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Monthly Archives: December 2017

An interesting email hit my desk this morning:

“The stock market goes up 80% of the time, so why worry about the declines?”

Like a “bull” – rising markets tend to be steady, strong and durable. Conversely, “bear” markets are fast “mauling” events that leave you deeply wounded at best and dead at worst.

Yes, the majority of the time the markets are “bullish.” It’s the “math” that ultimately gets you during a “bear” market.

The real devastation caused by “bear market” declines are generally misunderstood because they tend to be related in terms of percentages. For example:

“Over the last 36-months, the market rose by 100%, but has recently dropped by 50%.”

See, nothing to worry as an investor would still be ahead by 50%, right?

Nope. A 50% decline wipes out 100% of the previous gain. This is why looking at things in terms of percentages is so misleading. A better way to examine bull and bear markets is in terms of points gained or lost.

Notice that in many cases going back to 1900, a large chunk of the previous gains were wiped out by the subsequent decline. (A function of valuations and mean reversions.)

Recently Upfina posted a great chart on “Bear Market Repo’s” which illustrates this point very well. To wit:

“Many confuse bear markets with being black swan events that cannot be predicted, however, this is a faulty approach to investing. The economy, market, and nature itself move in cycles. Neither a bear market nor a bull market last forever and are actually the result of one another. That is to say, a bear market is the author of a bull market and a bull market is an author of a bear market. Low valuations lead to increased demand, and high valuations lead to less demand.”

The only point I am attempting to make today is don’t “confuse the math.” A 30-50% decline from any level in the market is destructive not only to your current principal value both also your financial goals particularly as it relates to you investing time horizon.

Time is the only thing we can’t get back.

As Upfina concludes:

“The critical discipline to protect your portfolio through bull and bear markets is hedging. Hedging is when you start a position to avoid the risk of another position. The keyword when it comes to investing with the goal of minimizing risk is correlation. You want to buy assets with a low correlation to diversify against bear markets.

A few investments which typically do well in bear markets are cash, long-term U.S. treasuries, the volatility index, gold, shorting the stock market, shorting high yield bonds, and buying safe sectors such as telecommunications and utilities.”

With everyone seemingly bearish on bonds and the dollar, and bullish on equities and oil, the contrarian in me thinks “hedging” against the “crowd” might be something worth considering.

Such “hedges” could well be the ticket to minimizing the next “bear market repo.”

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

Economy & Fed


Most Read On RIA

Research / Interesting Reads

“Love risk when making money. Hate risk when investing money.” ― Robert Rolih

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.”

The persistent rise in interest rates has become a dominant topic of the financial media. It is now common to read articles on how a rise in the 10-year Treasury bond rate to a specific level will produce some type of sea-change in perception and/or reality. Some of those points are already in the rear-view mirror (2.65%), while another was crossed this week (3.05%), and still others lie ahead (3.22%). Some commentators eschew a specific interest rate and instead specify a range, such as 3.50%-3.75%.

The focus on interest rates is understandable. Rising rates are, by definition, a negative influence on bond prices.  With tens of trillions of dollars of bonds outstanding, a rise in interest rates of, say, 1%, produces market losses of hundreds of billions of dollars. If the Fed’s beloved “wealth effect” ever existed, it is now a movie that is running in reverse, perhaps more quickly than it ever ran in forward.

In addition to negatively influencing bond prices, rising rates are perceived to be a negative influence on most other assets, such as real estate, commodities, or private businesses. Of course, this is also true of stock valuations.  Ever since the peak in interest rates in the early 1980s, falling interest rates have been used as a primary justification for rising stock valuations.

Oddly, investors of the Russell 2000 index (R2K), comprised of small-cap companies, don’t seem to care about the connection between rising interest rates and lower stock prices. Defying the predictions of many, R2K made a new all-time high this week while bond yields rose to 7-year highs. This combination is particularly at odds with financial theory because R2K companies have a greater exposure to rising rates than larger companies.  For example, the maturity of the debt of R2K companies matures earlier and carries a higher interest rate than large companies in the S&P500 index (SPX).

Looking at other influences on stock prices, R2K historically tends to rise when the dollar is strong, but it also tends to be weak when the price of oil is rising. So recent changes in the dollar and oil largely negate each other and don’t explain the R2K’s strength.

Diving further into relative valuations, the Wall Street Journal publishes valuations on a weekly basis, as shown in the table below.

The price/earnings ratio (PE) based on the past year’s earnings is far higher for R2K (88.75) than SPX (24.28) and even the NASDAQ 100 index (24.99), an index dominated by the largest U.S. growth (technology) companies, which should presumably be valued more highly than smaller companies. Looking forward, after waving the magic wand which uses operating earnings instead of GAAP earnings, R2K (26.15) is still valued more highly than the SPX (17.05) and NASDAQ (20.25). It is important to note that the P/E calculation for the R2K throws out the earnings of companies losing money, while SPX includes them. Ergo, the true P/E of R2K is larger than it appears. The following quote was from an article written in 2016 that analyzed R2K valuations:

“As a point of comparison, the widely reported P/E ratio of 46 for the R2K appears to be much lower than our value (237x). Unlike, the market benchmark S&P 500, the reported Russell P/E ratio excludes companies with negative earnings. Our analysis appropriately includes both positive and negative earnings.” – Banks in Drag : The Russell 2000 Exposed 

Historically, the R2K is trading near its all-time high in valuation, as shown below by the red line. Since 2003, the R2K traded at a higher valuation only a few times; during the earnings crash and recession of 2009, briefly during 2015, and again throughout 2017. Although calculates a slightly different P/E for the R2K (24.1) than the WSJ, it is still higher than both the SPX and NASDAQ, and as noted above likely much higher on an apples-to-apples basis.

R2K companies are more exposed to the U.S. economy than larger companies, because larger companies derive a greater percentage of revenues and profits from overseas.  So one explanation for the higher valuation of R2K companies is that U.S. economic growth will be stronger than global growth.  But it is also true that the Fed is well into a tightening cycle that is designed to restrain growth and inflation, while Europe and Japan still have the monetary petal pushed to the metal, including negative interest rates.  As previously explained HERE, the combination of rising interest rates and energy prices has preceded every U.S. recession of the past 45 years, and that combination is present yet again in 2018.

In conclusion, interest rates are rising, but they have not produced the expected effect on stock prices. R2K companies are trading at an all-time high in price as bond yields are breaking to multi-year highs. R2K companies are trading at a high PE multiple relative to larger, more stable companies that have less exposure to rising interest rates. R2K companies also are trading at a high PE multiple relative to historical norms. Perhaps all of these conditions will continue into the future, but that seems like a low-probability bet, which is a major source of risk for small-cap U.S. stocks.

I was recently reviewing some old notes and ran across a comment made by David Merkel from the Aleph Blog back in 2013. The discussion centered around the impact of volatility on investment disciplines. The most important concept is that most investors tend to chase performance. Unfortunately, performance chasing occurs very late in the investment cycle as exuberance overtakes logic which leads to consistent underperformance. What David touches on is the importance of being disciplined when it comes to your investment approach, however, that is singularly the most difficult part of being a successful investor.

“One of the constants in investing is that investment theories are disbelieved, prosper, bloom, overshoot, die, and repeat. So is the only constant change? That’s not my view.

There are valid theories on investing, and they work on average. If you pursue them consistently, you will do well. If you pursue them after failure, you can do better still. How many times have you seen articles on investing entitled ‘The Death of ____.’ (fill in the blank) Strategies trend. There is an underlying kernel of validity; it makes economic sense, and has worked in the past. But any strategy can be overplayed, even my favorite strategy, value investing. 

Prepare yourself for volatility. It is the norm of the market. Focus on what you can control – margin of safety. By doing that you will be ready for most of the vicissitudes of the market, which stem from companies taking too much credit or operating risk.

Finally, don’t give up. Most people who give up do so at a time where stock investments are about to turn. It’s one of those informal indicators to me, when I hear people giving up on an asset class. It makes me want to look at the despised asset class, and see what bargains might be available.

Remember, valid strategies work on average, but they don’t work every month or year. Drawdowns shake out the weak-minded, and boost the performance of value investors willing to buy stocks when times are pessimistic.”

When it comes to investing it is important to remember that no investment strategy works all the time.

Most guys know that in baseball a player that is batting .300 is a really solid hitter. In fact, according to the “Baseball-Almanac,” the ALL-TIME leader was Ty Cobb with a lifetime average of .366. This means that every time that Ty Cobb stepped up to the plate he was only likely to get a hit a 36.6% of the time.  In other words he struck out, or walked, roughly 2 out of every three times at bat. All of a sudden that doesn’t sound as great, but compared to the performance of other players – it was fantastic.

The problem is a .366 average won’t get you into the “investor hall of fame”; it will likely leave you broke. When it comes to investing it requires about a .600 average to win the game long-term. No, you are not going to invest in the markets and win every time. You are going to have many more losers than you think. What separates the truly great investors from the average person is how they deal with their losses – not their winners.

10-Rules That Work

There are 10 basic investment rules that have historically kept investors out of trouble over the long term. These are not unique by any means but rather a list of investment rules that in some shape, or form, has been uttered by every great investor in history.

1) You are a speculator – not an investor

Unlike Warren Buffet who takes control of a company and can affect its financial direction – you can only speculate on the future price someone is willing to pay you for the pieces of paper you own today. Like any professional gambler – the secret to long-term success was best sung by Kenny Rogers; “You gotta know when to hold’em…know when to fold’em”

2) Asset allocation is the key to winning the “long game”

In today’s highly correlated world there is little diversification between equity classes. Therefore, including other asset classes, like fixed income which provides a return of capital function with an income stream, can reduce portfolio volatility. Lower volatility portfolios outperform over the long term by reducing the emotional mistakes caused by large portfolio swings.

3) You can’t “buy low” if you don’t “sell high”

Most investors do fairly well at “buying,” but stink at “selling.” The reason is purely emotional, which is driven primarily by “greed” and “fear.” Like pruning and weeding a garden; a solid discipline of regularly taking profits, selling laggards and rebalancing the allocation leads to a healthier portfolio over time.

4) No investment discipline works all the time – Sticking to a discipline works always.

Like everything in life, investment styles cycle. There are times when growth outperforms value, or international is the place to be, but then it changes. The problem is that by the time investors realize what is working they are late rotating into it. This is why the truly great investors stick to their discipline in good times and bad. Over the long term – sticking to what you know, and understand, will perform better than continually jumping from the “frying pan into the fire.”

5) Losing capital is destructive. Missing an opportunity is not.

As any good poker player knows – once you run out of chips you are out of the game. This is why knowing both “when” and “how much” to bet is critical to winning the game. The problem for most investors is that they are consistently betting “all in all of the time.” as they maintain an unhealthy level of the“fear of missing out.” The reality is that opportunities to invest in the market come along as often as taxi cabs in New York City. However, trying to make up lost capital by not paying attention to the risk is a much more difficult thing to do.

6) Your most valuable, and irreplaceable, commodity is “time.”

Since the turn of the century investors have recovered, theoretically, from two massive bear market corrections. It took 14- years for investors to get back to where they were in 2000 on an inflation-adjusted total return basis. Furthermore, despite the bullish advance from the 2009 lows, the compounded annual total return for the last 18-years remains below 3%.

The problem is that the one commodity which has been lost, and can never be recovered, is “time.” For investors getting back to even is not an investment strategy. We are all “savers” that have a limited amount of time within which to save money for our retirement. If you were 18 years from retirement in 2000 – you are now staring it in the face with a large shortfall between the promised 8% annualized return rate and reality. Do not discount the value of “time” in your investment strategy.

7) Don’t mistake a “cyclical trend” as an “infinite direction”

There is an old Wall Street axiom that says the “trend is your friend.”  Investors always tend to extrapolate the current trend into infinity. In 2007, the markets were expected to continue to grow as investors piled into the market top. In late 2008, individuals were convinced that the market was going to zero. Extremes are never the case.

It is important to remember that the “trend is your friend” as long as you are paying attention to, and respecting its direction. Get on the wrong side of the trend and it can become your worst enemy.

