Monthly Archives: November 2015

Major Market Buy/Sell Review: 07-22-19

Each week we produce a chart book of the major financial markets to review whether the markets, as a whole, warrant higher levels of equity risk in portfolios or not. Stocks, as a whole, tend to rise and fall with the overall market. Therefore, if we get the short-term trend of the market right, our portfolios should perform respectively.

HOW TO READ THE CHARTS

There are three primary components to each chart:

  • The price chart is in orange
  • The Over Bought/Over Sold indicator is in gray
  • The Buy / Sell indicator is in blue.

When the gray indicator is at the TOP of the chart, there is typically more risk and less reward available at the current time. In other words, the best time to BUY is when the short-term condition is over-sold. Likewise when the buy/sell indicator is above the ZERO line investments have a tendency of working better than when below the zero line.

With this basic tutorial let’s review the major markets.

S&P 500 Index

  • As reported last week, the market cracked 3000 driven by hopes of a “Fed rate cut” at the end of the month.
  • As we noted then, on a technical basis the breakout is constructive and suggests higher highs BUT the near-term extremely overbought condition suggested a bit of a correction was coming.
  • That correction started last week, and may continue into next week. We did add a 2x-Short S&P 500 position to the Equity Long-Short portfolio to hedged this pullback.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position.
    • Stop-loss remains $275
    • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

  • Last week, we noted DIA did break out to new highs and triggered a short-term buy signal.
  • DIA is very overbought short-term, so like SPY above, we will look for a better entry point to suggest adding weighting to portfolios.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions
    • This Week: Hold current positions.
    • Stop-loss moved up to $252.50
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • QQQ rallied from the oversold condition and is now back to EXTREMELY overbought.
  • While QQQ did breakout to new highs along with DIA and SPY it is lagging in terms of relative performance.
  • With the “buy signal” getting elevated towards levels that have previously signaled short-term peaks, use corrections that do not violate support to add to positions.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $175
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • SLY continues to be a technical disaster. Small-caps are also not confirming the exuberance of its large-cap brethren because small-caps do not engage in massive stock repurchase programs.
  • Last week, SLY did break above the 200-dma but remains confined to a very negative downtrend.
  • SLY has triggered a short-term buy signal so that could help small-caps gain ground if they can hold up.
  • There are a lot of things going wrong with small-caps currently so the risk outweighs the reward of a trade at this juncture.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position.
    • Stop loss violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY, like SLY, is technically not in great shape. Mid-caps, like small-caps, also do not participate in major share repurchase programs and are economically sensitive. Both suggest the overall market environment is weaker than headlines suggest.
  • MDY did regain its 200-dma but the rally has been weak and has failed at resistance.
  • Mid-caps are also very overbought so take profits if you are long and tighten up stops.
  • Short-Term Positioning: Neutral
    • Last Week: Use any further rally this week to sell into.
    • This Week: Use any further rally this week to sell into.
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM rallied back to the top of its downtrend channel on news that the ECB will potentially cut rates and increase QE programs.
  • EEM is back on a “buy signal” but is confined to a more major downtrend currently.
  • We previously added a small trading position to the long-short portfolio which we closed out this past week due to lack of performance. We may retry a position if the technicals firm up.
  • Short-Term Positioning: Bearish
    • Last Week: Hold current position
    • This Week: Hold current position
    • Stop-loss set at $41
  • Long-Term Positioning: Neutral

International Markets

  • Like EEM, EFA rallied on news the ECB will leap back into action to support markets.
  • Last week, EFA broke above its downtrend line while maintaining a “buy signal.” That “buy signal” is now very extended.
  • We did add a trading position to our long-short portfolio model but it, like EEM, really was not performing well so we closed it out last week. We will try again later if technicals improve.
  • Short-Term Positioning: Neutral
    • Last Week: Hold position
    • This Week: Hold position.
    • Stop-loss is set at $64
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • We noted previously that Oil was able to push above the 50% retracement line on a bigger than expected crude draw and “Tropical Storm Barry” shutting down production in the Gulf.
  • That push is over, and economic realities have come back into focus. It is critically important oil holds support at $54 otherwise the low $50’s will come into focus very quickly.
  • Short-Term Positioning: Neutral
    • Last Week: Add trading position on pullback that holds $58
    • This Week: No position as support failed to hold.
    • Stop-loss for any existing positions is $54.
  • Long-Term Positioning: Bearish

Gold

  • Gold has quickly reversed its oversold condition to extreme overbought including its longer-term “buy signal.”
  • Gold broke above short-term resistance on Friday as news from the Fed suggested the Fed may “go big” at the end of the month on a rate cut.
  • Gold is too extended to add to positions here. Look for a pullback to $127-128 to add.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Profit-stop is at $130
    • Stop-loss for whole set at $126
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • As noted previously,
    • “Bond prices have gone parabolic and are now at extremes. Even the “buy” signal on the bottom panel has reached previous extremes which suggests a reversal in rates short-term is likely.”
  • That correction started two weeks ago and the consolidation has continued. The overbought condition is being reversed with the “buy” signal still intact.
  • If bonds continue to consolidate, an entry could form at $129-130.
  • Prices could pullback to the $126-127 range which would be an ideal entry point.
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions after taking profits.
    • This Week: Hold positions
    • Stop-loss is moved up to $125
    • Long-Term Positioning: Bullish

U.S. Dollar

  • The dollar has rallied above, and is holding support, at its 200-dma.
  • There is likely more rally to go next week particularly if it looks like the Fed may not be as accommodative as the market expects.
  • The dollar is starting to reverse its oversold condition, and the rally to $97 last week has put the dollar back on our radar as suggested last week. A break above resistance at $97 will suggest another leg higher for the dollar.
  • Short-Term Positioning: Bullish
    • Last Week: No Position
    • This Week: No Position

F.I.R.E. – Ignited By The Bull, Extinguished By The Bear

Do you remember this commercial?

The Etrade commercial aired during Super Bowl XLI in 2007. The following year, the financial crisis set in, markets plunged, and investors lost 50%, or more, of their wealth.

However, this wasn’t the first time it happened.

The same thing happened in late 1999. This commercial was aired 2-months shy of the beginning of the “Dot.com” bust as investors once again believed “investing was as easy as 1-2-3.”

Why this trip down memory lane? (Other than the fact the commercials are hilarious to watch.)

