for retirement until the age of 35, or older, most investors have just one market cycle to reach their goals. If that cycle happens to include a 10-15 year period in which total returns are flat, the odds of achieving their savings goals are massively diminished. If an investor’s 30-year investment cycle happens to end with a major market crash, the result was devastating. Time, duration and ending dates are crucially important to expected investor outcomes.”

What if you’re in retirement and distribution mode? Market headwinds can be devastating.

James B. Sandidge, JD in his study “Adaptive Distribution Theory,” for the Investments Wealth Institute, provides several eye-opening examples of drawdown risk. As we monitor portfolio distributions over rolling three-year periods, Clarity is prepared to have retirees make changes to withdrawal rates or dollars as they cannot count on time to breakeven from combined market and portfolio distribution erosion. What does matter is the timing of returns, especially losses.

Whether you retire in a market head or tailwind is good or bad luck.

If recently retired, we believe at RIA that you’re going to expect overall market headwinds over the next 10 years (sorry) and must prepare to reduce portfolio distributions.

I’m sorry. Again, it’s just a drawing of the straws. Nothing personal.

James includes several effective charts and tables in his work. Table 4 hits home for me.

An investor in a 60/40 portfolio who retired at the end of February 2008 suffered a 26.8% loss in the first 12 months of retirement. A 5% withdrawal was recommended for living expenses through that period. This hits home for me personally because I witnessed financial professionals suggesting 4-5% withdrawals that year and recite the “stocks always move higher in the long run,” mantra. It was almost like these pros wouldn’t believe what was happening and couldn’t help retirees adjust their spending expectations. The triple deadly combo of market loss, unrealistic withdrawal rate and investment managements fees lead to a first-year devastating principal erosion of 32.8%!

In 2010, the new retiree is probably anxious to return to the workforce. Subsequently, with a smaller asset base of $672,000, a 5% withdrawal is no longer $50,000. It’s $33,600. What a horrific life-changing experience. I never want to be the adviser on the other side of the desk delivering this bad news.

James outlines –

Thus the “risk three-step” – a rapid reduction of principal, followed by a reduction in cash flow, followed by investor panic. Many retires can tolerate gradual principal erosion, but many fewer would find a 33-percent drop in principal and cash flow acceptable after one year of retirement.”

Lance Roberts and I had to adjust down our return estimates for every asset class in our planning software; international and emerging markets have the greatest opportunities for long-term asset class returns, however they’re adjusted lower, too. If we model higher returns, the risk to get those returns increases thus putting clients in danger of not reaching their financial goals unless they increase their savings rates, reduce debts/expenses or work longer than anticipated.

Most likely, your plan investment return estimates are too optimistic. Again – Designed more for blood suckers. Not people.

To a broker, flat or bear market cycles don’t exist. Realistically, the dogma is false narrative. If you fall for it, you may wind up spending an investment life making up for losses or breaking even.

Most financial planning software generates outcomes based on something called “Monte Carlo” simulation. It’s as close as planners get to represent the variability of market returns over time.

Monte Carlo generates randomness to a portfolio and simulates, perhaps thousands of times, around an average rate of return. Unfortunately, asset-class returns most Monte Carlo tools incorporate tend to be optimistic.

In addition, even though Monte Carlo simulates volatility of returns, it does a very poor job representing sequence of returns which I think of as a tethered rope of successive poor or rich returns.

Per friend and mentor Jim Otar, a financial planner, speaker and writer in Canada:

“Markets are random in the short term, cyclical in the medium term, and trending in the long term. They are neither random, nor average, nor trending in all time frames. Secular trends can last as long as 20 years (up down or sideways). The randomness of the markets are piggybacked onto these secular trends. Assuming an average growth and adding randomness to it does not provide a good model for the market behavior over the long term and it makes the model to “forget” the black swan events.” 

It’s why at Clarity, as a backstop, we employ various planning methodologies which incorporate how market cycles operate and where your goals may fall within them.

Granted, a comprehensive plan experience won’t be the talk of your next cocktail party. However, it just may allow you the freedom and peace of mind to enjoy the benchmarks you work hard every day to reach.

Last, the only person who will succumb to the hidden dangers in financial plans, is you. However, you’re now aware of the financial minefields that are a ‘must avoid.’