8) If you think you have it figured out – sell everything.

Individuals go to college to become doctors, lawyers, and even circus clowns. Yet, every day, individuals pile into one of the most complicated games on the planet with their hard earned savings with little, or no, education at all.

For most individuals, when the markets are rising, their success breeds confidence. The longer the market rises; the more individuals attribute their success to their own skill. The reality is that a rising market covers up the multitude of investment mistakes that individuals make by taking on excessive risk, poor asset selection or weak management skills.  These errors are revealed by the forthcoming correction.

9) Being a contrarian is tough, lonely and generally right.

Howard Marks once wrote that:

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

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

The best investments are generally made when going against the herd. Selling to the “greedy” and buying from the “fearful” are extremely difficult things to do without a very strong investment discipline, management protocol, and intestinal fortitude. For most investors, the reality is that they are inundated by “media chatter” which keeps them from making logical and intelligent investment decisions regarding their money which, unfortunately, leads to bad outcomes.

10) Benchmarking performance only benefits Wall Street

The best thing you can do for your portfolio is to quit benchmarking it against a random market index that has absolutely nothing to do with your goals, risk tolerance or time horizon.

Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus. If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that ‘everyone else’ made 14%, you have made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy. Money in motion creates fees and commissions. The creation of more and more benchmarks and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.

The only benchmark that matters to you is the annual return that is specifically required to obtain your retirement goal in the future. If that rate is 4% then trying to obtain 6% more than doubles the risk you have to take to achieve that return. The end result is that by taking on more risk than is necessary will put your further away from your goal than you intended when something inevitably goes wrong.

It’s all about the risk

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecasted. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty.

It should be obvious that an honest assessment of uncertainty leads to better decisions. It may seem contradictory, embracing uncertainty reduces risk while denial increases it. Another benefit of “acknowledged uncertainty” is it keeps you honest. A healthy respect for uncertainty, and a focus on probability, drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.

The reality is that we can’t control outcomes; the most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

I am beginning to think, these days, that with the exception of Warren Buffett, nearly everyone worships at the altar of price momentum.

Seemingly, more than ever, commentators today are citing “levels”, charts, flows and my least favorite indicator (and one that has never been documented as a plausible and profitable endeavour)“unusual” call activity that is really quite usual. (As I have written in the past I am respectful of those that earn a living by utilizing some of the more thoughtful and disciplined methods of technical analysis.)

I, too, have caught a bit of that “technical” infliction as I try to complement my long term investments in a new regime of volatility – as, in recognition of a machine/algo dominated world that exaggerates short term price moves, I am trying to adopt to an investing world that is more reactionary and less anticipatory.

I am so old that I still remember fundamental investing — recognizing that in the short run the market is a voting machines, it is a weighing machine over time (again, Buffett).

My experience is that fundamentals nearly always win in the end and it is that approach that I champion.
Bottom Line

Near term I continue to view the market as at or near the upper end of a defined trading range – 2550 downside and 2725-2750 upside (reflected in S&P terms). Technically, this is an obvious level of resistance as well as an important Fibanocci level.

Some other short term concerns:

* Crude and energy stocks are market leaders – often a signpost of a late cycle market move.
* Bullish investor sentiment is rising. (See Divine’s comments this morning.)
* Concentrated and narrow leadership in ” MANA”

I see a bumpy market road in the second half of the year.

As expressed in “The Madness of (Investing) Crowds”; I outlined the pillars of my bearish views (the growing ambiguity of global growth trajectory, rising interest rates, the inconsistency of policy, etc.).

My core trading and investment strategy is based on the notion of upside reward vs downside risk (the difference between current prices and my calculation of “intrinsic value”) – expressed by the calculation of a list of fundamental outcomes and the probabilities of those outcomes.

While many see higher lows and higher highs – since the early February drubbing, I view today as a good time to derisk.

At least based on my perception of the fundamentals.


Consider the following companies:

  • A luxury automobile manufacturer whose cars average over $70,000 in price
  • A technology company that designs and manufactures consumer products
  • A video streaming company with a market cap of $134 billion, average revenue growth of 29% over the past five years and whose stock has risen by 243% in the last two years
  • A diversified energy conglomerate with a market cap of $324 billion
  • A technology company with a market cap of $849 billion
  • A financial institution with $5.2 trillion in deposits representing over 40% of all deposits held by U.S. commercial banks

The relativism of the equity market has taken on a whole new meaning over the past several years as the passive investment craze has re-ordered the equity universe according to its convenience. It appears to argue that there are no absolutes, nothing is objective and what may be suitable under one characterization may or may not be under another. It appears to depend upon the “whether” – whether or not the architects of passive investment instruments like index funds and ETFs choose at their discretion to include a stock for the sake of their convenience and financial incentive.

In hot markets, investors have a tendency to overlook these details in an assessment of investment options for their portfolio. An investor or manager may decide he or she is undesirably under-weight mid-cap stocks and seek a fund option that provides the needed exposure. They may need healthcare exposure or consumer discretionary or value or technology, but regardless of the need, the list of options can be a complex and nearly endless matrix.

The determination of a reliable fund to gain the desired exposure(s) is straight-forward. The name-brand funds are a mouse click away whether you want to invest $100 or $1 million. But the assumptions embedded in determining a reliable option, including the convenience of choice and execution, do not typically give fair consideration to the possibility that the investor or manager may not get the exposure they thought.

Look back to the list above:

  • The luxury automobile manufacturer is Tesla and is included for reasons unknown in a fund of consumer staples.
  • The technology company making consumer products is Apple and is included in a fund marketed as health and biotech-focused.
  • The video streaming company with average revenue growth of 29% and a skyrocketing stock price is NetFlix, which has been pitched as a value stock.
  • The diversified energy conglomerate with a market cap of $324 billion is Exxon Mobil and has been included in a mid-cap stock fund.
  • The technology company with the largest market cap in domestic markets ($849 billion) is again Apple, but it has been included in both a small- and mid-cap fund
  • The financial institution with $5.2 trillion in deposits is JP Morgan, and it is included in a technology fund

Sure, one could rationalize these inconsistent inclusions and get away with it. Since investors are not really that discerning when returns have been solid, why bother? However, the collective decisions being made on over $1.5 trillion in assets as they move from active to passive funds will have a dramatic impact on the market. In the words of the ancient Romans, “It’s all fun and games until someone loses an eye.

Categories that seem self-identified and straight-forward are anything but. They have been polluted by the relativism of those trying to maximize fee income. The popularity of indexation has required the index funds to include more liquid stocks from other categories. This destroys the integrity of the fund(s) and makes it increasingly homogeneous with the market basket. The distinction of the category is reduced because it includes stocks that do not qualify and should not be included.

Often in a search for liquidity or possibly performance, a large and easily tradeable stock prompts fund managers or index creators to include it when logic and pure definition of terms would say it should not be included. In this way, fund/index creation is a bit of a red herring in that you’re not getting what you think you are. Ultimately, it is to the fund/index creator’s benefit and the detriment of the investor.

We suspect the internal dialogue in the conference rooms of the passive funds goes something like this:

Executive #1: Liquidity is a problem, without finding a source of liquidity, we would have to halt new money into the fund.

Executive #2: You’re NOT going to halt new money! My bonus – and yours – depends on the growth of the fund!

Executive #3: Gents, no reason to worry. We can accommodate the new flow, we just need to apply a modification of interpretation of terms. After all, Apple was a small-cap stock in 1981…

Yes, relativism comes in all forms and it feels so good until it doesn’t. The problem described is systemic. It will help drive correlations amongst stocks with very different risk and earnings profiles more aggressively toward 1.00. Consider that during the recent market swoon, correlations between equity markets and equity sectors have been higher than short and long-term averages and even correlations seen during similar sell-offs in the past.

As described in our Unseen article Judgement Awaits, this is another example of the desire of certain institutions to make excess profits at the expense of the destruction of wealth they will ultimately impose upon investors.

For a copy of “Judgement Awaits”, please email us

Many professional investors/traders recognize that they cannot match the intellectual horsepower and political connections of the institutional players, so they steer clear of the speculative games that favor those players. Without the opportunities provided by these investors/traders, the institutional players need to resort to more sinister measures to draw in the witless participant. In the same ways that the east coast mob moved west to Las Vegas, they expand their boundaries to encroach on more mainstream products like index funds and ETFs.

The evidence of these moves and the changing relationship is apparent. In the recent February sell-off, the S&P 500, the NASDAQ composite and the Russell 2000 had a correlation of an almost perfect 98.99%. That circumstance is symptomatic and will prove highly destructive when markets become more volatile and less confident. Even those who think they are protected in lower beta sectors or asset classes believed to be defensive may find out the pervasiveness of passive investing has reduced the value of their “prudent” actions.

  • The level of Carbon Dioxide (CO2) spewing from the Mauna Loa volcano in Hawaii influences the yield of German ten year Bunds.
  • The number of Major League Baseball (MLB) pitchers per season with at least five complete games influences the yield of German ten year Bunds.

Sound ridiculous?  We think so to, but read on.

The Federal Reserve (Fed) plays an important role in steering economic activity as well as influencing the direction of the financial markets. As such it is incumbent upon investors to be well versed on current monetary policy as well as on the mindset of the members of the Fed. Numerous speeches and white papers provide investors the means to do just this.

Equally important, and we believe a more difficult task, is not to allow the Fed’s views and biases to automatically influence our beliefs. The Fed’s penchant for complicated economic lingo and long-winded answers can be confusing even for those in the industry. Further, graphs and other forms of data-based evidence, which at times can be misleading, are used to support such claims. Renowned economist Thomas Sowell, in a 2014 Wall Street Journal interview with Peter Robinson regarding the 5th edition release of his book Basic Economics: A Common Sense Guide to the Economy, was asked why it was a point of pride with him that the book did not contain the normal esoteric jargon of economics. Sowell replied, “Because I want people to read it, and if you make it unreadable, they aren’t going to read it.”

While we have many theories for why the Fed does not present their case in plain English, we simply remind you that their incentives are not always lined up with those of the economy and the financial well-being of the populace. It is quite likely Fed members know that if this were fully understood by the voting public things might change.

We were recently reminded by Fed Chairman Powell that we need to pay close attention to not only what they are saying but the evidence they use to support “facts.” In a recent speech, Powell posited that U.S. Treasury yields and the U.S. dollar influence the yield of German Bunds. The graph below served as evidence in his mind.

R-squared, as shown in the graphs (.21 and .23), measures the variability of data around its mean (trend line). An R-squared of +/- 1.00 entails that two variables have a perfect relationship with each other. As the R-squared declines the relationship weakens.  While there is no firm R-squared figure that defines statistically significant, a reading of +/- 0.60 tends to be a common level. Given the low R-squares above, one can only conclude that data and Mr. Powell’s thoughts are not entirely in sync. He would like to have us believe that because he deems it a significant relationship as presented in his speech, it is so.

We know that our opening statement relating CO2 and MLB pitching to Bund yields is ridiculous. However, consider that those relationships have much better statistical relevance than the one made by Federal Reserve Chairman Jerome Powell.


While we will not even begin to present a case for the relationships graphed above, we hope it shows you how statistics can be abused to make statements and theories that are not sound. This message is similar to ones we have posted on numerous occasions; it is incumbent on investors to apply a healthy skepticism to truth claims coming forth from intellectual authorities.

The Ph.D.’s at the Fed have demonstrated on many critical occasions (tech bubble, sub-prime) their penchant for being human. Investors who put blind faith in those with a vested interest in conveying a positive outlook are likely to be disappointed in the outcome and less wealthy as a result. Like a genuine effort to uncover the truth, critical thinking and serious analytical rigor are not easy especially considering the multitude of forces working against us.

The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.  – John Maynard Keynes

It’s time we expose a few of the greatest financial mismatches in history. At the top of my mind, due to a myriad of behavioral and cognitive hiccups, are select retail investors (you know who you are), who must come to grips with how they’re handling current stock market volatility.