Because this is typical of the mindset seen at the end of extremely long “cyclical” bull market cycles. 

Investing is simple. Just throw you money in the market and it goes up. Its so easy a “baby can do it.”

Here is something else you see at the end of bull market cycles:

 “This couple retired at 31 with $1 Million: Want to retire early? How “going against the grain” allowed this FIRE couple to ditch their jobs and travel the world.

How did they make this happen? Shen and Leung, who was also a computer engineer, are part of the FIRE movement — which stands for Financial Independence, Retire Early — where the goal is to save a lot so you can retire early. The couple retired at 31 with roughly $1 million in the bank. They’re currently withdrawing 3.5% a year from that nest egg, and say they can easily travel the world on that money — as they’ve got lots of practice being frugal.”

First, I want to give the couple a “fanatical thumbs up” for saving $1 million by their 30’s. That is an amazing feat which deserves respect and acknowledgment. 

Secondly, they are very budget conscious and willing to sacrifice the luxuries most people long for to live their dream.

Another “thumbs up.”

However, the rise of the “F.I.R.E.” movement is symptomatic of a late stage bull market advance. More importantly, we can also predict how things will turn out for Shen and Leung.

For this discussion I want to use the data provided by Shen and Leung to build our examples.

  • Invested asset value:  $1 million
  • Annualized withdrawal rate: 3.5%
  • Annualized return rate: 6% (Not specified but a reasonable estimate)
  • Living needs: $35,000 annually.
  • Life expectency: 85-years of age.

With these assumptions in place we can begin to do some forecasting about how things eventually turn out. However, we also have to assume:

  • The couple never has children
  • Never requires serious medical care (hopefully)
  • Never considers buying a house
  • Has no major life events, etc.

First, we need to start with the cost of living. As I showed recently in Part 1 of “Everything You’ve Been Told About Savings & Investing Is Wrong” is that the cost of living rises over time due to inflation. However, for most the increase in living costs rises dramatically more as needs for housing, children, education, travel, insurance, and health care occur through stages of life.

For this exercise, we will assume our example couple never changes their lifestyle so only inflation is a factor. We will use the historical average of 2.1% and project it out for 50-years.

Understanding this, we can now take their $1 million, compound it at 6% annually (the preferred mainstream method), and deduct 3.5% annually adjusted for inflation over their 50-year time horizon.

We need to assume that since our couple is in their 30’s, the investable assets are in taxable accounts. Also, if this is the case, and they are not touching the principal, then we need to adjust the annual withdrawals for capital gains tax. The bottom two area charts adjust for 2.1% annual inflation and inflation plus a 15% tax on withdrawals. (Tax is paid on the gains taken to fund the withdrawal and the dividends paid in on an annual basis)

Not surprisingly, if our couple can indeed live on $35,000 a year, even when adjusting for inflation and taxation, a $1 million portfolio growing at 6% annually can indeed support them for their entire lifespan.

Reality Is Different

In Part 3 of our recent series on “saving and investing,” we laid out the issue, and importance, of variable rates of return. To wit:

“When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what happened to their money is substantial over long-term time frames.”

The chart below is exactly the same as above, however, this time we have used the average annual 50-year returns from previous periods in history where starting valuations were greater than 20x earnings as they are today. (High starting valuations beget lower future returns historically speaking.) 

Over a 50-years, our couple will get the benefit of complete valuation and market cycles. In this case, since they are starting with high valuations at the outset, the first 30-years contains a long-period of lower returns, but that last 20-years receives the benefit of higher returns due to valuation reversion.

Due to market volatility and periods of negative growth, the original $1 million portfolio only grows to $3 million when including nominal spending. However, when accounting for volatility, inflation, and taxes, the survival rate of the portfolio diminishes sharply due to two reasons:

  1. Down years reduce the growth rate of the portfolio over the given time frame.
  2. Withdrawals in down years exacerbate the decline in the portfolio. (i.e. Portfolio declines by $65,000 plus the $35,000 annual withdrawal increases the 6.5% decline to 10%.)

Obviously, not accounting for volatility when planning to retire early can have severe future consequences. In this case they will run out of money in year 47.

The Big Bad Bear

As I said at the beginning of this missive, the “F.I.R.E.” movement is the result of a decade-long bull market cycle.

Most likely, our young couple will be met with a “bear market” sooner, rather than later, in their early retirement. If we use the return model from our recent article on “investors and pension funds,” we see a rather dramatic shift in life-expectancy of the portfolio.

“The chart below is the S&P 500 TOTAL REAL return from 1995 to present. I have projected an average return of every period in history where the market peaked following P/E’s exceeding 20x earnings. This provides for variable rates of market returns with cycling bull and bear markets out to 2060. I have also projected ‘average’ returns from 3% to 8% from 1995 to 2060. (The average real total return for the entire period is 6.56% which is likely higher than what current valuation and demographic trends suggest it should be.)”

The benefit of this model is that it shows the impact to portfolio returns when bear markets are “front-loaded,” as will likely be the case for most the “F.I.R.E.” followers. (Note, in the return model above the “bear market” is 5-years into the future)

The reason for the dramatic short-fall is that a major, “rip your face off,” bear market will cut asset values by 50% very early on. All of a sudden, the annual withdrawal rate of 3.5% becomes 7%, which outpaces the ability of the portfolio to grow fast enough to catch up with the withdrawal rate and the loss of principal. In this more realistic example, our couple will run out of money in 30 years.

This is the exact problem “pension funds” face currently.

The Other Problems From “Playing With F.I.R.E.”

While we have mainly addressed the issues surrounding assumptions being used by the ‘F.I.R.E.” movement in having enough assets to retire, there are some other important issues which should be considered.