“What should have happened? First, I think it would have helped to have some perspective on Italy. The country’s gotten pretty dysfunctional, with almost no growth whatsoever. There’s also that aforementioned 11% unemployment rate, plus an immigrant population that all parties concede will cost more than the country can currently afford.

At the same time, Europe’s recent history of chaos has provided multiple opportunities to invest here in America, because you can count on some people panicking over the “black swan theory.” Finally, you can be sure that what happens in Italy won’t be related to any individual companies, as all anyone cares about now are the indices. Those trade both here or abroad as if they’re their own beasts these days, unrelated to anything corporate at all like earnings, or dividends, or prospects.

Now, I concede you can’t not report these things in the media. But I also think that the Italian crisis should have been reported in the light of what it really was — an oddity that produced a quick spike in Italian bonds as a product of a government changeover. Nothing more.

But on a slow news day with almost no earnings and the usual Trumpian trade tensions growing less and less newsworthy, it was something new and exciting to report. And it was easily framed as frightening and worrisome, because there are no consequences whatsoever for it not to be framed that way. If it turned out to be terrible for our markets, the dread would be warranted. But if it turned out to have a positive resolution (which was the case), well, nobody pays for the scare stories.

It’s an asymmetrical standard at work, and the only two things you can do are 1) expect it and 2) exploit it. Otherwise, shame on you for selling given how often these European “woe-is-me” stories burst onto the scene, explode and then recede within a few weeks’ time. Or even less in the case with this particular Italian job”.

– Jim “El Capitan” Cramer  – “Rome’s Political “Crisis’ Was Just an Italian Job” discusses the past week in review – particularly from his vantage point of the Italian “debt crisis.”

I agree with some elements of Jim’s missive and disagree with others.

I agree that the market downdraft provided a short term opportunity in the U.S. – that is about history and about the passive strategies and products that dominate our markets and tend to exaggerate short term moves.

My tactical response, as described in a series of columns last Tuesday was to cover my Spyder shorts for a nice profit, and I went net long in exposure. Seeing the market with no memory from day to day emerge (Tuesday – down big, Wednesday – up big, Thursday – down big) I went on to (incorrectly) scale into a short as stocks rallied after a few days of inconsistent price action later in the week – and I incurred modest losses on my Spyder hedge which I covered in premarket trading.

But more importantly I believe the Italian debt crisis is not an oddity – it lies at the epicenter of a world (private and public) immersed in debt as the global economic recovery ages. It is an example of the systemic financial problems and risks in Europe that have been swept under the rug – and that, over the intermediate term, should not be dismissed as a “one off.” This is particularly true if the ECB, as planned, moves away from a “money for nothing” policy.

Indeed as I remarked, while that Italian indigestion could elongate our domestic economic expansion – as the risk of a short term shock in higher inflation and interest rates abate – we should not lose sight that the synchronized economic expansion is growing more ambiguous and that the world, like never before, is flat and interconnected.

Mark Grant touches on this alternative view in is his commentary this morning:

I honestly believe that the markets, and most investors, do not understand exactly what is happening in Italy. Of course, the boys in Brussels, and Berlin, will claim that nothing of significance is happening, at all, in Italy, but then what else is new? I have the sense that these people understand, well enough, but they are following the time worn German playbook, “Deny, Deny and Deny.”

Mr. Salvini has stated, “As Italians, not as slaves of Berlin or Brussels.” It is a different time, as history echoes, once again, but I recall the rather famous words of Seneca the Younger (4 BCE-65 CE), “The master eats more than he can hold; his inordinate greed loads his distended belly, which has unlearned the belly’s function, and the digestion of all this food requires more ado than its ingestion. But the unhappy slaves may not move their lips for so much as a word. Any murmur is checked by a rod; not even involuntary sounds – a cough, a sneeze, a choke – are exempted from the lash. If a word breaks the silence the penalty is severe. Hungry and mute, they stand through the whole night.”

Mr. Salvini, rightly or wrongly, feels that Italy has been enslaved and he has bound with the Five Star Movement in his fight against the European Union. That much is clear to me. Did you expect him, in his first few days in office, to try to overthrow the European Masters? I believe that he, and the newly elected Italian government, have other tactics in mind. I also believe that they will begin to be effectuated in the not too distant future.