It’s a moment of truth

Too many investors possess a hook-up mentality with stocks. Holding periods are at historic lows. According to the New York Stock Exchange’s extensive database, the average holding period for stocks in 1960 was 8 years, 4 months.

As of December 2016, it was 8.3 months.

Last year’s unprecedented stock market performance for the S&P 500 was the worst event for investor psyche.

I’ll explain.

No doubt, it was a magical year. The market closed higher every month (first time in history). The Sharpe Ratio, or returns on the S&P relative to the risk-free (Treasury Bills) and volatility was 3.7. Since volatility was non-existent last year, risk-adjusted returns for the market were among the best I ever lived through; at least the highest in over 50 years.

Think of it like dating the most popular girl (or guy), in high school. In the beginning, you wonder how the heck it happened. Such luck! Eventually, you believe you’re entitled to dating prom kings and queens in perpetuity. The problem is ego. You convince yourself the perfect prom date is the norm and begin to compare every date after to “the one.” What a great way to set yourself up for failure, missed opportunities and myopia that slaughters portfolio returns (and possibly, relationships!)

In 2017, equity investors witnessed a storybook investment scenario. This year so far? Reality bites. It’s not that your adviser doesn’t know what he or she is doing; it’s not the market doing anything out of the ordinary, either. The nature of the market is volatility, jagged edges and fractals. The sojourn, the Sunday drive in perfect weather with the top down on a newly-paved road in 2017, was an outlier. The environment you’re investing through today is the norm; therefore, the problem must be the driver, the investor who doesn’t realize the road conditions are back to resembling 5pm rush-hour in a downpour.

Do you experience frustration with a purchase your adviser implements or recommends if the price doesn’t quickly move in your favor? Do you question every move (or lack thereof), a financial partner makes?

How often do you say to yourself – “She didn’t take enough profit. Why did he buy that dog? Why isn’t he or she doing anything? (Sometimes doing nothing is the best strategy, btw).

Do you constantly compare portfolio performance every quarter with a stock market index that has nothing to do with returns required to meet a personalized benchmark or long-term goal like retirement?

Ostensibly, the ugly truth is there may be a mismatch between your brain and your brain on investments. Listen, stocks aren’t for everyone. Bonds can be your worst enemy. Even the highest quality bond fluctuates and can be sold at a loss before maturity. This is the year as an investor you’re going to need to accept that volatility is the entrance fee to play this investment game.

According to Crestmont Research, volatility for the S&P 500 tends to average near 15%. However, volatile is well, volatile. Most periods generally fall within a band of 10% to 20% volatility with pockets of unusually high and low periods.

The space between gray lines represents four-year periods. Observe how volatility collapsed in 2017, lower than it’s been in this decades-long series.

Per Crestmont:

“High or rising volatility often corresponds to declining markets; low or falling volatility is associated with good markets. Periods of low volatility are reflections of a good market, not a predictor of good markets in the future.”

So, as an investor, what are the greatest financial mismatches you’ll face today?

Recency Bias

Recency bias or “the imprint,” as I call it, is a cognitive affliction that convinces me the trade I made last Thursday should work like it did when I placed a trade on a Thursday in 2017 when the highway was glazed smooth for max-market performance velocity. This cognitive hiccup deep in my brain makes me predisposed to recall and be seduced by incidents I’ve observed in the recent past.

The imprint of recent events falsely forms the foundation of everything that will occur in the present and future (at least in my head). Recency bias is a mental master and we are slaves to it. It’s human. It’s the habit we can’t break (hey, it works for me). In my opinion, recency bias is what separates traders from long-term owners of risk assets.

When you allow volatility to deviate you from rules or a process of investing, think about Silly Putty. Remember Silly Putty? Your brain on recency bias operates much like this clammy mysterious goo.

Consider the market conditions. The brain attaches to recent news, preconceived notions or the financial pundit commentary comic-of-the-day and believes these conditions will not change. To sidestep this bias, at Clarity and RIA we adhere to rules, a process to add or subtract portfolio positions.

Unfortunately, rules do not prevent market losses. Rules are there to manage risk in long-term portfolio allocations.

Losses are to be minimized but if you’re in the stock market you’re gonna experience losses. They are inevitable. It’s what you do (or don’t do), in the face of those losses that define you. And if you’re making those decisions based on imprinting or Silly Putty thinking, you are not cognitively equipped to own stocks.

Hindsight Bias

When you question your adviser’s every trade or the big ones you personally missed, you’re suffering from hindsight bias. Hindsight bias is deception. You falsely believe the actual outcome had to be the only outcome when in fact an infinite number of outcomes had as equal a chance. It’s the ego run amok. An overestimation of an ability to predict the future.

The market in the short-term is full of surprises. A financial partner doesn’t possess a crystal ball. For example, to keep my own hindsight bias under control, I never take credit for an investment that works gainfully for a client. The market must be respected. Investors, pros or not, must remain humble and in infinite awe of Mr. Market. A winning trade in the short term is luck or good timing. Nothing more.

With that being said, stock investing is difficult. Unlike the pervasive, cancerous dogma communicated by money managers like Ken Fisher who boldly states that in the long-run, stocks are safer than cash, stocks are not less risky the longer you hold them. Unfortunately, academic research that contradicts the Wall Street machine rarely filters down to retail investors. One such analysis is entitled “On The Risk Of Stocks In The Long Run,” by prolific author Zvi Bodie, the Norman and Adele Barron Professor of Management at Boston University.

I had a once-in-a-lifetime opportunity to break bread with Dr. Bodie recently in Nashville and spend quality time picking his brain. I’m grateful for his thoughts. He expressed lightheartedly how his retail books don’t get much attention although the textbook Financial Economics co-written with Robert C. Merton and David L. Cleeton is the one of choice in many university programs.

In a joking manner, he calls Wharton School professor and author of the seminal tome “Stocks for the Long Run,” Jeremy Siegel his “nemesis.” He mentions his goal is to help “everyday” people invest, understand personal finance and be wary of the financial industry’s entrenched stories about long-term stock performance. He’s a man after my own heart. He’ll be interviewed on the Real Investment Hour in early June.

In the study, he busts the conventional wisdom that riskiness of stocks diminishes with the length of one’s time horizon. The basis of Wall Street’s counter-argument is the observation that the longer the time horizon, the smaller the probability of a shortfall. Therefore, stocks are less risky the longer they’re held. In Ken Fisher’s opinion, stocks are less risky than the risk-free rate of interest (or cash) in the long run. Well, then it should be plausible for the cost of insuring against earning less than the risk-free rate of interest to decline as the length of the investment horizon increases.

Dr. Bodie contends the probability of a shortfall is a flawed measure of risk because it completely ignores how large the potential shortfall might be. Sound familiar? It should. We write of this dilemma frequently here on the blog. Using the probability of a shortfall as the measure of risk, no distinction is made between a loss of 20% or a loss of 99%.

If it were true that stocks are less risky in the long run, it should portend to a lower cost to insure against that risk the longer the holding period. The opposite is true. Dr. Bodie uses modern option pricing methodology i.e., put options to validate the truth.

Using a simplified form of the Black-Scholes formula, he outlines how the cost of insurance rises with time. For a one-year horizon, the cost is 8% of the investment. For a 10-year horizon it is 25%, for a 50-year time frame, the cost is 52%.

As the length of horizon increases without limit, the cost of insuring against loss approaches 100% of the investment. The longer you hold stocks the greater a chance of encountering tail risk. That’s the bottom line (or your bottom is eventually on the line).

Short-term, emotions can destroy portfolios; long term, it’s the ever-present possibility of tail risks or “Black Swans.” I know. Tail risks like market bubbles and financial crises don’t come along often. However, only one is required to blow financial plans out of the water.

An investor (if he or she decides to take on the responsibility), must follow rules to manage risk of long-term positions that include taking profits or an outright reduction to stock allocations. It’s never an “all-or-none” premise. Those who wholesale enter and exit markets based on “gut” feelings or are convinced the stocks have reached a top or bottom and act upon those convictions are best to avoid the stock market altogether.

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”  – Charles Mackay, Extraordinary Popular Delusions and The Madness of Crowds

The Bull Market in Complacency has resurfaced. Reject it and consider derisking, now.

I find myself, after a period of being long of equities, back in the bearish minority again – and I moved back into a net short exposure late in the day on Friday.

And, I observe, that many of the same investors who were bearish at the February lows are now bullish at the recent mid-May highs.

Fear of a large drawdown seems to have been all but eliminated in the eyes and thoughts of market participants as the Bull Market of Complacency seems to have reappeared.

2017 was a year of hope and anticipation (in large measure because of the optimism surrounding lower corporate tax rates) as price earnings ratios expanded by almost three multiple points. Interest rates were still suppressed and volatility was at historic lows. Last year was one in which Wall Street recovered and prospered better than Main Street.

In 2018, markets are more or less unchanged as the reality of instability and inconsistency of policy and economic uncertainty have reemerged. This year, unlike last year, Main Street has thrived and Wall Street has stagnated. And a new regime of volatility has emerged, coincident with a general rise in interest rates – particularly in maturities of ten years or less.

Let me summarize my top ten, current market concerns:

1. A tug of war between fiscal expansion and monetary contraction seems likely to be won by Central Bankers in the year ahead. History proves that the monetary typically wins out of the fiscal particularly since there are legitimate concerns whether the tax cuts will “trickle down” to the consumer. Moreover, we are at a tipping point towards higher rates (in the U.S. and elsewhere) after nine years of interest rate repression in which the accumulation of debt in both the private and public sectors are at record levels. Not only has the Fed turned, but each day gets us a day closer to the end of ECB QE. (The Italian 2 year yield went from -.265% to -.10% in one day). So, risk happens fast when a massive bubble has been created.

2. There is a growing ambiguity in domestic and non US high frequency economic data. Citigroup’s Global Surprise Economic Index has turned down and Citigroup’s EU Surprise Index is at a two year low. U.S. data (ISM, PMI and others) have often failed to meet expectations. Reports are that retail started the quarter weakly and, this morning, retailer Home Depot (HD) missed consensus comp views.

A flattening yield curve is endorsing the notion of late cycle economic growth. And, according to my calculus, the yield on the ten year U.S. note (given current inflation breakevens) implies U.S. Real GDP growth below +1.70%/year.

3 . The rise in global interest rates may continue – providing a reduced value to equities (on a discounted dividend model) and serving as a governor to global economic and US corporate profit growth. C.I.T.A. (“cash is the alternative) is getting busy while T.I.N.A. (“there is no alternative”) seems to be without a date to the prom this spring.

For the first time in 12 years the yield on the three month U.S. Treasury note now exceeds the dividend yield of the S&P Index:

Source: Zero Hedge

Meanwhile, the six month Treasury bill yields over 2% (2.09% this morning) and the two year Treasury bill’s yield is over 2.55%.

Inflation, too, is likely at a multi-year infection point.

I continue to view June/July 2016 as The Generational Low In Yields. Non US yields are at even more unjustified levels and will lead to large mark to market losses over the next few years – imperiling retail and institutional investors and banks in Europe that have leveraged positions in over-priced fixed income. (Just look at Argentina, a country that has defaulted on its sovereign debt on eight separate occasions – most recently in 2001. As a measure of lameness, investors scooped up 100-year Argentina bonds last June).

Bonds are in year two of a major Bear Market – fixed income (of all types) are overvalued (and I remain short bonds).

4 . The Orange Swan represents clear risks for the equity markets and for the real economy. As I have written in my Diary and stated on Fox News yesterday afternoon, hastily crafted tweets by the White House are dangerous in a flat, networked and interconnected world. The inconsistency of policy (which seems to be designed and conflated with politics as we approach the mid-term elections) seems to be weighing on business fixed investment plans which, I have learned through many of my corporate contacts, are being deferred (and even derailed) in the face of uncertainty and lack of orthodoxy and inconsistency of the delivering policy by “The Supreme Tweeter” who resides in Washington, D.C.

5 . Investor sentiment has grown more optimistic and fears of a large drop in stocks has been all but disappeared.