  1. Loss of your skill set. In retirement it is probable your skill set erodes and becomes outdated over time. New technologies, trends, innovations, etc. are running at a faster pace than ever.
  2. Becoming unemployable. One of the things seen following the financial crisis was employers preferring to hire individuals who were already employed rather than hiring those out of work. The reasoning was that if you were good enough to keep your job during the recession, you obviously have a valuable skill set. Once you are out of the “labor force” for a while, it becomes more difficult to regain employment as employers tend to prefer those with a very steady work history, a growing career, and relevant skill sets.
  3. Life. Besides simply running out of money sooner than you planned because of a bear market, a rising cost of living more than you counted on, or higher taxes (all of which are very likely in the near future) there is also just “life.”  It doesn’t matter how carefully you plan; “S*** Happens!” More importantly, it always happens when you least expect it and at the worst possible time. These things cost money and impact our best laid spending and saving plans. The problem with “retiring early,” is that it leaves plenty of time for things to go wrong. 
  4. Unplanned Accident/Medical Problem. Young people suffer from an “invincibility syndrome.” They tend to not carry insurance, due to the cost, because they “never get sick.” While we certainly hope it never happens, a major accident or health issue can extract tens to hundreds of thousands of dollars of capital critically impairing retirement plans.
  5. Too Old To Do Anything About It. The biggest problem for “F.I.R.E.” practitioners is that running out of money late in life leaves VERY few options for the rest of your retirement years. If our math above is even close to correct, which history suggests it is, then our young couple will be faced with going back to work in the 70’s. That is not exactly the retirement most are hoping for. 

As I stated in our previous series, retiring early is far more expensive than most realize. Furthermore, not accounting for variable rates of returns, lower forward returns due to high valuations, and not adjusting for inflation and taxes will leave most far short of their goals. 

While it sounds like I am bashing the “F.I.R.E. Movement,” I am not. I am for ANY program or system that gets young people to save more, stay out of debt, and invest cautiously. The movement is a good thing and it should be embraced.

But, it is also a symptom of a decade-long period of making “easy money” in the financial markets.

These periods ALWAYS end badly and the next “bear market” will quickly “extinguish the F.I.R.E.” as losses mount and dreams have to be put on hold.

It will happen. It always appears easiest at the top.

And, given one of E*Trade’s latest commercials, the next bear market may be coming sooner than we expect.

RIA PRO: Why The Fed Could Cut By 50bps & Why It Won’t Matter


  • Review & Market Update
  • Why The Fed Could Cut By 50bps
  • Why It Won’t Matter
  • Sector & Market Analysis
  • 401k Plan Manager

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Market Review & Update

Last week, we laid out the bull and bear case for the market:

The Bull Case For 3300

  • Momentum
  • Stock Buybacks
  • Fed Rate Cuts
  • Stoppage of QT
  • Trade Deal

The Bear Case Against 3300

  • Earnings Deterioration
  • Recession
  • No Trade Deal/Higher Tariffs
  • Credit-Related Event (Junk Bonds)
  • Mean Reversion
  • Volatility / Loss Of Confidence

We laid out the case for a near-term mean reversion because of the massive extension above the long-term mean. To wit:

“There is also just the simple issue that markets are very extended above their long-term trends, as shown in the chart below. A geopolitical event, a shift in expectations, or an acceleration in economic weakness in the U.S. could spark a mean-reverting event which would be quite the norm of what we have seen in recent years.”

This analysis led us to take action for our RIAPRO subscribers last week (30-Day Free Trial), as we added a 2x-short S&P 500 index fund to Equity Long-Short Account to hedge our longs against a potential mean reversion. (on Friday that portfolio was UP .03% while the market FELL by 0.62%)

“This morning, we are adding a small 2x S&P 500 short position to the trading portfolio to hedge our core long positions against a retracement over the next few weeks. We will remove the short if the market can regain its footing and move higher, or the market sells off and reaches oversold conditions.”

This is the purpose of hedging, as it reduces volatility over time, which inherently reduces the risk of emotionally based trading mistakes.



The correction this past week was not surprising as we wrote previously:

“With a majority of short-term technical indicators extremely overbought, look for a correction next week. What will be important is that any correction does not fall below the early May highs.”

While the market is still hanging above the May highs, further corrective actions are likely next week as the short-term oversold conditions have not been resolved as of yet. The deviation above the long-term mean is also only starting to reverse as well.

Importantly, once we get past the end of the month, and assuming the Fed does indeed cut rates and no “trade deal” with China, the markets will return their focus to economics and earnings. As we stated previously:

“Such continues to suggest the August/September time frame for a larger corrective cycle is still in play.”

More importantly, as Chris Kimble noted on Friday, the market is continuing to ignore the economic warnings being sent by bonds and commodities.

Moreover, the “Dumb Money” is now all the way back in.

These last two charts confirm the old Wall Street axiom:

“Individuals buy  the most at the top, and the least at the bottom.” 

This is why we are hedging our risk, carrying a higher level of cash, and holding onto our bonds as if they were the last lifeboat on the Titanic.



Why The Fed Will Cut By 50bps

It is now widely expected the Fed will cut rates at the end of the month following comments by Fed officials last week. Per the WSJ:

New York Fed President John Williams on Thursday stoked expectations for a hefty cut. Already-low interest rates are a big reason to cut aggressively at the first sign of economic distress, he said. ‘Don’t keep your powder dry—that is, move more quickly to add monetary stimulus than you otherwise might.’ But a bank spokesman later walked that back, saying Mr. Williams didn’t intend to suggest the central bank might make a large cut this month.”

Interestingly, that statement was quickly walked back by the NY Fed:

“However, in an unprecedented move, the NY Fed subsequently released a statement stating that President Williams’s speech on Thursday afternoon was not intended to send a signal that the Fed might make a large interest rate cut this month but rather it was “an academic speech on 20 years of research.”

Why did the NY Fed do this?

Simple: as BofA explains, ‘the FOMC was uncomfortable with the market moving toward a 50bp cut and wanted to push the market back to a 25bp baseline.’ In other words, as Meyer puts it, ‘Williams unintentionally misguided the markets.'”

With the markets pushing record highs, recent employment and regional manufacturing surveys showing improvement, and retail sales rebounding, it certainly suggests the Fed should remain patient on hiking rates for now at least until more data becomes available. Patience would also seem logical given very limited room to lower rates before returning to the “zero bound.”

However, there is also support for rate cuts. This is the point we will discuss today.

It’s Beige

Let’s begin with the Fed’s Beige Book report.