The New Yorker Magazine joins me in my contrarian corner. “Looking further ahead, however, there is great uncertainty surrounding not just Italy but the entire nineteen-nation eurozone. For the first time since it was formed, in 1999, the monetary union will be confronting a government in one of its core member countries that is implacably opposed to many of its rules and policies.” You see, I may hold the minority view on what is about to happen in the European Union, by way of Italy, but I am not totally alone in my sentiment.

The new government has a very distinctive policy agenda, which includes the establishment of a state-provided universal basic income. The League coalition also supports higher spending in various areas and it is also calling for a flat tax of fifteen per cent. Both parties want to roll back the quite unpopular pension reforms, that the E.U. regards as essential.

The E.U., it should be noted, doesn’t prohibit specific policies, but it does enforce broad fiscal targets that limit how much member countries can tax and spend. If the new government in Rome flouts these policies, Brussels will demand changes and most likely threaten it with fines. Brussels will shove, and Rome will shove back and that is when the real rebellion will occur, in my estimation.

Depending on how antagonistic the situation becomes, the European Central Bank could even threaten to withdraw its support for Italian government bonds, which it has been purchasing in large quantities, as part of its quantitative-easing program. The number is approximately $400 billion of Italian bonds, to date. One caveat of the ECB’s program is that any member government has to formally agree, in writing, to the policies and regulations of the European Union, before they will buy bonds and provide financial support. I just do not see the new Italian government signing up for what is going to be demanded.

I recall the words of Yanis Varoufakis, during the Greek crisis, “If you insist on policies that condemn whole populations to a combination of permanent stagnation and humiliation, you will soon have to deal not with Europeanist leftists like us but, instead, with anti-Europeanist xenophobes who see it as their vocation to disintegrate the European Union.” A decent prediction and a coming reality, in my view.

In any event, regardless of your personal view, what cannot be dismissed is that there is now a formidable amount of “risk” on the table for the European Union as it confronts the demands of the new Italian government. If you can honestly deny that, then you have been wooed by the political comments rolling out from Brussels and Berlin almost non-stop. “Do not be taken in,” I say, “because this is a very dangerous situation.”

Play the Great Game as you will but when I see Grant’s first ten rules, “Preservation of Capital,” under threat, then I am no longer willing to enter the arena. I am out of Italy. I am out Italian banks. I am out of European banks, in general, because of counterparty risks. I am also out of the European Union, as a general theme, because of the upcoming Italian revolt, which I believe will be taking place.

Spartacus has returned!

Bottom Line

Italy’s debt crisis isn’t a “one off.” It is symptomatic of the potential emerging risks – in an aging global recovery – in an increasingly flat world that is immersed in historically high debtloads (in both the private and public sectors).

2017 was a year of hope (and too little second level thinking) – that corporate tax reform would catalyze growth (and “trickle down”) – as multiples on the S&P Index expanded by three points. Wall Street prospered over Main Street.

2018 is a year of reality setting in (and too much first level thinking) – with a compression in price earnings ratios. With all the earnings excitement consider that stocks are basically flat for the year. Main Street is prospering over Wall Street.

The global expansion is aging. Note that employment, in particular, is a reliable indicator of a late economic cycle. (Consider the last time we were at 3.8% unemployment was April, 2000 – which marked the top and end of a 10 year “up” economic cycle). That was the lowest unemployment rate in a half a century, exactly the same unemployment rate (3.8%) that exists today.

While it “appears” that we are moving back to the upper end of a trading range, the market remains one without any memory – one that is dominated by products and strategies that frequently provide false signals.

Be skeptical of what the market is saying (over the near term), stay opportunistic, consider the emerging risks (which almost always appear when interest rates climb in a leveraged backdrop) and be flexible and impassioned in your trading — in the new regime of volatility that is upon us.

Median household income is $1.5 million; you just didn’t know it. That’s what the Wall Street Journal’s Andy Kessler thinks. I’m not making that up. He dedicated his most recent column to constructing a proof for that thesis.

Granted, Kessler doesn’t say it exactly like that. Instead, he works backwards from nominal median household income of $51,640 in 2016 to the equivalent, in his estimate, of a mere $347 in 1973. But to go from $51,000 to $347 in 44 years, you have to discount the $51,000 by around 12% annually. If that sounds like a big discount rate, it is. But that’s what Kessler thinks all the technological advances that have occurred since 1973 are worth, despite the fact that the clumsy Bureau of Labor Statistics inflation numbers haven’t accounted for them accurately.