6 . Technicals and resistance points mark a short term threat to stocks. Not only has the market risen for eight consecutive days but an important Fibonacci point has been been met (from the January highs). As well, the S&P Index is now at the 2725-2750 resistance level – the upper end of the recent trading range. Yesterday, the lynx-eyed David Rosenberg remarked, on CNBC, that on breadth and volume the rally has been less powerful than recent rallies.

7 . The dominance of passive and price momentum based strategies are exaggerating short term market runs – contributing to a false sense of investor security. Though our investment world exists as buyers live buyer and sellers live lower, beware of a change in momentum that can turn the market’s tide.

8 . After nearly a decade, both the market advance and a sustained period of domestic economic growth have grown long in the tooth.

9. Though market valuations are high they are not too stretched – but other classical market metrics (equity capitalization to GDP, price to book, price to sales) are very stretched.

10. A new regime of volatility, seen recently, might signal a change in market complexion.


In this past weekend’s newsletter, I updated our previous analysis for the breakout of the consolidation process which has been dragging on for the last couple of months. To wit:

“From a bullish perspective there are several points to consider:

  1. The short-term ‘sell signal’ was quickly reversed with the breakout of the consolidation range.
  2. The break above the cluster of resistance (75 and 100-dma and closing high downtrend line) clears the way for an advance back to initial resistance at 2780.
  3. On an intermediate-term basis the “price compression” gives the market enough energy for a further advance. 

With the market close on Friday, we do indeed have a confirmed breakout of the recent consolidation process. Therefore, as stated previously, we reallocated some of our cash back into the equity side of our portfolios.”

It’s now time to make our next set of “guesstimates.”

With the market back to very short-term “overbought” territory, a bit of a pause is likely in order. We currently suspect, with complacency and bullish optimism quickly returning, a further short-term advance towards 2780 is likely.

  • Pathway #1 suggests a break above the next resistance level will quickly put January highs back in view. (20% probability)
  • Pathway #2a shows a rally to resistance, with a pullback to support at the 100-dma, which allows the market to work off some of the short-term overbought condition before making a push higher. (30% probability)
  • Pathway #2b suggests the market continues a consolidation process into the summer building a more protracted “pennant” formation. (30% probability)
  • Pathway #3 fails support at the 100-dma and retests the 200-dma. (20% probability)

Again, these are just “guesses” out of a multitude of potential variations in the future. The reality is that no one knows for sure where the market is heading next. These “pathways” are simply an “educated guess” upon which we can begin to make some portfolio management decisions related to allocations, risk controls, cash levels and positioning.

But while the short-term backdrop is bullish, there is also a rising probability this could be a “trap.” 

“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.
  • 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 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 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.”

In 2015-2016 we saw a similar rally off of support lows which failed and ultimately set new lows before central banks global sprung into action to inject liquidity. As I have stated previously, had it not been for those globally coordinated interventions, it is quite likely the market, and the economy, would have experienced a much deeper corrective process.

While the markets have indeed gone through a correction over the last couple of months there is no evidence as of yet that central banks are on the verge of ramping up liquidity. Furthermore, the “synchronized global economic growth” cycle has begun to show “globally synchronized weakness.” This is particularly the case in the U.S. as the boost from the slate of natural disasters last year is fading.

More importantly, on a longer-term basis, the recent corrective process is the same as what has been witnessed during previous market topping processes.

In each previous case, the market experienced a parabolic advance to the initial peak. A correction ensued which was dismissed by the mainstream media, and investors alike, as just a “pause that refreshes.” They were seemingly proved correct as the markets rebounded shortly thereafter and even set all-time highs. Investors, complacent in the belief that “this time was different” (1999 – new paradigm, 2007 – Goldilocks economy), continued to hold out hopes the bull market was set to continue.

That was a mistake.

The difference, in both previous cases, was the Federal Reserve had shifted its stance from accommodative monetary policy, to restrictive, by increasing interest rates to combat the fears of “inflation” and a potential for the economy to “overheat.”

As stated in our list of concerns above, the Federal Reserve remains our biggest “flashpoint” for the continuation of the “bull market.” 

Furthermore, the surge in stock buybacks to pay for “stock option grants” is also worrisome. While such activity will boost the markets in the short-term, there is a longer-term negative consequence. As noted by Barron’s:

“Standard & Poor’s 500 companies are on track to announce $650 billion worth of buybacks this year, according to a Goldman Sachs estimate, smashing the previous record of $589 billion set in 2007.”

But as noted by Societe’ General (via Zerohedge) those buybacks may boost stock prices temporarily but are not likely to show up in the economy longer-term.

“We recognize that calculating the stock option effect is an educated guess as we look at the amount repurchased versus the actual reduction in the share count and assume the difference is the option issuance effect (though issuance can be for other reasons).

It looks like the bulk of last quarter’s repurchases went on stock options (aka wages). But looking at the table below it appears as if buybacks have indeed gone to pay higher wages, but we suspect not in the way policymakers hand in mind.”

Such is a critical point considering that ultimately revenues are driven by economic growth of which 70% is derived from consumption. Boosting wages for the top 20% of wage earners, is not likely to lead to stronger rates of economic growth.

With year-over-year earnings comparisons set to fall beginning in the third quarter of this year, another support of the bull market thesis is being removed.

The biggest challenge of portfolio management is weaving short-term price dynamics (which is solely market psychology) into a long-term fundamentally and economically driven investment thesis.

Yes, with the breakout of the consolidation process last week, we did indeed add exposure to our portfolios as our investment discipline dictates. But such does not mean that we have dismissed our assessment of the risks that currently prevail.

There is a rising possibility the current rally is a “bull trap” rather than the start of a “new leg” in this aging bull market.

This is why we still maintain slightly higher levels of cash holdings in our accounts, remain focused on quality and liquidity, and keep very tight risk controls in place.

Is it possible that stocks aren’t overpriced? Financial adviser Josh Brown raises the possibility, arguing that earnings can grow into their prices. After all, Amazon, Netflix, and Nvidia have seemed overpriced to investors for a long time, but their economic performance keeps improving. As Brown puts it, with all of these stocks in the recent past, “[t]he fundamental stories grew up to justify the valuations investors had already been paying (Brown’s emphasis).”

And this can also happen to entire markets. Five years ago, the market’s cyclically adjusted P/E ratio (CAPE or Shiller PE) was higher than it had been in 87% of all readings up until that point. But the stock market has been up 90% since then. “No one could have known that the fundamentals would arrive to back up the elevated valuations for stocks eventually,” according to Brown.

This last statement is odd. In May of 2013, the S&P 500 carried a CAPE of 23. Now its CAPE is 31. It’s not clear from this simple valuation metric that stock earnings have grown into their new, elevated prices. Past ten-years’ worth of earnings ending in 2013 were $78, according to Robert Shiller’s data. For the most recent ten-year period, they are $84. Ironically, one could make the argument that earnings have grown into the 2013 price five years later, but not the 2018 price. It we apply the May 2013 price to the past decade’s worth of earnings ending today, we get a CAPE of around 21. That’s much more reasonable than the current one of 31.

In fact, if we agree that the long-term historical average CAPE of nearly 17 is outdated, and that the new average should be around 20 or 22, then the 2013 price of the market relative to the past decade’s worth of earnings ending today is roughly the correct valuation. That also means all the price advances the market has made since 2013 do not reflect underlying economic reality or earnings power value of the market. In other words, earnings have increased, but stock prices have increased much more so that the market should be trading at 2013 prices given the past decade’s worth of earnings.

Brown’s point, of course, is that the earnings growth of the past decade can repeat over the following decade. But that also means that for stocks to deliver robust returns, the current 31 CAPE valuation must reappear 10 years from now. That’s possible, but investors and advisers must contemplate how they would like to bet and what they must tell clients if they are behaving as fiduciaries.

It’s possible that we could wake up to a 31 CAPE in a decade, and that U.S. stocks will have delivered 7% or so nominal returns (2% dividend yield plus 4%-5% EPS growth). It’s also possible that earnings-per-share can increase at a greater clip than they have historically. Nobody should say those things are simply impossible. But if you are managing your own money, or advising others in a fiduciary capacity (which means you must treat their money with all the care you do your own), how reasonable is it to expect that as what forecasters might call a “base case?” At best, assuming we’ll all wake up to a 31 CAPE in a decade must be a very rosy, low-probability scenario.

There’s an irony to Brown warning against those who carry on about backward looking valuation metrics. One of the most well-known observations of behavioral finance is that human beings can be seduced by recent patterns, including recent securities price movements. We tend to assume, without any evidence other than the recent pattern, that price trends will continue. Everyone will have to decide for themselves whether deriving encouragement from a 90% stock price move without a commensurate earnings increase, as Brown does, reflects proper attention to simple arithmetic or our susceptibility to extrapolate recent stock price movements and returns into the future.

In my last U.S. stock market update in April, I showed that the major indices were still in a confirmed uptrend despite the volatility experienced in the first quarter of this year. Despite a large amount of seemingly bearish and threatening news – from tech scandals to geopolitics – the market’s rally has continued over the past several weeks. In this market update, I will show the key levels that traders should watch to help determine if the U.S. stock market can break out to new highs or if another wave of weakness is ahead.

Last week, the SP500 experienced a breakout above its downtrend line that started in late-January, which is a bullish sign as long as this breakout remains intact. The 2,800 resistance is the next hurdle that the SP500 needs to clear. If the SP500 can successfully clear 2,800, the 2,872-2,900 resistance zone (the January 2018 highs) is the final level that needs to be broken in order for the next phase of the bull market to begin. If the SP500’s recent breakout fails and leads to another wave of weakness, however, the two year-old uptrend line and the 2,532 to 2,550 zone (the 2018 lows) are the key supports to keep an eye on.

SP500 Weekly Chart

Like the SP500, the Dow Jones Industrial Average broke above its downtrend line last week. 25,800 and 26,600 (the January high) are the next major resistance levels that the index needs to break above in order for the bull market to continue. If last week’s breakout turns out to be a dud, however, the uptrend lines and the 23,300 to 23,500 support zone (the 2018 lows) should be watched carefully.

Dow Weekly Chart

The tech-heavy Nasdaq Composite Index is approaching its major resistance levels at 7,500 and 7,650. These levels need to be broken in a decisive manner in order to confirm the next leg of the bull market. If the Nasdaq fails to break above these levels and another wave of weakness ensues, the two year-old uptrend line and the 6,600 and 6,800 levels are the key supports to pay attention to.

Nasdaq Weekly Chart

The small cap Russell 2000 has held up quite well despite the volatility in Q1 2018. The index has remained within its bullish channel pattern, which means that the uptrend is still intact. The index needs to clear its 1,600 to 1,620 resistance zone in a convincing manner in order to give another bullish signal. In the event of another wave of weakness, the bottom of the two year-old channel pattern and the 1,436 to 1,482 zone are the most important support levels to watch.

Russell 2000 Weekly

For now, traders should watch last week’s breakout to see if it has staying power. Many nascent breakouts of the past couple months have failed and led to subsequent bearish moves. In order to be extra sure that the market is in the clear this time around, traders may want to wait for the indices to break above their next overhead resistance levels for additional confirmation.

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A couple of weeks ago, I discussed the coming “Pension Crisis.”  The important point made was the unrealistic return assumptions used by pension managers in order to reduce the contribution (savings) requirement by their members.

“However, the reason assumptions remain high is simple. If these rates were lowered 1–2 percentage points, the required pension contributions from salaries, or via taxation, would increase dramatically. For each point reduction in the assumed rate of return would require roughly a 10% increase in contributions.

For example, if a pension program reduced its investment return rate assumption from 8% to 7%, a person contributing $100 per month to their pension would be required to contribute $110. Since, for many plan participants, particularly unionized workers, increases in contributions are a hard thing to obtain. Therefore, pension managers are pushed to sustain better-than-market return assumptions which requires them to take on more risk.

But therein lies the problem.

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

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

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

“Suze Orman explained that if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement.” 