  • Labor markets remained tight, with contacts across the country experiencing difficulties filling open positions. The reports noted continued worker shortages across most sectors, especially in construction, information technology, and health care. (Tighter job market leads to higher costs, which impacts profitability.)
  • Compensation grew at a modest-to-moderate pace, although some contacts emphasized significant increases in entry-level wages. Most District reports also noted that employers expanded benefits packages in response to the tight labor market conditions. (Note: cost of labor is rising, which will impede corporate profit margins. Increases in labor costs ALWAYS precede the onset of a recession.)
  • Tariffs were mentioned 49 times in the report.
  • Districts generally saw some increases in input costs, stemming from higher tariffs and rising labor costs. However,  firms’ ability to pass on cost increases to final prices was restrained by brisk competition. (Note: higher input costs without the ability to pass it on impacts profitability.)

Click to Enlarge

Recession Probabilities 

The Fed’s own recession probabilities index has spiked to levels historically coincident with the onset of a recession. (Yes, this time could be different, but probably not a bet the Fed is willing to take.)

Yield Curve Inversions

Interest rates are a direct reflection of economic growth. As I wrote in December 2018  in “Why Gundlach Is Still Wrong About Higher Rates:”

“Given the structural backdrops to the economy, there is an inability to increase rates of productivity substantially, output, wage growth, savings, or consumption, which would lead to stronger rates of economic growth. In fact, we are currently running some of the weakest rates of economic growth, productivity, and wages on record.”

Currently, 50% of the 10-yield curves we track are inverted and have remained so for more than 3-months. Historically, when inversions last for one-quarter or more in duration, recessions have not been too far behind.

However, one of the biggest reasons the Fed is about to cut rates by up to one-half point is to un-invert the Fed Funds to the 10-year Treasury rate. The inversion between the ultra-short and long-end of the curve is impairing loan activity. The Fed clearly understands that if they don’t resolve this inversion, the probability of a recession grows rapidly.

Cass Freight Index

There is also substantial “hard data” evidence the economy in under severe pressure. While “sentiment-based” surveys, or “soft data,” has rebounded recently, data like the “Cass Freight Index” is ringing alarm bells.

Leading Economic Indicators Drop

However, it is the Leading Economic Indicator (LEI) index, which has our attention currently.

As Mish Shedlock noted on Thursday:

“The Conference Board’s LEI index turned negative in June. The yield curve finally made a negative contribution. The conference board provides this press release on Leading Economic Indicators for June.

The US LEI fell in June, the first decline since last December, primarily driven by weaknesses in new orders for manufacturing, housing permits, and unemployment insurance claims. For the first time since late 2007, the yield spread made a small negative contribution.” – Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board

The consensus estimate was for LEI of +0.1, the read was a -0.3

This decline is not surprising to us. In July of 2018, as noted in the chart below, we laid out a predicted path of reversion in the LEI index. As you can see, the reversion has been even sharper than we originally estimated.

What is more concerning, and a reason the Fed is likely acting now, is there is a high correlation between the LEI and GDP, economic activity, and corporate profits. When compared to nominal GDP, the LEI index is suggesting a sharp slowdown is just ahead.

The Chicago Fed National Activity Index (CFNAI) is one of the broadest measures (80-sub components) of economic activity. The LEI and CFNAI, not surprisingly, also have a high correlation, which suggests further weakness is ahead.

Of course, if GDP, and underlying economic activity, is slowing down, it should not be surprising that corporate profits also decline.

The LEI is certainly not a perfect indicator for recessionary activity and has provided many false signals since the 2009 lows. However, the recessionary correlation is the highest when the LEI is signaling a recessionary warning at the same time the Fed Funds/10-Year yield inversion in place.

I think the Fed is beginning to panic as they were never able to get yields up to high enough levels to be effective in the next recession. Of course, this is exactly what we said would happen numerous times previously:

“The Fed surely understands that economic cycles do not last forever, and after eight years of a ‘pull forward expansion,’ it is highly likely we are closer to the next recession than not. While raising rates would likely accelerate a potential recession, and a significant market correction, from the Fed’s perspective, it might be the ‘lesser of two evils.’ Being caught at the ‘zero bound’ at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline.”

Janet Yellen was smart enough to “exit” and stick Jerome Powell with the “tab.”

While the market rallied back from its 20% decline last year on “hopes” of an end to the “trade war” and “rate cuts,” the market is missing an important part of the picture.

Rate cuts may not work.



Why It Won’t Matter

My friend Patrick Watson recently penned the problem for the Fed:

“This used to be pretty simple. When the economy slowed, the Fed would cut rates. This encouraged borrowing and investment. People bought houses. Businesses expanded and hired people. The economy would recover.

Now, it doesn’t seem to work that way. Peter Boockvar succinctly explained why in one of his recent letters. The problem is that ‘easy money’ stops working when it becomes normal, as it now is.

Lower rates don’t encourage borrowing unless potential borrowers think it’s a limited-time opportunity. Which they don’t anymore, and shouldn’t, since the Fed shows no sign of ever going back to what was once normal.”

Exactly correct.

Also, “stimulus” works best when the “patient” is in the worse possible condition, not when the patient is healthy. As I wrote in “QE – Then, Now, & Why It May Not Work:

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bailout’ the markets today, is much more limited than it was in 2008.

However, there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to the present.”

“The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the ‘norm’ are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.”

Let me be clear; it is certainly possible that asset prices could rise in the short-term given the “training” investors have received over the last decade to “Buy The F***ing Dip.” However, given the economic and fundamental backdrop, rate cuts will not change the onset, duration, or intensity of the coming recession.

Yes, participate with the “rate cut rally.” 

We will be.

Just make sure you have a strategy to “leave the party before the cops arrive.”

If you need help or have questions, we are always glad to help. Just email me.

See you next week.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet  


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels

Sector-by-Sector

Improving – Healthcare, Materials

Improving – Healthcare, Materials

We have maintained an overweight position in Health Care as part of our defensive positioning. As noted last week, Materials have now begun to improve its performance relative to the S&P 500 as well. We are currently carrying 1/2 weight in Materials due to the “trade war,” and without a resolution, there remains a risk to the sector.

Current Positions: Overweight XLV, 1/2 XLB

Outperforming – Staples, Real Estate, Financials, Utilities

As noted last week, the rotation in defensive positioning has continued, and these sectors are currently leading overall market performance. The defensive lead has begun to wear off a bit over the last week, and Real Estate has pulled back a bit. We are maintaining our target portfolio weight in Financials for now. Take profits and rebalance across sectors accordingly.