However, if we move in the opposite direction, beginning with the nominal median income in 1973 — $10,500 — and compounding it for 44 years at 12%, we arrive at around $1.5 million. This is what a more accurate “hedonic adjustment” for technological advances would reflect as the median household’s purchasing power, according to Kessler. For example, smart phones, as Kessler describes them, act as:

“Our newspaper deliveryman, librarian, stenographer, secretary, personal shopper, DJ, newscaster, broker, weatherman, fortuneteller—shall I go on? The mythical man of 1973 certainly couldn’t afford $100,000 or more for dozens of workers at his beckoning.”

And, Kessler asks, how much would we pay for someone to sit in our cars and perform the task of automatic breaking systems? Of course, the answer could well be nothing. We’d simply live with the extra risk as we did from the invention of the automobile until the invention of automatic breaking. And most of us would give up our smart phones for an extra $100,000 or roughly twice the median household income. If smart phones are really worth what Kessler says they are, this is the test they must pass. I doubt a smart phone would stack up to $100,000 for most people.

Here’s another way to think of hedonic adjustment and whether the middle class is living “high on the hog,” as Kessler says. In 1973, the average rent was $175 per month or $2100 per year. In other words, rent was around 20% of household income. Today, however, rent is around $1200 per month or $14,400 per year. That’s 28% of $51,000. So we have smart phones and automatic breaking systems on our cars, but do those things make up for rent taking out a bigger piece of our paycheck every month? Kessler doesn’t say.

He does say that most hedge fund managers he knows think the CPI is obsolete as a measure of inflation, and prefer the CRB Commodity Index. There’s nothing particularly wrong with using a basket of commodities as an inflation gauge, but it’s hard to know how a commodity index accounts for the technology development that Kessler thinks is so sorely missing from CPI.

More importantly, Kessler talks to hedge fund managers and was once one himself, but he doesn’t seem to have ever had a conversation with one of the investors Michael Lewis profiled in his book The Big Short. As Lewis tells it, Steve Eisman was trained as a stock analyst specializing in banks and other lending companies, and he didn’t know much about the bond market. But he arrived at his decision to short  subprime mortgage-backed bonds partly from having observed as an equity analyst of “specialty finance” companies that middle class Americans were experiencing income stagnation and could only maintain their standard of living by borrowing through credit cards and against the value of their homes. Of course, Wall Street and the companies Eisman covered were happy to oblige them in this endeavor.

Eisman was a big critic of the banks leading up to the crisis, and shorted many of their stocks in addition to subprime mortgage-backed bonds. But here’s Eisman’s statement in a 2016 NYTimes op-ed column, where he argues against breaking up the banks after their post-crisis reforms, lest that would cause us to avoid the real  problem of income stagnation:

“The central economic problem of our time is income inequality, especially the lack of personal income growth for most Americans, which was one of the underlying causes of the financial crisis. In lieu of rising incomes, credit was allowed to be democratized. Living standards were maintained only because increased credit supplemented deteriorating incomes. That helps explain, post-crisis, why United States growth is slow: Without easy credit, consumers cannot increase spending, because their incomes have fallen since 2007.”

I don’t know what prescient bets the hedge fund managers Andy Kessler speaks to have made. But when he contemplates the fortunes of today’s middle class, Kessler might want to expand the circle of investors with whom he exchanges ideas.

On Monday, stocks opened higher as the bulls pushed the market above overhead resistance. In this past weekend’s missive, I updated our ongoing “pathway” analysis which continues to drive our overall portfolio positioning currently. To wit:

“As shown by the reddish triangle, the ongoing consolidation process continues. Eventually, this will end with either a bullish or bearish conclusion. There is no ‘middle ground’ to be had here.

  • Pathway #1 – a breakout to the upside on heavy volume that pushes the market through resistance at 2780 and back to old highs. (Probability 20%)
  • Pathway #2a and #2b – a breakout to the upside which fails resistance at 2780. The market then either a) retests the 100-dma and then is able to push to old highs, or, b) fails at 2780 a second time and continues the consolidation process through the summer. (Probability 50%)
  • Pathway #3 – the market breaks down next week on continued geopolitical worries, economic data or some unexpected catalyst and retests the 200-dma. (Probability 30%)

I have increased the more “bearish” probability from 20% last week to 30% this week given the triggering of a short-term ‘sell-signal.’ (Lower panel)

With the higher open on Monday, the market broke above the downtrend resistance and is set up to test resistance at 2780. With the market back to overbought currently, it is likely that 2780 may well be a challenge to the bulls in the near term. Pathway #2a and #2b continue to be the highest probability outcomes currently.