Ms. Orman’s statement is correct. It just requires the 25-year old to achieve an 11.25% annual rate of return (adjusting for inflation) every single year for the next 40-years. (That’s not very realistic)

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating future returns, future retirement values are artificially inflated which reduces the required saving amounts need by individuals today. Such also explains why 8-out-of-10 American’s are woefully underfunded for retirement currently.

The Real Math

As shown in the long-term, total return, inflation-adjusted chart of the S&P 5oo below, the difference between actual and compounded (7% average annual rate) returns are two very different things. The market does NOT return an AVERAGE rate each year, and one negative return year compounds the future shortfall.

When imputing volatility into returns, the differential between what individuals are promised (and this is a huge flaw in financial planning) and what actually happens to their money is substantial over the accumulation phase of individuals. Furthermore, most of the average return calculations are based on more than 100-years of data. So, it is quite likely YOU DIED long before you realizing the long-term average rate of return.

Too Simple

I get it.

I am an average American too. I don’t want to be told what I can, and can not, spend or do today because I have a required savings goal to meet future needs. After all, that is YEARS into the future and I have plenty of time to get caught up. The words “budget” and “saving” might as well be lumped into the “4-letter word” category.

We all want a simple answer. If you do “X” then “Y” will be the outcome.

See, simple. It is why our world is being reduced to sound bytes and 140-character compositions. Financial, retirement and investment planning are no different. Just give me an “optimistic” answer.

For example, as shown in the chart below courtesy of Michael Kitces, the common assumptions made in retirement planning are simple. The chart assumes a retiree has a $1,000,000 balanced portfolio and is planning for a 30-year retirement. It assumes 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 adjusts each subsequent year for inflation, spending down the retirement account balance by the end of the 30th year.

The next chart takes the average of all periods above (black line) and uses those returns to calculate the spend down rate in retirement assuming similar outcomes for the markets over the next 30-years. As above, I have calculated the spend down structure to include inflation and taxation on an initial $1 million portfolio.

As you can see, under this scenario, due to the skew of 1934 and front-loaded returns, the retiree would not have run out of money over the subsequent 30-year period. However, once the impact of inflation and taxes are included, the outcome becomes substantially worse.

The chart below shows the same as above but with the 1934 period excluded. The outcome, not surprisingly, is not substantially different with the exception of the retiree running out of money one-year short of their goal rather than leaving an excess to heirs.

Important Considerations For Retiree Portfolios

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached, or will reach, retirement age by 2030. Unfortunately, the majority of these individuals are woefully under saved for retirement and are “hoping” for compounded annual rates of return to bail them out.

It isn’t going to happen and the next “bear market” will wipe most of them out permanently.

The analysis above reveals the important points individuals should start giving serious consideration to:

  • Lowering expectations for future returns and withdrawal rates.
  • With the potential for front-loaded returns going forward unlikely, increase savings rates.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered, it’s better to overestimate.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • Future income planning must be done carefully with default risk carefully considered.
  • Most importantly, drop compounded annual rates of return for plans using variable rates of future returns.

In this Central Bank driven world, with debt levels rising globally, interest rates rising, economic growth weak with a potential for a recession, and valuations high, the uncertainty of a retirement future has risen markedly. This lends itself to the problem of individuals having to spend a bulk of their “retirement” continuing to work.

Of course, this could be why there are currently more individuals over the age of 65 still in the workforce than ever before in history.

Oh, and there also the tiny fact the majority of American’s don’t have $1 million saved for retirement. For most it is less than $250,000.

But that is an entirely different problem.

“Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.” – Sun Tzu: The Art Of War

The biggest mistake investors make over the long-term is investing without a strategy. The point that Sun Tzu was making, as it relates to investing, is that having a strategy, such as buying and holding stocks, will indeed work. However, doing so without “tactics,” or a methodology to control risk and reduce emotional mistakes, will substantially lengthen the “route to victory.” In investing, “time” is both our most precious commodity and our biggest enemy.

In the mainstream push to promote the “buy and hold” myth, the problem of “time” in the equation is often overlooked. The chart box below shows a $1000 investment from either a period of low or high valuations. It assumes a real, total return holding period until death assuming the individual starts saving at 35-years of age using historical life-expectancy tables. No withdrawals were ever made. (Note: the periods from 1983 forward are still running as the investable-life expectancy span is 40-plus years.)

The gold sloping line is the “promise” of 6% annualized compound returns. The blue line is what actually happened with invested capital from 35 years of age until death, with the bar chart at the bottom of each period showing the surplus or shortfall of the goal of 6% annualized returns.

In every single case, at the point of death, the invested capital is short of the promised goal. The difference between “close” to goal, and not, was the starting valuation level when investments were made.

Back to Sun Tzu.

Strategy is the overarching premise the derives your investment selections. Selecting the right strategy requires some thought about your mental state, aversion or acceptance of risk, and most importantly your “duration” or “time horizon.”

Warren Buffett has a great “strategy” for investing. He buys great companies at “bargain” prices. However, his time horizon is 100-years. You can not invest like Mr. Buffett because you most likely don’t have 100-years to capture the expected return on investment nor do you have $1 billion to buy a company with.

While the example is a bit extreme, the premise is valid. Many investors may “believe” they are long-term investors, but in reality they lack the time frame to achieve the long-term expected returns. The problem becomes the inability for the portfolio to withstand a sharp drawdown in price, and recover, within the actual time horizon they have to meet retirement needs.

Tactics are the methods of controlling risk, taking advantage of short-term opportunities and mitigation of loss. Tactics alone, more commonly known as “day trading,” will end badly for most due to emotional behaviors. Tactics, when married with a strategy, will reduce the risk of drawdowns and increase the probability of investment success over a given time period.

This is what we have been addressing over the last couple of months.

As portfolio managers, we are “long-term” investors by nature. We have positions in our portfolios which are “core”to our investment “strategy.” However, our “tactical” approach to risk management, such as stop-prices, cash levels, and hedging, all are part of the “controls” used to mitigate loss and create returns within the “duration” of client’s objectives.

While the “break out” of the two-month long consolidation yesterday is certainly encouraging, longer-term “sell signals” remain firmly intact keeping our cash levels higher than normal. We are “tactically” looking to take advantage of the breakout by modestly increasing equity exposure as needed, but we do so with controls in place in case something goes wrong.

We are still within a very late-stage bull market with rising stresses from slowing credit growth, elevated valuations, increasing inflationary pressures without offsetting wage growth and geopolitical stresses. This isn’t a “battle” to charge head first into without having a carefully thought out strategy with tactics to back it up.

“Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win”– Sun Tzu: Art Of War

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

Economy & Fed


Most Read On RIA

Research / Interesting Reads

“History repeats itself all the time on Wall Street” ― Edwin Lefevre

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.”

The stock market is a market of stocks, or at least it was prior to the ascendance of indexing.  The idea is that certain stocks, or sectors, act as bellwethers for the overall stock market is well-known.

The S&P 500 index (SPX) is composed of eleven economic sectors, among which are technology, utilities, energy, health care, financials, and industrials.  All eleven sectors have a positive correlation with SPX, meaning that they generally go up or down together with the overall market.   At one end of the correlation scale, the utilities sector has the lowest correlation to SPX, at .26 over the past 30 years (on a scale between 0 and 1).  This means that only 26% of the price of the utility index can be explained by the price of the SPX. One explanation for the low correlation is that utilities are regulated entities with high dividends, so the stocks behave more like bonds than stocks.  Energy stocks also have a relatively low correlation of .37, possibly because extremely high energy prices, which are good for energy companies, are bad for the economy and hence the broad stock market.

The industrial sector has the highest correlation with the SPX over the past 30 years, at .86.  Industrial stocks are ones such as Boeing, GE, 3M, and Caterpillar, which produce large capital goods that are used in the transportation, mining, and manufacturing sectors of the economy.  One explanation for the high correlation between the industrial sector and SPX is that if business managers are confident enough to invest capital on large purchases, they must see a relatively bright economic future.  In contrast, if the outlook is uncertain or poor, business managers tend to suspend or pull back on capital expenditures.

Because of the high correlation between the industrial sector and SPX, it is important for investors to examine nuances within the industrial sector for clues about the economy and the stock market.  XLI is a popular industrial sector ETF, which contains a mixture of capital goods and transportation stocks.  The top 10 holdings comprise 45% of the portfolio, with Boeing as the largest holding, at 8%.  XLI also has significant holdings of transportation stocks such as FedEx and Union Pacific.

The chart of XLI’s performance relative to SPX (which we will name XLI/SPX) is shown below.  XLI has performed similarly to, but not identical to, SPX, as suggested by the high correlation between industrial stocks and SPX.  Over the past five years, SPX has risen 62%.  Over that same time span, XLI has outperformed SPX by an additional 16%, as seen where the blue line ends on the right margin.  Over the past five years, there are several interesting points when XLI/SPX peaked, troughed, or moved sharply.   Those points are marked with ovals.

From mid-2013 to mid-2014, industrial stocks were booming along with the increased production of US shale oil, which required machinery to extract from the fields, and rail/truck to transport to storage and pipeline hubs.  However, the peak in XLI/SPX in June 2014 foreshadowed the eventual transition from boom to bust.  As oil fell from $110 in late 2014 to $26 per barrel in early 2016, industrial stocks performed relatively poorly.

In February 2016, the world’s top central bankers met in Shanghai to discuss how the drastic change in the price of oil was inflicting instability on global economies and financial markets.  Their response was the so-called Shanghai Accord.  Among other policy responses, China agreed to give a booster shot to its spectacular (for better and worse) credit creation machine.  Industrial stocks got the memo that China would build more infrastructure (and ghost cities), so XLI/SPX spurted 6% in a short period of time.

The next surge in XLI/SPX occurred in November 2016, when XLI outperformed SPX by 9%. The reason was the surprise election of Donald Trump, who had proposed trillion-dollar infrastructure proposals during his campaign.  More broadly, a Republican sweep of the US government appears to have been seen as friendly to businesses and the military budget.

The final surge in XLI/SPX occurred in late 2018 as expectations rose that a tax cut/reform bill would pass.  XLI increased 6% relative to SPX as a result.  Traditional Keynesian economic theory deems deficit spending to be a booster shot to GDP, which should increase spending of all forms.  In addition, the bill mandated that capital expenditures could be expensed in their entirety in the first year.   Normal tax accounting would require the expenditures written off over 3 or 5 years, so the new mandate effectively lowers the after-tax cost of companies who buy long-lived assets such as machines and vehicles.

Most recently, however, XLI/SPX fell 6%, unwinding the spike that occurred in late 2017.  Why would that occur?  To help answer that question, we compare the XLI/SPX price chart to underlying reality.  In this case, the most relevant economic data for industrial stocks is New Orders for Capital Goods Excluding Aircraft, as reported by the Census Bureau.

Looking at the green arrows, we can see that relative performance of XLI leads changes in orders for capital goods.  For example, the 2014 peak in XLI/SPX occurred prior to the peak in new orders.  The trough in XLI/SPX occurred in Q3 2015, which was prior to the trough in orders in early 2016.  The surge in XLI/SPX in November 2016 occurred prior to the mid-2017 spike in new orders.  In summary, in mid-2014, early 2016, and again in late 2016, the stock market anticipated correctly a change in the underlying economic data.  That is, a change in XLI/SPX preceded either a change in trend or a change in the slope of the trend for capital goods orders.