Current Positions: Overweight XLP, XLU, Target weight XLF, XLRE

Weakening – Technology, Discretionary, Communications

The previous “leaders” have been lagging in terms of relative performance, but have rallied over the last week a bit. Discretionary, Communications, and Technology have broken out to new highs but are extremely overbought currently. We will look to increase our exposure on short-term weakness.

Current Position: 1/2 weight XLY, Reduced from overweight XLK, Target weight.

Lagging – Energy, Industrials

Energy began to improve this last week but failed at resistance and oil prices dropped. We are maintaining our half-weight in the sector but are close to being stopped out. Industrials have been relatively weak in terms of relative performance and are continuing to struggle with multiple tops. There is no rush to increase exposure currently, but we are watching for a decisive breakout. For now, we are maintaining our “underweight” holdings in these two sectors until more evidence of improvement is available.

Current Position: 1/2 weight XLE & XLI

OVERALL RECOMMENDATION

The entire market is back to an extreme “overbought.” Take some action to rebalance portfolio risk if you have not done so previously.

That remains good advice heading into next week.

Market By Market

Small-Cap and Mid Cap – While small-cap did finally break above its 50- and 200-dma is to join Mid-caps in a late-stage catchup rally, the move was quite unimpressive on a relative strength basis. With small and mid-caps back to extremely overbought conditions, this is likely a great opportunity to rebalance portfolio risk and reducing weighting to an underperforming asset class for now until things improve.

Current Position: No position

Emerging, International & Total International Markets

We are still watching these positions for a potential add to portfolios, but the extreme overbought condition keeps us sidelined for the movement. A pullback that reduces the overbought condition but does not violate support will provide the right entry point. Patience will be rewarded either by avoiding portfolio drag or gaining a more advantageous entry point.

Current Position: No Position

Dividends, Market, and Equal Weight – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with economic growth and inflation. Currently, the short-term bullish trend is positive, and our core positions are providing the “base” around which we overweight/underweight our allocations based on our outlook.

The rally over the last several weeks has fully reversed the previous oversold condition. Make sure and rebalance weightings in portfolios if you have not done so already. #Hedge

Current Position: RSP, VYM, IVV

Gold – Gold continued to consolidate at elevated levels despite the market rally and hopes for a Fed rate cut. Fed Williams comments of a potential 50bps cut sent the metal soaring on Friday. This continues to be bullish set up for “gold bulls.” We are holding out positions for now and continue to look for a better entry point on a pullback to add to holdings.

Current Position: GDX (Gold Miners), IAU (Gold)

Bonds 

Bonds took a hit last week as money rotated out of bonds and back into equities but found support at the 50-dma. You can add to your bond holdings if you need to as a Fed rate cut is going to be supporting for higher bond prices.

Stay long current positions for now, and look for an opportunity to add to holdings.

Current Positions: DBLTX, SHY, TFLO, GSY, IEF

High Yield Bonds, representative of the “risk-on” chase for the markets have been consolidating despite the rally in equities. This is not the time to add to holdings just yet, but a good time to like take profits and reduce risk short-term. Given the deteriorating economic conditions, this would be a good opportunity to reduce “junk-rated” risk and improve credit quality in portfolios. 

OVERALL RECOMMENDATION

The entire market complex is back to an extreme “overbought.” Take some action to rebalance portfolio risk if you have not done so previously.

That remains good advice heading into next week.

Sector / Market Recommendations

The table below shows thoughts on specific actions related to the current market environment. 

(These are not recommendations or solicitations to take any action. This is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

Portfolio/Client Update:

No change this past week to holdings.

We noted last week that the market was extremely overbought and due for a correction. We saw some of that rotation on Friday, and our portfolios continue to perform well due to the defensive tilt.

For our newer clients, we have changed our focus to “risk control” and “capital preservation strategies” over “capital growth and risk-taking strategies.” While we do recognize the need to participate when markets are rallying, this is a dangerous environment to be heavily long in.

There is also a massive deviation between value and growth, which generally exists at the peaks of bull market cycles. We are actively searching for a “deep value” fund manager to add a fairly concentrated position into for portfolios. The reversion of value provides a significant risk hedge in the short-term and a long-term capital gain opportunity. We will discuss this more in detail in a future update when we locate the right manager.

In the meantime, we continue to carry tight stop-loss levels, and any new positions will be “trading positions” initially until our thesis is proved out.

  • New clients: Our onboarding indicators have reverted to “risk-on” so new accounts will be onboarded selectively into their models where risk can be controlled. Positions that were transferred in are on our global review list and being monitored. We will use this rally to liquidate those positions to raise cash to transition into the specific portfolio models.
  • Equity Model: No changes this past week. We are looking to taking profits across the breadth of our portfolio as we are currently sporting gains of 20-40% in many positions just since the beginning of the year. We have already taken profits once back in May, and taking profits a second time will allow us to remove our stop-loss levels for now and look for deep corrections to rebuild holdings.
  • ETF Model: No change but we are reviewing our holdings for rebalancing needs.

Note for new clients:

It is important to understand that when we add to our equity allocations, ALL purchases are initially “trades” that can, and will, be closed out quickly if they fail to work as anticipated. This is why we “step” into positions initially. Once a “trade” begins to work as anticipated, it is then brought to the appropriate portfolio weight and becomes a long-term investment. We will unwind these actions either by reducing, selling, or hedging if the market environment changes for the worse.


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.

401k-PlanManager-AllocationShift

Market Stumbles As Overbought Condition Bites

As noted last week, the market breakout was straining the deviation from the long-term moving average. Such a situation rarely last for very long.

That corrective process started at the end of last week despite Fed officials trying to assure the markets a rate cut is coming.

As noted last week:

“With Q2 reporting season going into full swing next week, as noted above, there is a potential short-term risk to share prices which could provide a better entry point to add to equity exposure. Be patient for that confirmation.

As stated previously, July and August tend to be challenging months for the market, so we want to be careful, particularly with the economic backdrop weakening.

That remained the case this week.  If you have not taken any actions in your plan, do the following on Monday.

  • If you are overweight equities – Hold current positions but remain aware of the risk. Take some profits and rebalance risk to some degree if you have not already. 
  • If you are underweight equities or at target – rebalance risks, look to increase holdings in domestic equities opportunistically if the markets can hold support at the May highs next week. 

With the markets back to extremely overbought conditions, patience will likely be rewarded.