However, a “one-day” move is not necessarily the start of a new trend.

As we discussed previously, from a portfolio management perspective we rely much more heavily on “weekly” data as it smooths out the “volatility” of daily price movements. Given that we are “longer-term” investors, seeking to deploy capital for extended periods of time, using weekly data helps reduce the issues of “head fakes” or “false breaks” which lead to a variety of bad investing outcomes and behaviors. Also, weekly data reduces the emotional “wear and tear” on investors over time by keeping the primary focus on the “trend” of the data.

If we take a look at the weekly chart, a slightly clearer picture emerges.

As shown in the chart above, the consolidation process continues as in the daily chart above. While the market is appearing to bullishly “break out” of the current consolidation pattern, such will not be “confirmed” until the end of the trading week. On Friday, if prices have reversed, then the “break out” will NOT have occurred and portfolio allocations will remain flat.

Furthermore, on a “weekly basis,” the intermediate-term “sell signal” remains which suggests continued pressure on stock prices in the short-term. While the signal is improving, it has not confirmed an increase in equity allocations just yet. The market is also wrestling with a 61.8% Fibonacci retracement from the February lows which is providing some resistance.

We want to give the “benefit of the doubt” to the “bulls” currently. The action on Monday was indeed bullish, and sets us up to add further equity exposure to portfolios, but we will wait for confirmation of the weekly data.

Our worry is the “bulls” seem to charging directly into a potential “trade war.”

A “Trade War” Cometh

As discussed this past weekend, there are a litany of issues which currently concern us particularly has we meander further into the “seasonally weak” period of the year.

  • Italian “debt” is a problem. While it was quickly dismissed by the markets, the potential impact to the global financial system is magnitudes larger than Greece was.
  • The elected officials in both Spain and Italy are not particularly “EU” friendly with both recent appointments primarily anti-establishment officials. 
  • Deutsche Bank is a major issue of concern.
  • The Fed is raising interest rates and reducing their balance sheet.
  • Short-term interest rates are rising rapidly.
  • The yield curve continues to flatten and risks inverting.
  • Credit growth continues to slow suggesting weaker consumption and leads recessions
  • The ECB has started tapering its QE program.
  • Global growth, especially in Europe, is showing signs of stalling.
  • Domestic growth has weakened.
  • While EPS growth has been strong, year-over-year comparisons will become challenging.
  • Rising interest rates are beginning to challenge the equity valuation story. 

However, the biggest immediate concern is the implementation by the current Administration of “tariffs” not only on China but the EU, Mexico, and Canada.

On June 1st, the Administration announced tariffs on steel and aluminum products. On June 15th, the Administration will announce further tariffs on roughly $50 billion of imported products from China.

While “tariffs” sounds like a rather benign issue, it is simply another word for “tax.” In this case, it is a 25% tax increase on the goods and services being penalized. But it is not just those specific goods and services that rise in price, but all related and affected goods and services.

When tariffs are applied, the cost of steel, aluminum, and everything comprised of those commodities, will rise in price. Products, like automobiles, which use imported parts will also rise in price if the imported component increases in cost. As Doug Kass noted previously:

“What I believe they don’t understand is how interconnected the global economy is today compared to the past. As each year progresses, the role of world trade increases and the role of non-US operations in our largest multinationals multiply. Just look at the ever-expanding role of exports (and non-US sales) in the S&P Index – it’s increased as a percentage of total revenues by 2.5x in the last few decades.”

Throw into the mix a stronger dollar, and the risks increase further. As Garfield Reynolds blogged for Bloomberg:

“The law of unintended consequences is striking again. This time it’s the surge in the U.S. dollar that’s being fueled by decisions from President Donald Trump -who seems to prefer a weaker currency – to intensify his attacks on the current ‘unfair’ global trade regime.

The U.S.’s insistence on using tariffs as a weapon came as the White House dropped any effort to seek trade rebalancing through a weaker USD and decided against naming any nations as FX manipulators.