However, the late-2017 spike in XLI/SPX has so far not been followed by a spike in new orders, as indicated by the red arrow.  It is too soon to draw a definitive conclusion, but the drop in XLI/SPX over the past few weeks could signify that investors are giving up on a new surge in new orders for capital goods.  It is also possible that the decline in XLI/SPX is the beginning of a sustained period of underperformance.  If that occurred, XLI/SPX would confirm the message of a flattening yield curve, increasing the probability of a recession in 2018-19, as discussed in detail in The Next Recession Is Closer Than You Think


  • The industrial sector, as represented by the XLI ETF, is the most highly correlated sector with SPX (.86 over the past 30 years). It appears that whatever is good/bad for the industrial sector is closely aligned with what is good/bad for SPX, which itself is closely aligned with what is good/bad for the economy.
  • The XLI/SPX ratio measures the performance of industrial stocks relative the S&P 500 index. Over the past five years, changes in XLI/SPX have been a leading indicator, meaning it foreshadowed changes in trends for new orders in the capital goods industry.
  • The most recent spike in XLI/SPX occurred in late 2017 as the tax cut/reform bill was passed, apparently in anticipation that tax changes would spur a capital spending boom.
  • However, new orders for capital goods have not boomed; they have remained flat since Q3 2017. The recent decline in XLI/SPX could be a signal that the boom isn’t going to happen.
  • Persistent weakness in XLI/SPX, if it continues, would confirm the message of the flattening yield curve, which is strongly associated with economic weakness, increasing the probability of a recession. A recession in 2018-19 would clearly not be expected by the Fed, economists, and politicians, who are forecasting real GDP growth of 2-3%.

There’s always something else to worry about. For a while now, investors we admire such as Grantham, Mayo, van Oterloo (GMO) and Research Affiliates have been touting the cheapness of foreign stocks, especially emerging markets stocks. This past August James Montier of GMO argued that an allocation to the S&P 500 Index, given its valuation then, counted more as speculation than as an investment. Also, in November, Research Affiliates published a paper questioning whether anyone needed U.S. stock exposure.

Valuations of foreign stocks are indeed more compelling than those of their U.S. counterparts. But U.S. investors must account for other things when venturing abroad, including currency moves. When U.S. investors own a foreign stock that trades on a U.S. exchange, they receive two returns, the return of the stock in its local currency and the movement of the local currency relative to the U.S. dollar. In other words, U.S. investors take on foreign currency exposure when they own foreign stocks. Lately that has provided some pain as the dollar has surged thanks to rising interest rates. From the lows of this year in February, the U.S. dollar has surged more than 4% against a basket of foreign currencies.

And that means investors in foreign stock have suffered, though those stocks have not necessarily performed badly in their local currencies. For example, the MSCI EM Index has dropped 1.72% and 3.97% over the past month-to-date and three month periods, respectively, through May 9, 2018 when translated into dollar terms – in other words, for ordinary U.S. investors without a currency hedge. But in local currency, over the same two time periods, the same index has dropped only 0.73% and 1.46%, respectively.

In the realm of developed markets, the MSCI EAFE Index has delivered a month-to-date and three-month return through May 9, 2018 of -0.07% and 0.37%, respectively, when translated to the dollar. But it has delivered 1.10% and 3.29%, respectively, to investors with a hedge, thanks to the strengthening dollar and weakening foreign currencies.

Currency moves are hard to time, and that means most investors like to stay unhedged or hedged at all times. Is there one of these that’s better? A paper by asset manager AQR argues that, over time, investors haven’t gotten paid for the volatility they’ve incurred from foreign currency exposure. The lesson for long-term U.S. Investors is to hedge their currency exposure. That makes some sense because while currencies move up and down against each other over long periods of time, those moves tend to cancel each other out. There’s no long term gain to be captured from a currency bet.

Now, despite the dollar’s run lately, the greenback looks relatively high versus a foreign basket of currencies over a longer period of time. In that case, foreign currency exposure might actually help. So if investors are expecting the dollar to fall over a longer period of time, they can hedge some prearranged percentage of their foreign stock portfolio.

Some instruments with which investors can gain hedged currency exposure to foreign stocks are the Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) and the xTrackers MSCI Emerging Markets Hedged Equity ETF (DBEM). The first gains exposure to the MSCI EAFE with a currency hedge, and the second gains exposure to the MSCI EM Index with a currency hedge.

May I Please Have Some Yield?

Apart from the esoteric realm of currency hedging, rising rates have also caused rates to, well, rise on short-term debt funds. And that can be a boon to investors – especially those with a penchant to ride out expensive markets with at least some of their money in cash. PIMCO’s Enhanced Short Maturity Active ETF (MINT) might be a decent choice for safety with some yield. It owns high quality short-term debt instruments (Effective Maturity – 0.61 years), including both sovereign and corporate debt, and its current yield is 2.18%. Not all the instruments are from the developed world, and the fund can take a bit more risk than the average money market fund. But the fund doesn’t use options, futures, or swaps and discloses its holdings on a daily basis.

This article was co-authored by J. Brett Freeze of Global Technical Analysis and Michael Lebowitz

Monetary Velocity, an oft-misunderstood metric that quantifies the pace at which money is spent, has recently shown signs of rising after trending lower for the better part of the last decade. Since increasing velocity is frequently associated with inflation, it comes as no surprise the Federal Reserve (Fed) has upped their vigilance towards inflation. While one would think higher interest rates and a reduced balance sheet both currently being employed by the Fed, would hamper inflation, there exists a well-known financial identity that argues otherwise.

In this article, we closely examine the Monetary Exchange Equation with a focus on monetary velocity.  Decomposing this simple formula and extracting the inflation identity shows precisely how the level of economic activity and the Fed’s monetary actions come together to affect price levels. This analysis demonstrates that the broadly held and seemingly logical conclusions are incorrect.

Might it be possible the Fed is stoking the embers of inflation while the world thinks they are being extinguished?

Monetary Exchange Equation

To understand how the Fed’s commitment to continued interest rate hikes and balance sheet reduction (Quantitative Tightening – QT) affect inflation or deflation, the Monetary Exchange Equation should be analyzed closely.  The equation is not a theory, like most economic frameworks based on assumptions and probabilities. The equation is a mathematical identity, meaning the result will always be true no matter the values of its variables. The monetary exchange equation is as follows:


The equation states that the amount of nominal output purchased during any period is equal to the money spent.  Said differently, the price level (P) times real output (Q) is equal to the monetary base (M) times the rate of turnover or velocity of the monetary base (V). The monetary base – currency plus bank reserves, is the only part of the equation that the Federal Reserve can directly control.  Therefore, we believe to form future price expectations, an analysis of the Monetary Exchange Equation using the forecasted monetary base is imperative.

The Inflation Identity

Through simple algebra, we can alter the Monetary Exchange Equation and solve for prices. Once the formula is rearranged, the change in prices (%P) can be solved for, as shown below. In doing so, what is left is called the Inflation Identity.

%P = %M + %V – %Q

Before moving on, we urge you to study the equation above. The logic of this seemingly modest formula is often misunderstood. It is not until one contemplates how M, V, and Q interact with each other to derive price changes that the power of the formula is fully appreciated. 

Per the inflation identity, the rate of inflation or deflation (%P) is equal to the rate of money growth (%M), plus the change in velocity (%V), less the rate of output growth (%Q).  The word “less” is highlighted because in isolation, assuming no changes in the monetary factors (%M and %V), inflation and economic growth should have a near perfect negative relationship.  In other words, stronger economic growth leads to lower prices and vice versa. While that relationship may seem contradictory, consider that more output increases the supply of goods, therefore all other things being equal, prices should decline. Alternatively, less output results in less supply and higher prices.

It is important to note that the inflation identity solves for the GDP deflator, which is one of the price indices on which the Fed relies heavily. While the equation does not solve for the more popular consumer price index (CPI), the deflator is highly correlated with it. The graph below highlights the perfect (correlation = 1.00) relationship between the deflator and the price identity as well as the durable, but not perfect (correlation = 0.93), relationship of CPI to the deflator and price identity.

Data Courtesy: Federal Reserve

Let us now discuss %M, %V and %Q so we can consider how %P may change in the current environment.

%M – As noted earlier, the change in the monetary base is a direct function of the Fed’s monetary policy actions. To increase or decrease the monetary base the Fed buys and sells securities, typically U.S. Treasuries and more recently Mortgage-Backed Securities (MBS). For example, when they want to increase the money supply, they create (print) money and distribute it via the purchase of securities in the financial markets. Conversely, to reduce the monetary base they sell securities, pulling money back out of the system. The Fed does not set the Fed Funds rate by decree. To target a certain interest rate they use open market transactions to increase or decrease money available in the Fed Funds market.

Beginning in 2008 with Fed Funds already lowered to the zero bound, the Fed, aiming to further increase the money supply, resorted to Quantitative Easing (QE). Through QE, the Fed bought large amounts of Treasuries and MBS from primary dealers on Wall Street. Largely through this action, the monetary base increased from $850 billion to $4.13 trillion between 2008 and 2015.

%V – Velocity is calculated as nominal GDP divided by the monetary base (Q/M). Velocity measures people’s willingness to hold cash or how often cash turns over. Lower velocity means that people are hoarding cash, which usually happens during periods of economic weakness, credit stress, and fear for the going-concern of banking institutions. In contrast, higher velocity tends to result in people avoiding holding cash.  This typically happens during times of economic growth, lack of credit stress, and rising interest rates.  During such periods, the opportunity cost of physically holding cash increases, as cash holders are incentivized by rising interest rates on deposits and/or productive returns on money in other investments.

Unlike the monetary base, velocity is influenced by the Fed through interest rates but not directly controlled by the Fed.  The graph below shows the relationship between the Fed Funds effective rate and velocity.

Data Courtesy: Federal Reserve

The deflation of the Great Depression occurred as credit stress, weak economic growth, and bank failures created an acute demand by the public to hold money. It was deemed safer to stuff your mattress with cash than to trust a bank to hold it for you. The effect was a sharp decline in velocity (%V). When coupled with inadequate growth in the monetary base (%M), the combination overwhelmed the inflationary impact of lower output growth (%Q).  The result of this effect was deflation (%P).

Similar to the Great Depression, velocity dropped precipitously during and coming out of the Great Financial Crisis of 2008.  Determined not to make the same perceived mistake, the Fed under Ben Bernanke increased the monetary base substantially. After cutting Fed Funds to zero and executing three rounds of QE, its balance sheet increased from $800 billion to over $4 trillion as shown below. Partially as a result of these actions, the GDP Deflator never registered a negative year-over-year reading but, and this point is critical, neither did it spike higher as was forecast by critics of QE.

Data Courtesy: Federal Reserve

%Q – Like velocity, the level of economic output (Q) is not directly set by the Fed, but it is influenced by their actions.  The supply and demand for credit, and therefore related economic activity, ebbs and flows in part based on the Fed’s interest rate policy. Historically the Fed will raise rates when economic growth “runs hot,” and inflationary pressures are on the rise. Alternatively, the Fed lowers rates to spur economic activity, incentivize borrowing, and boost inflation (or avoid deflation) when economic conditions are weak or recessionary.

The Fed’s influence on output (Q) varies over time as it is heavily dependent on the composition of economic growth. Currently, with demographics and productivity providing little support for economic growth, debt (be it government, corporate or household) has been a predominant driver of economic activity. In such an environment, one can presume that the level of interest rates plays a bigger role in determining output (%Q) than one in which debt is not the primary driver of growth. This factor helps explain why double-digit interest rates in the 1970’s, although painful, did not crush economic growth yet investors today are fretting over a 3.0% yield on Ten-Year Treasury Notes.

Current Monetary Dynamics

Since 2015 the Fed has increased the Fed Funds rate six times, bringing it from the range of 0.00-0.25% to its current range of 1.50-1.75%. In October of 2017, it began reducing the size of its balance sheet (QT). Thus far, they have allowed their balance sheet to shrink by $128 billion. To be very clear, it is this dynamic of the balance sheet reduction that alters the implications of Fed actions on the expected change in prices. This is a policy action with which our system is entirely unfamiliar.

Given that the Fed appears firmly in favor of continuing to tighten policy for the remainder of 2018 and throughout 2019, we assess how changes in the monetary base (%M) might affect inflation.

As a reminder: %P = %M + %V – %QTherefore, if we can accurately model the change in the monetary base (%M), velocity (%V), and output (%Q), we should be able to form expectations for the rate of price change (%P).

As stated earlier, recent economic growth has largely been driven by debt, both for current economic activity and the debt remaining from prior consumption. Given that higher interest rates disincentivize new borrowing and make servicing existing debt more expensive, the Fed’s actions should limit GDP growth. However, we must recognize that the surge in fiscal stimulus and recent tax reform should provide economic benefits to offset the Fed’s actions. Whether the Fed fully offsets or partially offsets fiscal policy is an important consideration.