If you need help after reading the alert; do not hesitate to contact me.

401k Plan Manager Beta Is Live

We have rolled out a very early beta launch to our RIA PRO subscribers

Be part of our Break It Early Testing Associate” group by using CODE: 401

The code will give you access to the entire site during the BETA testing process, so not only will you get to help us work out the bugs on the 401k plan manager, you can submit your comments about the rest of the site as well.

We have several things currently in development we will be adding to the manager, but we need to start finding the “bugs” in the plan so far.

We are currently covering more than 10,000 mutual funds and have now added all of our Equity and ETF coverage as well. You will be able to compare your portfolio to our live model, see changes live, receive live alerts to model changes, and much more.

We are building models specific to company plans. So, if you would like to see your company plan included specifically, send me the following:

  • Name of the company
  • Plan Sponsor
  • A print out of your plan choices. (Fund Symbol and Fund Name)

I have gotten quite a few plans, so keep sending them and I will include as many as we can.

If you would like to offer our service to your employees at a deeply discounted corporate rate, please contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principle. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)


Model performance is based on a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. This is strictly for informational and educational purposes only and should not be relied upon for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril. 

#WhatYouMissed On RIA: Week Of 07-19-19

We know you get busy and don’t check on our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything that you might have missed.


The Best Of “The Lance Roberts Show”

Podcast Interview Of The Week

Our Best Tweets Of The Week

Our Latest Newsletter


What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

See you next week!

The Wisdom of Peter Fisher

“In recent years, numerous major central banks announced objectives of achieving more rapid rates of inflation as strategies for fostering higher standards of living. All of them have failed to achieve their objectives.” – Jerry Jordan, former Cleveland Federal Reserve Bank President

In March 2017, former Treasury and Federal Reserve (Fed) official, Peter R. Fisher, delivered a speech at the Grant’s Interest Rate Observer Spring Conference entitled Undoing Extraordinary Monetary Policy. It is one of the most insightful and compelling assessments of the Fed’s post-financial crisis policy actions available.

Now a professor at the Tuck School of Business at Dartmouth, Fisher is a true insider with experience in the government and private sector that affords him unique insight. Given the recent policy “pivot” by Chairman Powell and all members of the Fed, Fisher’s comments from two years ago take on fresh relevance worth revisiting.

In the past, when Fed leadership discussed normalizing the Fed’s post-crisis policy actions, they exuded confidence that it can and will be done smoothly and without any implications for the economy or markets. Specifically, in a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” More recently, Janet Yellen and others have echoed those sentiments. Current Fed Chairman Jerome Powell, tasked with normalizing policy, appears to be finding out differently.

Define “Normal”

Taking a step back, there are important issues at stake if the Fed truly wants to unshackle the market economy from the influences of extreme monetary policy and the harm it may be causing. To normalize policy, the Fed first needs to explicitly define “normal.”

For instance:

  • The Fed should take steps to raise interest rates to what is considered “normal” levels. Normal can be characterized as a Federal Funds target rate in line with the average of the past 30 years or it might be a level that reflects sufficient “dry powder” were the Fed to need that policy tool in a future economic slowdown.
  • The Fed should reduce the size of their balance sheet. In this case, normal under reasonable logic would be the size of the balance sheet before the financial crisis either in absolute terms or as a percentage of nominal gross domestic production (GDP). Despite some reductions, it is not close on either count.

The Fed consistently feeds investors’ guessing games about what they deem appropriate. There appears to be little rigor, debate, or transparency about the substance of those decisions. Neither Ben Bernanke nor Janet Yellen offered details about how they would accurately characterize “normal” in either context. The reason for this seems obvious enough. If they were to establish reasonable parameters that defined normal levels in either case, they would be held accountable for differences from their prescribed benchmarks. It might force them to take actions that, while productive and proper in the long-run, may be disruptive to the financial markets in the short run. How inconvenient.

In most instances, normal is defined as something that conforms to a standard or that which has been common under historical experience. Begin by looking at the Fed Funds target rate. A Fed Funds rate of 0.0% for seven years is not normal, nor is the current rate range of 2.25-2.50%.

As illustrated in the chart below, in each of the past three recessions dating back to 1989, the Fed cut the fed funds rate by an average of 5.83%. In that context, and now resting at less than half the average historical pre-recession level, a Fed Funds rate of 2.25-2.50% is clearly abnormal and of greater concern, insufficient to combat a downturn.

Interest rates should mimic the structural growth rate of the economy. As we have illustrated in prior analysis and articles, particularly Wicksell’s Elegant Model, using a 7-year cycle for economic growth reflective of historical expansions, that time-frame should offer a reasonable proxy for “structural” economic growth. The issue of greater concern is that, contrary to the statement above, structural growth appears to be imitating the level of interest rates meaning the more the Fed suppresses interest rates, the more growth languishes.

Next, let’s look at the Fed balance sheet. Quantitative tightening began in late 2017 gradually increasing as the Fed allowed their securities bought during QE to mature without replacing them. As shown in the blue shaded area in the chart below, QT reduced the Fed balance sheet by about $500 billion, but it remains absurdly high at nearly $4.0 trillion. As a percentage of GDP, it has dropped from a peak of 25.3% to 19%. Before the point at which QE was initiated in September 2008, the size of the Fed balance sheet was roughly $900 billion or 6% of nominal GDP and was in a tight range around that level for decades. Now, with the Fed halting any further reductions in the balance sheet, are we to assume 20% of GDP to be a normal level? If so, what is the basis for that conclusion?

The bottom line: simple analysis, straight-forward logic, and common sense dictate that monetary policy remains abnormal.

Fisher helps us understand why the Fed is so hesitant to normalize policy, despite their outward confidence in being able to do so.

Second-Order Effects

As Fisher stated in his remarks at the conference, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” This is a powerfully important statement highlighting second-order effects. He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.” Prophetic indeed.

The “easy” part of getting rates and the balance sheet back to “normal” is now proving to be not so easy. What the Fed did not account for when they unleashed unprecedented policy was the habits and behaviors among governments, corporations, households, and investors. Modifying these behaviors will come at a debilitating cost.

Think of it like this: Nobody starts smoking cigarettes with a goal of smoking two packs a day for 30 years, but once introduced, it is difficult to stop. Furthermore, trying to stop smoking can be very painful and expensive. NOT stopping is medically and scientifically proven to be even more so.