As Trump’s trade stance became more truculent, the dollar just kept climbing. That was puzzling because classic havens such as JPY, CHF, and gold were seeing little benefit as market fears heightened.

It’s become clear that the dollar gained because the impact of Trump’s stance was seen benefiting U.S. assets on a relative basis.”

“Yes, a major trade war is likely to cause damage to the U.S. economy, but a lot of that will be in the longer term. It’s going to cause significantly more pain, especially in the short term, to all those exporters Trump is targeting; and the U.S. is far and away the world’s largest net importer.

This issue is helping to leach investment out of EM in particular, with major developing economies among those most at risk from a U.S.-initiated trade war. Developing Asia, for example, sends 18% of its exports to the U.S., almost three times what it sends to Japan, the next- biggest single-country destination.

With the 10-year treasury rate now extremely overbought on a monthly basis, combined with a stronger dollar, the impact historically has not been kind to stock market investors. While it doesn’t mean the market will “crash” today, or even next week, historically rising interest rates combined with a rising dollar has previously led to unexpected and unintended consequences previously.

As I have stated previously:

“We remain keenly aware of the intermediate-term “risks” and we continue to take actions to hedge risks and protect capital until those signals are reversed.”

We also remain acutely aware of the longer-term capital risks due to elevated valuation levels, the length of the economic cycle, and weakening annualized comparisons going forward. While it is not yet time to be exceedingly “bearish” on equities, it is no longer advantageous to be exceedingly “bullish” either.

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

This article is Part I of a series discussing the fallacies of always owning stocks for the long run (aka “buy and hold” and passive strategies). Given the current bull market is not only long in the tooth compared to prior bull markets, but sitting at valuations that have always been met with more severe declines, we believe the points made in this series of articles are important for investors to understand.

This series of articles will cover the following key points:

  • “Buy and Hold,” and other passive strategies are fine, just not all of the time
  • Markets go through long periods where investors are losing money or simply getting back to even
  • The sequence of returns is far more important than the average of returns
  • “Time horizons” are vastly under-appreciated.
  • Portfolio duration, investor duration, and risk tolerance should be aligned.
  • The “value of compounding” only works when large losses are not incurred.
  • There are periods when risk-free Treasury bonds offer expected returns on par, or better than equities with significantly less risk.
  • Investor psychology plays an enormous role in investors’ returns
  • Solving the puzzle: Solutions to achieving long-term returns and the achievement of financial goals.

Part I: Buy and Hold Can Be Hazardous To Your Wealth

One would think that following two major market corrections of over 50% within the last two decades, investors would have a better appreciation for how much time it takes to compound your way out of losses. While buy-and-hold investors who stayed true to their strategy over the last two decades are indeed ahead, they lost many years of valuable compounding time in a quest to “get back to even.

Just recently, Michael Lebowitz tweeted a chart that highlighted the issue of the time required to “get back to even.”

The tweet, and graph, was a simple reminder that markets spend a good deal of time declining and retracing those declines. These are long periods when investors are not compounding their wealth. As he noted:

“This fact should be top of mind given ‘history, risk levels, and valuations.'”

Not surprisingly, his tweet quickly sparked rebuttal from some promoters of “buy and hold” investment strategies. Of note was a Tweet from Dan Egan.

Dan thinks that Michael’s message is “Fear Mongering.” If presenting factual data, and highlighting the certainty of market cycles, is fear mongering then maybe he is right. If so, he might also want to consider that investors should be fearful given current valuations and the economic underpinnings of corporate earnings. If fear is what it takes to help investors understand the next five years will likely not be similar to the last five, then it will have served a valuable purpose.

The reason, however, this message seems lost on many investment professionals and individuals is because:

  • They have never been through a major market reversion
  • They have only lived through one (2008) and assume another “financial crisis” cannot happen in our lifetimes.
  • They find it easier to passively manage money and blame major drawdowns on the markets rather than commit to the efforts, rigorous analysis, and mental fortitude to go against the crowd. These are all important traits needed to manage an active investment strategy.

As David Rosenberg recently noted, since 2009 nearly 13.4 million individuals have taken on roles in the financial industry. What this suggests, is there are many professionals currently promoting a “buy-and-hold” strategy who have never actually been through a “bear market” cycle. Even Dan Egan who quickly dismissed the analysis did not start his career with Betterment until after the financial crisis.