This leaves us with velocity (%V). As mentioned, velocity tends to increase as rates increase and the money supply declines. After a long decline in monetary velocity, we are witnessing a change, albeit subtle thus far, alongside tightening monetary policy.

The recent low in velocity was achieved in the third quarter of 2014 at a level of 4.35.  The monetary base peaked in the same quarter at a level of $4.049 trillion. From that point of inflection, the Fed waited five quarters before beginning to raise rates in a slow, incremental fashion.  As expected, once the Fed began raising rates and subsequently reducing its balance sheet, velocity gradually increased further as shown below.

Data Courtesy: Federal Reserve

The scatter plot below highlights the near-perfect correlation (r-squared = 0.9414) between %M and %V.

Data Courtesy: Federal Reserve

While %M and %V are highly correlated, it is important to grasp that the directional changes of %M and %V are not one for one. Note the formula on the graph that solves for %V given a level of %M is as follows:  %V = (-1.0983 * %M) + 6.9543

For instance, a 5% increase in %M would result in a change in velocity of 1.4628 [(-1.0983 * 5 ) + 6.9543 = 1.4628]. Without regard for output growth, the monetary components of the identity would produce a 6.4628% ( 5 + 1.4628 ) increase in prices.  If we assume a 3% output-growth-rate, %P will equal 3.4628%.

The relationship between positive monetary growth and velocity is well known, as it has been the status-quo of inflation-forecasting for the better part of the last 60 years. Interestingly, however, the response of velocity (%V) is vastly different for a declining, as opposed to increasing, monetary base. Using quarterly observations beginning in 1960, the annual change in the monetary base (%M) has been negative in only 21 of 233 quarters (9%).  Given the infrequency of money supply declines, do policymakers, economists, and market participants fully understand the ramifications of a sustained decrease in the monetary base?  

The table below showing how velocity (%V) reacts to changes in %M, assuming constant output (%Q), helps us better understand the relationship between %M and %V.

First, as demonstrated above, a reduction in the monetary base has a much larger magnitude-of-impact on velocity than an increase in the monetary base. Second, there exists what we call a positive “convexity” effect.  At larger increments of percentage changes in the monetary base, the differential between the effects on %P widens. As shown, a 10% increase in %M, assuming a constant %Q, results in %P of 3.5%. However, a 10% decline in M results in a %P of 5.4%, almost 2% more despite an equal change in M. As shown, the “convexity” gap widens further when the money supply changes at greater rates.

Using the Federal Reserve’s guidance on the pace of QT, and assuming a constant %Q, we modeled the change in the monetary base (%M), the change in velocity (%V), and the resulting change in inflation (%P).

The forecast above is somewhat conservative as it is solely based on QT and doesn’t incorporate any further open market operations in the Fed’s quest to increase the Fed Funds rate.

This is where forming inflation expectations gets a little more complicated. If we assume the Fed follows through on their proposed actions, how much can economic growth offset increases in %P? When considering that important question, our primary concern, is that if economic growth weakens as a result of higher interest rates or other factors, the outlook is for higher inflation. In the example above, consider that by May of 2021 prices are expected to rise by 6.7% annually. Now recalculate that number for one percent (%Q) economic growth and %P increases further to 7.9%. On the other hand, assuming 4% economic growth would leave %P in May of 2021 around current levels of 2.7%.

Further Considerations

  • Economic Growth (%Q) – Weaker growth is inflationary, while stronger growth reduces inflation. Will economic growth stumble with higher interest rates? Will tax cuts and fiscal stimulus keep growth humming along despite higher rates?
  • Monetary Base (%M) – Close attention should be paid to the Fed’s pace of QT. Further, we must also gauge the Fed’s intent to continue raising interest rates as this action also reduces %M.
  • Velocity (%V) – Given the liquidity tightening actions the Fed is taking, and will likely continue to take, we should expect that the increase in %V has the potential to shock the markets, first bonds with equities close behind.
  • Federal Reserve – How does their tightening posture change based on the factors above? Will they realize the pitfalls embodied in their policy and change course? Will they make a grave mistake by ramping up their inflation vigilance, not understanding that they are the ones stoking inflation’s embers? Alternatively, might it be possible the Fed is trying to thread the proverbial needle by carefully balancing economic growth with the monetary supply?

The last thing the Fed wants to do is generate higher inflation with reduced economic growth, otherwise known as stagflation. As such, we must pay careful attention to Fed speeches and FOMC meeting minutes to glean a better understanding of how their policy expectations might change.

Stagflation, while historically rare, has proven to be an unfriendly investment climate for stocks and bonds. We think it is critical for investors to take their cues not only from Fed actions and talk, but also from economic growth outlooks and, maybe most important, changes in %V.


Assuming that further reductions in the money supply, higher velocity and weaker output ensues, we can confidently declare that inflationary pressures will increase. For investors, it is extremely important to be cognizant that such a conclusion runs counter to the popular narrative that slower growth and higher interest rates are deflationary.  We do not want to take too much for granted in assuming the economists at the Fed are aware of these dynamics, but the potential for the Fed and investors to be caught by surprise while inflationary pressures rise is palpable. If the Fed were to be stoking inflation under a belief they are taming it, such an event would be a central banking error of historic proportions.

As emphasized above, it is essential to note that the size of their balance sheet is significantly larger than it ever has been. Therefore, sustained reductions in the balance sheet stand to be more significant than anything witnessed in the past. Given the Fed’s tone, alongside the identity and the factors discussed in this article, the potential for sharply increasing velocity is a distinct possibility. We venture that the equity and fixed income markets will not look favorably upon such an event, nor the increasing potential for stagflation.

Perhaps it is time to reconsider the Fed’s actions in this new light.

Are you prepared?

Most important: Are you aware? Aware of the common mishaps and misperceptions that may curtail a happy & healthy retirement?

The Real Investment Advice and Clarity Financial pre-retirement preparation checklist can help identify potential mistakes and navigate a smooth transition to a revitalized and fulfilling retirement.


Do you maintain an exercise regimen that includes activities such as yoga, Pilates, weight training, walking and other types of aerobic activities for at least 30 minutes a day?  Y / N

Leisure-time physical activity is associated with longer life expectancy, even at relatively low levels of activity and regardless of body weight, according to a study by a team of researchers led by the National Cancer Institute (NCI), part of the National Institutes of Health.  The study, which found that people who engaged in leisure-time physical activity had life expectancy gains of as much as 4.5 years.

Do long life expectancies run in your family?  Y / N

Your parents may largely dictate how long you’re going to live. And your mom appears to have most of the control over your “aging gene.”

Do you smoke or a regular user of nicotine products?  Y / N

Cigarette smoking causes more than 480,000 deaths each year in the United States. This is nearly one in five deaths.

Do you consume alcohol more than twice a week?  Y / N

Alcohol use is related to a wide variety of negative health outcomes including morbidity, mortality, and disability. Research on alcohol–related morbidity and mortality takes into account the varying effects of overall alcohol consumption and drinking patterns. Alcohol use increases the risk for many chronic health consequences (e.g., diseases) and acute consequences (e.g., traffic crashes), but a certain pattern of regular light–to–moderate drinking may have beneficial effects on coronary heart disease.

Have you taken advantage of a life-expectancy calculator to better plan for the length of portfolio withdrawals needed in retirement?  Y / N

The Living to 100 Life Expectancy Calculator uses the most current and carefully researched medical and scientific data in order to estimate how old you will live to be. Most people score in their late eighties… how about you? Check it out at

Medical costs affect retirees differently. Unfortunately, it’s tough as we age to avoid healthcare costs and the onerous inflation attached to them. Thankfully, proper Medicare planning is a measurable financial plan expense as a majority of a retiree’s healthcare costs will be covered by Medicare along with Medigap or supplemental coverage.

At Clarity, we use an annual inflation factor of 4.5% for additional medical expenses (depending on current health of the client), and the cost of long-term care.

Good health is a significant contributor to financial and physical wellness in retirement. 

In a report from Healthview Services, a provider of cost-projections software, healthcare costs in retirement are rising twice as fast as the typical annual increase in Social Security benefits.

Latest estimates outline total out-of-pocket spending for an average 65-year old couple retiring today could exceed $400,000 when Medicare premiums, supplemental insurance and deductibles are included. Keep in mind that cost-of-living adjustments for Social Security are overwhelmed by the rising costs of Medicare Part B premiums.

Healthview Services projects a 5.5% annual increase in healthcare costs over the next decade.

Per Medicare Trustees as reported by Savvy Medicare, a training program for financial planners, Part B and Part D insurance costs have averaged an annual increase of 5.6% and 7.7% respectively, over the last 5 years and are expected to grow by 6.9% and 10.6% over the next five years.

Preventative actions such as regular workout regimens, eating properly and healthy sleep habits can work to reduce the financial stress of the most significant costs retirees face.


Are you prepared for the emotional transition to retirement?  Y / N

There exists a level of anxiety for new retirees even though we as professionals feel a sense of accomplishment. Years ago, I deemed this discomfort as “crossover risk.” Clients who told me they were going to “retire,” were back at work a year later and the opposite occurred too.

Eventually, crossover risk lessens. However, the first year of retirement, the bridge, has become increasingly stressful. Enough to where I now call the first year: “The Black Hole”

Have you given thought to your social networks or activities you’ll partake in during retirement?  Y / N

The closer retirement gets, the nearer the exit sign, the stronger your commitment to go through a return-on-life exercise should become. A successful evolution occurs when new retirees redefine success on their own terms.

Transition steps that I’ve seen initiated successfully: Working part-time to ease into a retirement mindset, giving of time to a favorite charity, family vacations especially with grandkids, a new pet, a house renovation project, courses on photography and cooking, and rigorous physical endeavors like yoga and aerobics.


Have you undertaken comprehensive financial planning to determine whether you’re on track?  Y / N

A plan that assesses income, medical and housing needs along with wishes and wants can crystallize actions that need to be taken to succeed, validate current habits and expose financial vulnerabilities. A holistic plan encompasses all assets, liabilities, insurance, savings, investments and employs realistic rates of returns for risk assets like stocks and bonds.

Financial planning is far from perfect. After all, working with projected returns on risk assets like stocks, estimating how long a person may live and where inflation may be at the time of retirement, is an intelligent guessing game at best.

Consider the plan a snapshot of your progress toward financial life benchmarks. Where you are, outlined direction of where you need to go. Are you on track to meet your needs, wants and wishes? A plan is a diagnostic; the exercise is one of financial awareness.

Studies show that people who follow a retirement plan are more successful than those who don’t. But know the common pitfalls you’ll face, depending on the professional who creates the plan and where his or her loyalties lie.

Unfortunately, most planning systems as well as planners tend to provide overly-optimistic outcomes with asset return projections and life expectancies that may be far from what you’ll experience living in real world.


Most financial plans are created to push product. They’re a means to a lucrative end for brokers. An afterthought.

When in fact, a comprehensive financial plan should stand alone as a roadmap to financial success, and that includes recognition of how stock markets flow through cycles – bull, bear, flat and realistic assessments of inflation and life expectancies.

Consider a second opinion of a completed plan if your first was generated by an employee of a big box financial retailer. Always seek a Certified Financial Planner who acts as fiduciary.

Have you considered a formal retirement income strategy?  Y/N

To re-create a paycheck in retirement, you’ll seek to prepare for a steady, middle lane approach to an income stream. In other words, a withdrawal rate that meets requirements to meet fixed expenses and reasonable discretionary spending, then tested through a simulation of real market returns over decades.

Unfortunately, when traveling retirement road there will always be unforeseen curves throughout the journey.

We believe at Real Investment Advice and Clarity Financial, that distribution portfolios may be in for an extended period of a sequence of low or flat returns for stocks and bonds. This will require a right lane shift to less income or a lower portfolio distribution rate for a sustained period. At the minimum, distribution portfolios will require ambitious monitoring.