Fisher goes on to explain in real-world terms how two households are impacted in an environment of extraordinary policy actions. One household possesses savings; the other does not. Consider their traditional liabilities such as mortgage and auto loans, “but also their future consumption expenditures, their liability to feed and clothe themselves in the future.” The family with savings may feel wealthier from gains in their invested savings and retirement accounts as a result of extraordinary policies pushing financial markets higher, but they also must endure an increase in the cost of living. In the final analysis, they end up where they started. “They may… perceive a wealth effect but, ultimately, there is only a wealth illusion.”

As for the family without savings, they had no investments to go up in value, so there is no wealth effect. This means that their cost of living rose and, wages largely stagnant, it occurred without any form of a commensurate rise in income. That can only mean their standard of living dropped. As Fisher states, given extraordinary policy imposed, “There was no wealth effect, not even a wealth illusion, just a cruel hoax.” He further adds, “…the next time you hear that the net-wealth of American households is at an all-time high, do spend a minute thinking about the present value of the unrecorded future consumption expenditures, particularly of households with no savings.”

What is remarkable about Fisher’s analysis is contrasting it with the statements of Fed officials who say they are acting in the best interest of all U.S. citizens. Quoting from George Orwell’s Animal Farm, “All animals are equal, but some animals are more equal than others.”

A man can easily drown crossing a stream that is on average 3 feet deep. Household wealth as a macro measure of monetary policy success in a period when wealth inequality is at such extremes perfectly illustrates this imperfection. As Fisher states, “Out of both humility and self-preservation, let’s hope the Fed finds a way to stop targeting the level of wealth.”

Linear Extrapolation

Fisher also addresses the issue of Fed forward guidance stating, “Implicit in forward guidance…is the idea that dampening short-term market uncertainty and volatility is a good thing. But removing uncertainty from our capital markets is not, in my view, an unambiguous blessing.”

Forward guidance, whereby the Fed provides expectations about future policy, targets an optimal level of volatility without being clear about what “optimal” means. How does the Fed know what is optimal? As we have stated before, a market made up of millions of buyers and sellers is a much better arbiter of prices, value, and the resulting volatility than is the small group of unelected officials at the Fed. Yet, they do indeed falsely portray an understanding of “optimal” by managing the prices of interest rates but theirs is a guess no better than yours or mine. Based upon their economic track record, we would argue their guess is far worse.

Fisher goes on to reference John Maynard Keynes on the subject of extrapolative expectations which is commonly used as a basis for asset pricing. Referring to it as the “conventional valuation” in his book The General Theory of Employment, Interest and Money, Keynes said this reflects investors’ assumptions “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” Connecting those dots, Fisher states that “forward guidance is the process through which the Fed – through its more explicit influence on the expected rate of interest – becomes the much more explicit owner of the “conventional valuation” of asset prices… the Fed now has a heightened responsibility and sensitivity to asset pricing.

That conclusion is critically important and clarifies the behavior we see coming out of the Eccles Building. In becoming the “explicit owner” of valuations in the stock market, the Fed now must adhere to a pattern of decisions and actions that will ultimately support the prices of risky assets under all circumstances. Far from rigorous scrutiny of doubts and assumptions, the Fed fails in every way to apply the scientific method of analyzing their actions before and after they take them. So desperate are they to manage the expectations of the public, their current posture leaves no latitude for uncertainty. As Fisher further points out, the last time we saw evidence of a similar stance was in 2007 when the Fed rejected the possibility of a nation-wide decline in house prices.

Summary

Fisher fittingly sums up by restating the point he made at the beginning:

“…the Fed and other central banks appear to have avoided being candid about the uncertainty (of extraordinary monetary policies) in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.”

The power of Fisher’s perspectives is in his candor. Now at a time when the Fed is proving him correct on every count, it is worthwhile to refresh our memories. We would encourage investors to read the transcript in full. Given the clarity of the insights he shares, summarized here, their importance cannot be overstated.

Undoing Extraordinary Monetary Policy

Dollars & Nonsense Market Review

If there was one message to be taken away from the first half of 2019, it was that the Fed still reigns supreme in the minds of investors as to what drives markets. After a remarkably strong first quarter during which the Fed flipped its position on rate increases, performance remained very respectable in the second even though fundamentals began eroding and the yield curve inverted. 

Such attention to plans for rate decreases belies another reality that is far more important for long-term investors. The global financial system has grown in complexity and this complicates the Fed’s ability to control US dollar liquidity. High levels of government debt further impinge on its ability to nurture economic growth. Now, after ten years of interventionist monetary policy, it is a good time for investors to turn their focus away from the nonsense of short-term machinations and to start considering the longer-term consequences.  

For many investors and analysts, money is a dull subject that wreaks of tedium and only serves to distract from more interesting investment analysis. As Chris Martenson describes in his Crash Course,

“Money is something that we live with so intimately on a daily basis that it probably has escaped our close attention.” 

This is potentially a blind spot for many investors. For those who may have learned about money and money supply in a college economics class years ago, things have changed a lot and the global financial system has evolved considerably. For those who never paid much attention to the subject, liquidity has become a more important component of the overall investment equation.

In order to fully understand some of the changes, it helps to refresh the basics. For starters, Martenson captures the essence of money with a practical notion:

Money is a claim on human labor. With a very few minor exceptions, pretty much anything you can think of that you might spend your money on will involve human labor to bring it there. I say it’s a claim rather than a store, because the human labor in question might have happened in the past, or it might not have happened yet.

Wikipedia provides a good account of how those claims come into existence with a definition of money supply:

“The money supply of a country consists of currency (banknotes and coins) and, depending on the particular definition used, one or more types of bank money (the balances held in checking accounts, savings accounts, and other types of bank accounts). Bank money, which consists only of records (mostly computerized in modern banking), forms by far the largest part of broad money in developed countries.”

Money is originally created by the Fed or another central bank. As Martenson describes,

“Money is created … [when] the Federal Reserve buys a Treasury bond from a bank.”

In this case, the money “literally comes out of thin air” as the money is created simply by the act of the Fed buying the debt. In order to validate the message, Martenson quotes the Federal Reserve publication, “Putting it Simply”:

When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn.  When the Federal Reserve writes a check, it is creating money.”