“Experience” is the most valuable teacher of investing over time. Severe market draw downs have permanent negative effects on an individual’s financial goals, their lives, and their families. Dan would likely have a much different opinion if he had to sit across the table from someone who had just lost 50% of their retirement savings pleading with him about how they are ever going to get it back.

This is why all great money managers throughout history have all operated under one simple investment philosophy – “buy low, sell high.”

Even the great Warren Buffett once noted the two most important rules of investing.

  1. Don’t Lose Money
  2. Refer To Rule #1

Josh Brown also commented on Michael’s tweet and made a good suggestion. (We are going to cover the concept of dollar cost averaging later in this series.)

Per Josh’s request, 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. Given that most investors do not start seriously saving for retirement until the age of 35, or older, most investors have just one market cycle to reach their goals. If that cycle happens to include a 10-15 year period in which total returns are flat, the odds of achieving their savings goals are massively diminished. If an investor’s 30-year investment cycle happens to end with a major market crash, the result was devastating. Time, duration and ending dates are crucially important to expected investor outcomes.

Second and more importantly, “buy and hold” investors fail to consider risks, expected returns and alternative strategies. Consider that from 2000 through 2013, the S&P 500 Index, including dividends and inflation, delivered a zero rate of return. And from 2000 through 2017, it returned a scant 0.30% more than risk-free Treasury bonds (5.4% annualized for stocks versus 5.1% annualized for bonds). Further, to reach that return it required the expansion of valuation multiples to extreme and risky levels. Equity investors have endured two 50% draw downs, and over a decade of no returns, to achieve an 18-year, 30 basis point annualized pickup over bonds. In recent years that entailed holding equities that were well above long-term averages and presented a poor risk/return framework.

Given current valuations, it is possible, perhaps even likely, that we will wake up on New Year’s Day 2025 to a stock market that has lagged or only barely matched the return of bonds for a full quarter century. The chart below shows the annualized performance of 10-year equity returns versus 10-year U.S. Treasury notes based on over 100 years of history. Clearly equity investors will need to defy history to outperform risk-free bonds. Stocks vs. Bonds: What to own over the next decade.

Summary – Part I

As shown and described, markets go through cycles. During these cycles, there are often incredible opportunities to own stocks. However, these cycles also include periods when risk should be minimized and greed should be constrained. Active management, unlike the static, one-size-fits-all mindset of the popular “buy and hold” strategy, seeks to measure risk and expected returns and invest in a manner in which one is aggressive when valuations are cheap, and defensive when they are rich. The philosophy of this approach seeks first to avoid large losses which are the key to compounding wealth.

The bottom line, and the topic for Part II, is that corrections and crashes matter a lot. Avoiding losses weighs far more heavily in compounding wealth than does chasing returns. In the next article we will walk through the math of compounding and explain why investing in markets that are expensive may provide short-term satisfaction but more than likely will severely harm your ability to meet your retirement goals.

J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.


We believe that the chief determinant of future total returns is the relative valuation of the index at the time of purchase. We measure valuation using the Price/Peak Earnings multiple as advocated by Dr. John Hussman. We believe the main benefit of using peak earnings is the inherent conservatism it affords: not subject to analyst estimates, not subject to the short-term ebbs and flows of business, and not subject to short-term accounting distortions. Annualized total returns can be calculated over a horizon period for given scenarios of multiple expansion or contraction.

Our analysis highlights expansion/contraction to the minimum, mean, average, and maximum multiples (our data-set begins in January 1900) . The baseline assumptions for nominal growth and horizon period are 6% and 10 years, respectively. We also provide graphical analysis of how predicted returns compare to actual returns historically.

We provide sensitivity analysis to our baseline assumptions. The first sensitivity table, ceterus paribus, shows how future returns are impacted by changing the horizon period. The second sensitivity table, ceterus paribus, shows how future returns are impacted by changing the growth assumption.

We also include the following information: duration, over(under)-valuation, inflation adjusted price/10-year real earnings, dividend yield, option-implied volatility, skew, realized volatility, historical relationships between inflation and p/e multiples, and historical relationship between p/e multiples and realized returns.

Our analysis is not intended to forecast the short-term direction of the SP500 Index.  The purpose of our analysis is to identify the relative valuation and inherent risk offered by the index currently.