Wade D. Pfau, Ph.D., CFA and professor of Retirement Income at The American College in a study titled Capital Market Expectations and Monte Carlo Simulations for the Journal of Financial Planning, outlines how sequence-of-returns risk can send your financial car into a ditch. He writes–

“…with less time and flexibility to make adjustments to their financial plans, portfolio losses can have a bigger impact on remaining lifetime standards of living once retirees have left the workforce.”

It’s recommended to assess withdrawal rates and spending habits over rolling three-year periods. This ongoing exercise helps to identify cyclical trends and whether adjustments need to be made.

Have you incorporated Social Security and Medicare planning into your analysis?  Y / N

Social Security is an inflation-adjusted income you cannot outlive. Make sure pre-conceived notions aren’t part of your strategy. Read: The One Social Security Myth.

The correct Medicare strategies can save thousands of dollars in lifetime penalties. Read: 4 Ways To Plan For The Retirement Apocalypse.

These topics are uncomfortable for many financial professionals. The wrong decisions may cost you thousands of dollars in retirement. At Clarity, we are trained and well-versed in Social Security and Medicare planning strategies.

This checklist isn’t intended as a pass/fail. It should be perceived as a wake-up call.

Retirement just doesn’t happen. There’s work to be done. Small improvements like cutting expenses and working two years longer than originally planned can add exponential positive impact.

(Thanks to Morningstar’s John Rekenthaler for including one of my emails to him in a column consisting of reader reponses while he tended to his wife who, as he reports, suffered a fainting spell. We wish both of them well, of course.)

Do we need a recession or another credit event similar to 2008 to tell us stocks are overpriced and cause them to tumble? John Rekenthaler of Morningstar seems to think so. I sent him an email in response to an article he wrote doubting the verdict of recent bubble-callers like GMO and Research Affiliates. I said stocks were objectively expensive (using the Shiller PE), and that meant future returns would likely be low.

But John thinks that a turn in the economic cycle will determine a downturn in the stock market, and tell us, after the fact, if stocks are overpriced. Since we don’t know when that will occur or what it will look like, we must remain agnostic as to the future returns of the stock market. As he responds to my email in a new article:

“One of these years the economic cycle will turn, thereby making projected corporate earnings wildly overstated rather than moderately so. Stocks will get crushed. If that happens in 2018 or 2019, then equity prices will indeed have been high, and returns will indeed be low. If the economy holds out until 2020 or longer, though, then today’s values should look reasonable.”

Unfortunately, while stock markets tend to tumble when the economy goes South, since the Great Depression there’s scant evidence that single recessions tell us anything about how stocks are priced or indicate anything about their future 10-year returns. For that all-important forecast, one must consult starting valuations more than recessions or moment in the economic cycle.

Consider the 50% decline the S&P 500 Index suffered from 2000 through most of 2002. The recession in 2000 was minor. In fact, it didn’t’ even meet the standard definition of two straight quarters of GDP contraction. GDP contracted in the second quarter of 2000, then again in the fourth quarter of that year, and never again.

Did that recession warrant a 50% price reduction in stocks? Did it somehow prove that stocks were overpriced? Or were stocks just wildly overpriced to begin with, as the Shiller PE hit 44 in early 2000?

The point isn’t that we may or may not have a recession over the next 2, 3 or 5 years. The point is stocks are at a Shiller PE seen only twice before in history – 1929 and the run-up to 2000. Come recession or not, over the next decade investors in the S&P 500 will capture a 2% dividend yield. They may also capture 4%-5% earnings-per-share growth. That puts nominal returns at 6%-7%, which isn’t bad at all. Unfortunately, the third component of future returns consists of where the future PE ratio will sit. Will the Shiller PE maintain itself above 30? Or will it contract to something resembling the historical average of nearly 17? Even if that average is outdated, is the new norm 32? Or is it more like 20 or 22?

Whether a recession comes within the next 5 years or not has little to do with these questions. And though it may send stocks down for most of its duration, it ultimately will have told us nothing about longer term returns compared to how much starting valuation can tell us. In fact, the two features of the Shiller PE are that it’s based on a prior decade’s worth of earnings and is pretty good at forecasting the next decade’s worth of returns. It’s not based on short-term earnings, and it’s not good at forecasting short-term stock returns. A recession doesn’t matter one whit insofar as it’s a typical part of a full cycle that the Shiller PE aims to capture in its earnings calculation and in its stock return forecast.

It’s possible we might wake up in a decade to a 32 Shiller PE. And it may have remained there all along, or it may have arrived there again as the result of any number of gyrations. The question is what should financial writers be telling their readers (and financial advisers telling their clients) about that possibility?

Yesterday, I discussed the “compression” of the market being akin to a “coiled spring” that when released could lead to a fairly decent move in one direction or another. To wit:

“As you can see in the ‘reddish triangle,’ prices have been continually compressed into an ever smaller trading range. This ‘compression’ is akin to coiling a spring. The more tightly the spring is wound, the more energy it has when it is released.”

As shown, the bulls are “attempting a jailbreak” of the “compression” that has pressured markets over the last two months. While the breakout is certainly encouraging, there isn’t much room before it runs into a more formidable resistance of the 100-day moving average. Furthermore, with interest rates closing in on 3% again, which has previously been a stumbling point for stock prices, it is too soon to significantly increase equity risk in portfolios.

This is just one day.

As I stated previously, as a portfolio manager I am not too concerned with what happens during the middle of the trading week, but rather where the market closes on Friday. This reduces the potential for “head fakes” as we saw last week with the break of the of the 200-dma on Thursday which was quickly reversed on Friday. The weekly close was one of the two outcomes as noted in our previous Quick-Take:

“If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks.”

This breakout will provide a reasonable short-term trading opportunity for portfolios as I still think the most probable paths for the market currently are the #3a or #3b pathways shown above.

If we get a confirmed break out of this “compression range” we have been in, we will likely add some equity risk exposure to portfolios from a “trading” perspective. That means each position will carry both a very tight “stop price” where it will be sold if we are wrong as well as a “profit taking” objective if we are right.

Longer-term investments are made when there is more clarity about future returns. Currently, clarity is lacking as there are numerous “taxes” currently weighing on the markets which will eventually have to be paid.

  • Rising oil and gasoline prices (Tax on consumers)
  • Fed bent on hiking rates and reducing their balance sheet. (Tax on the markets)
  • Potential trade wars (Tax on manufacturers)
  • Geopolitical tensions with North Korea, Russia, China and Iran (Tax on sentiment)
  • Traders all stacked up on the “same side of the boat.” (Tax on positioning)

We continue to hold higher levels of cash, but have closed out most of our market hedges for now as we giving the markets a bit more room to operate.

With longer-term indicators at very high levels and turning lower, we remain cautious longer-term. However, in the short-term markets can “defy rationality” longer than anyone can imagine. But it is in that defiance that investors consistently make the mistake of thinking “this time is different.”

It’s not. Valuations matter and they matter a lot in the long-term. Valuations coupled with rising interest rates, inflationary pressures, and weak economic growth are a toxic brew to long-term returns. It is also why it is quite possible we have seen the peak of the market for this year.

I will update this “Quick Take” for the end of the week data in this coming weekend’s newsletter. (Subscribe at the website for email delivery on Saturday)

It’s official — house prices are now as high as they were at the bubble peak in 2006 according to the S&P/Case-Shiller 20-City Composite Home Price Index. Moreover, Americans believe they will continue to soar, according to an article by Quentin Fottrell at MarketWatch.. That makes sense from the perspective of behavioral finance. People often extrapolate recent price movements into the future, which contributes to plenty of misjudgments and sometimes bubbles and crashes.

Does all this mean prices are now in bubble territory again? It’s not so easy to say because a bubble is hard to define. But it sure looks like prices are expensive on some reasonable metrics.

First, it has taken 12 years to regain the 2006 bubble peak. That’s a reasonably long period of time. Also, if prices are indexed to 100 in January 2000 and the index is a 209 now, that means home prices have appreciated around 4.1% annualized. That doesn’t seem like a crazy rate of appreciation,  but the problem is that inflation, measured by the CPI has increased by 2.1% over that time. And median household income has increased by 2.2% from 2000 through 2016.

One problem with this analysis is that the 20-City Index might be weighted more heavily to areas where people’s wages are increasing at higher rates than the median. The U.S. economy is bifurcated now, so that people living in the 20 cities in the index might be doing better than people in the rest of the country. The 20-City index contains New York and San Francisco, after all. Also, at least some of the cities in the 20-City Index suffer from severe supply constraints due to onerous zoning regulations.

New Approach to Measuring Affordability

Not only is measuring median prices to median income across the country inadequate, but so is measuring those things in a particular area. Median income and prices don’t capture the full distribution of incomes, and they don’t focus on renters specifically – those best positioned to become first-time home buyers — according to a recent study by the Urban Institute. Nor do median numbers capture the full distribution of home prices. In some areas, for example, there is a wide variety of homes available, but in other areas there is only a narrow set of home types available. Additionally, focusing on renters is important because renters typically have lower incomes, making them less able to afford a home than the median family.

The Urban Institute’s study creates two new affordability indexes called HARI or Housing Affordability for Renters Index, one for local renters and another for measuring housing affordability for nationwide renters who may move to a region. A local index number means that percentage of local renters can afford to buy a home in that area. Local indexes range from 5% to 37%, while the index covering all renters in the nation ranges from 3% to 42% depending on the region to which a renter might move.

Using Washington, D.C. as an example, the paper shows the steps in the methodology. First, renters’ incomes are broken down into 22 intervals of $10,000, and the percentage of the renter population is indicated for each interval. In DC, more than 40% of renters have incomes in intervals of 1 through 6 or $1 through $60,000. By comparison, 15% of new borrowers have incomes in that range. In interval 7, (incomes from $61,000 to $70,000), the share of renters versus new homeowners with a mortgage is similar. In intervals 8 and above, the percentage of renters is less than the share of new homeowners.

Next, borrower probability for each interval level is aggregated to get cumulative mortgage borrower probability. At each income level, the aggregated number represents the share of houses affordable to renters with that income. So income level 10 ($91,000-$100,000), represents 5.2% of DC renters, and those renters can afford 45% of DC homes that have recently sold. Finally, an aggregate of the share of renters who can afford a house in each income interval is aggregated to arrive at the affordability index. For Washington, D.C in 2016, it was 29.6%, meaning 29.6% of renters in DC could afford a house in DC in 2016.

Nationwide renters have lower incomes than DC renters (70% of nationwide renters have incomes in intervals 1-6, compared to 40% of DC renters). And because of this income difference only 17.1% of nationwide renters can afford a house in DC.

Using St. Louis, Houston, San Francisco and Washington, D.C. (two cities that are intuitively more affordable and two cities that are intuitively less affordable), the new indices show that new borrowers are likely to have significantly higher incomes in the more expensive cities. St. Louis has peak borrower probability of 12% at income interval 4, while San Francisco has peak borrower probability – a little over 5% — at income interval 14.

But the affordability index isn’t determined only by incomes of local new borrowers. That statistic is combined with the full distribution of local renters’ incomes to see if renters earn comparable incomes to borrowers. In St. Louis and Houston, most renters fall in the first 10 income intervals. But in the more expensive cities, there are more renters at higher income intervals.

An interesting result from the study is that “cross-sectional investigation shows that the MSA-level indexes vary less than many might expect.” In other words, the difference between the most unaffordable city – Los Angeles, where 18% of renters can afford to buy – compared to the most affordable – Phoenix, where 31% of renters can afford to buy – isn’t that great. Another surprising result is that Washington, D.C. is more affordable (29.6% affordability) than Houston (22.4% affordability) when considering local renters only. Does this also indicate income and wealth bifurcation? The authors don’t say, but it is a surprising statistic.

There is more to the paper, including a comparison of current affordability to affordability in 2005. That comparison is mostly flattering to the current market, and it may have been better for the authors to consider another point of comparison given the strange market conditions in 2005. Nevertheless, these new affordability indices convey a much deeper and more complex reality compared to, say, the rosier National Association of Realtors’ Affordability Index, which has current affordability at over 100 (meaning median income can afford the median home assuming a 20% down payment) in every region of the country.