On Tuesday, the market tumbled on concerns over Italian debt. (A problem, by the way, I discussed a couple of years ago.) However, on Wednesday, the market reversed course and apparently the crisis was over. Make no mistake, nothing was fixed or resolved, investors just chose to ignore the problem under the belief that Central Bankers will unite in some form of bailout.

It isn’t just Italian debt, which is magnitudes larger than Greece’s debt crisis, but it is also Spain and a host of other smaller European countries that continue to ramp up debt in hopes that economic growth will someday bail them out. However, sustained economic growth has failed to appear.

As long as interest rates remain low and negative in some cases, debt can continue to be accumulated even with weaker rates of economic growth. More importantly, as long as rates remain low, the banking system can continue to play the “hide-the-debt game” through derivatives, swaps and a variety of other means.

But rates are rising, and sharply, on the shorter-end of the curve.

Historically, sharply rising rates have been a catalyst for a debt related crisis. As long as everything remains within the expected ranges, the complicated “math” behind trillions of dollars worth of financial instruments function properly. It is when those boundaries are broken that things “go wrong” and quickly so.

People have forgotten that in 2008 a major U.S. financial firm crashed as its derivative based exposure “blew up.” No, I am not talking about Lehman Brothers, the poster-child of the financial crisis, I am talking about Bear Stearns.

In just 365-days, Bear Stearns stock went from $159 to $2, with about half of the loss occurring within a few weeks.

Bear Stearns was the warning shot for the financial markets in early 2008 that no one heeded. Within a couple of months, the markets dismissed Bear Stearns as a “non-event” and rallied to a higher level than prior to the event, and almost back to highs for the year.

Remember, there was “nothing to worry about” at the time, even though the Fed was increasing interest rates, as the “Goldilocks economy” could handle tighter monetary policy. Sure, housing had been slowing down, mortgage delinquencies were rising, along with credit card defaults, but there wasn’t much concern.

Today, we are seeing similar signs.

Interest rates are rising, along with delinquencies, defaults, and a slowing housing market. But no one is concerned as the “Goldilocks economy” can clearly offset these mild risks. And no one is paying attention to, what I believe to be, one of the biggest risks to the global financial markets – Deutsche Bank. 

Deutsche Bank is clearly showing signs of financial trouble. More importantly, it is magnitudes larger, in terms of derivative-based exposure, than Bear Stearns and Lehman Brothers combined. Bear Stearns and Lehman Brothers were not banks and did not hold deposits. As such, they posed significantly less risk to the financial system.

As Doug Kass recently noted:

“The collateral risks to Europe are large – most notably to ECB and to Germany. In it’s extreme it could mean Italy separates from the rest of the EU. To me, as I have written in the past, Deutsche Bank is particularly exposed.

But, to this observer, who has consistently warned about Deutsche Bank being the next Black Swan and the imbalances in the European banking system (particularly in Italy), the risks of a possible negative multiplier effect on other European financial intermediaries and on the region’s economic prospects is profoundly real.”

But, while “everyone loves a good bullish thesis,” let me restate the reduction in the markets previous pillars of support:

  • The Fed is raising interest rates and reducing their balance sheet.
  • Short-term interest rates are rising rapidly.
  • The yield curve continues to flatten and risks inverting.
  • Credit growth continues to slow suggesting weaker consumption and leads recessions
  • The ECB has started tapering its QE program.
  • Global growth, especially in Europe, is showing signs of stalling.
  • Domestic growth has weakened.
  • While EPS growth has been strong, year-over-year comparisons will become challenging.
  • Rising energy prices are a tax on consumption
  • Rising interest rates are beginning to challenge the equity valuation story. 

“While there have been several significant corrective actions since the 2009 low, this is the first correction process where liquidity is being reduced by the Central Banks.”

Oh, and just one last chart. During 2007, and into 2008, the S&P 500 traded sideways in a 150-point range. That range was extended to 300-points before the crash actually occurred.

It was believed to be just a “pause that refreshes.”

Since January of this year, the S&P 500 has been trading in a 300-point range (similar in percentage terms to the period preceding Bear Stearns).

It is also believed to just be a “pause that refreshes.” 

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

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“Government is one of the five evils – along with fire, floods, thieves and enemies.” ― Jeffrey Friedland, All Roads Lead To China

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