The money the Fed creates then serves as the foundation from which bank lending can further expand money supply. Since banks are only required to maintain a fraction of loans outstanding in reserve, any loans in excess of those reserves constitutes money creation. In short, “money is loaned into existence.”

This constitutes the basic traditional perspective of money and money supply. Banks are responsible for the bulk of money supply through the provision of credit. This system tends to be procyclical, but those tendencies are checked by close regulatory scrutiny and the ability of regulators to shut down banks when they become insolvent.

As shadow banking emerged, however, it became harder to track and control money supply because operations occurred primarily outside of the authority of banking regulators. Wikipedia provides a good working definition of shadow banking that was given by Ben Bernanke:

“Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions — but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper [ABCP] conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies”

Cross Borders Capital elaborates on the concept of shadow banking in its report, “Why has global liquidity crashed again?“:

“What shadow banks do is to transform these bank assets and liabilities by re-financing them in longer and more complex intermediation chains”

As a result, the overwhelming practical effect of shadow banking is not so much to provide new sources of credit, although that can happen, but rather to “increase the elasticity of the traditional banking system.

One of the key differences between shadow banks and traditional banks is that shadow banks do not have access to funding via customer deposits. As a result, shadow banks are entirely reliant upon wholesale funding. In other words, their operations depend entirely on capital markets, which at times can be quite volatile.

Another important monetary development, that emerged alongside shadow banking, has been the Eurodollar system. Wikipedia defines Eurodollars as “time deposits denominated in U.S. dollars at banks outside the United States”. Jeffrey P. Snider, from Alhambra Partners, has discussed the Eurodollar system extensively [here] and [here] and emphasizes that the Eurodollar system is “much broader than the standard definition” and is not “a technically precise term”. 

Snider instead describes Eurodollars as a “system of interbank liabilities” that real economy participants use “in order to accomplish real-world activity.” In other words, it includes “the transformation of banking into a wholesale model often free of deposits altogether.”

The Eurodollar system is especially notable because:

[It] is a system that operates in the shadows and creates supply of US dollars and creates all kinds of complex transactions in US dollars that the US central bank, the Federal Reserve doesn’t really know about because it’s outside of their regulatory purview.” Further, “the use of these Eurodollars is theoretically unlimited.

A very basic takeaway from all of this, then, is that the monetary system has expanded beyond the traditional model of fractional reserve banking. Therefore, it is important to understand the ways in which shadow banking and the Eurodollar system are different in order to understand the implications for money supply and monetary policy. 

One of those ways in which things have changed is, as the Federal Reserve Bank of New York’s report “Money, liquidity, and monetary policy” notes, “the growing importance of the capital market in the supply of credit.” More specifically, 

“The balance sheet growth of broker-dealers provides a sense of the availability of credit. Contractions of broker-dealer balance sheets have tended to precede declines in real economic growth, even before the current turmoil. For this reason, balance sheet quantities of market-based financial intermediaries are important macroeconomic state variables for the conduct of monetary policy.”

The Eurodollar system and shadow banks also differ from fractional reserve banking in that they operate outside the “regulatory purview” of central banks. This makes it far harder for central banks to monitor their activity and even harder to control it. As a result, the mechanics of liquidity, and therefore of monetary policy, have also changed. Cross Borders Capital notes:

“Liquidity is consequently a more general concept than textbook money supply measures because it extends beyond traditional domestic retail deposit-taking banks into cross-border and wholesale-funded shadow banks … Textbook economics also fails to understand the inherent system-wide risks because it sees every credit as a debt (debit) and every debt as a credit.”

The risks are amplified because “wholesale funding is collateral-based and highly pro-cyclical, and it has the potential to feed-back negatively on to the funding as well as the lending activity of traditional banks.” In other words, the addition of shadow banking and the Eurodollar system to the traditional banking system is like adding cocaine to a human body. It amps things up in the short-term, but also makes them more erratic and precarious in the longer-term. As Jeffrey Snider describes, “This [Eurodollar] is a dysfunctional system, so we’re not really positive about any of this stuff.”

At this point it is fair to ask, “Why discuss shadow banking and the Eurodollar system now?”

These phenomena have been around for many years and have been reported before for those curious enough to dig into the minutiae. For the last ten years, though, it hasn’t mattered. Liquidity has been ample enough and long-term consequences distant enough that the best thing to do has been to completely disregard risk. In the process, many investors have learned exactly the wrong lessons and risk being seriously wrong in the not-too-distant future.

Now, with substantially higher government (and corporate) debt outstanding, with the recession-fighting capacity of central banks vastly reduced, and with the end of a business cycle approaching, the equation has changed. Understanding the mechanics of liquidity and the constraints it places on monetary policy will be crucial for investors to understand in order to weather adversity.

One important lesson is that low rates are not an unalloyed good as many believe. Lower rates can temporarily ease the burden of interest payments for indebted entities and lower rates can temporarily encourage risk-taking. 

Lowering rates cannot create wealth, however, and John Hussman explains well the limited efficacy of doing so:

“Tinkering with security valuations doesn’t create aggregate “wealth” – it simply takes future returns and embeds them into current prices. Long-term ‘wealth’ is largely unchanged, because the actual wealth is in the future cash flows that will be delivered to investors over time, and once a security is issued, somebody has to hold it at every point in time until that security is retired. The only thing elevated investment valuations do is provide an opportunity for current holders to receive a transfer of wealth by selling out to some poor schlub who pays an excessive price for the privilege of holding the bag of low future returns over time.

In addition, the effectiveness of low rates as stimulative monetary policy is contingent on beginning debt levels. As Van Hoisington and Lacy Hunt write in their second quarter review and outlook, a drop in real yields would be a “stimulant to economic activity”, but only in the event “debt levels were considerably lower.” 

As is, in the presence of relatively high levels of debt, low rates ultimately constrict economic activity. They describe the mechanics:

When real yields are low or negative, investors and entrepreneurs will not earn returns in real terms commensurate with the risk. Accordingly, the funds for physical investment will fall, and productivity gains will continue to erode as will growth prospects.

In other words, accelerating government debt is like a noose on an economy. You might be able to create some space with low rates that can provide some breathing room and some temporarily good news. Longer term, however, natural forces will eventually cause the economy to choke.

Another consequence of keeping rates too low over a long period of time is that it encourages yield-seeking behavior and risks unleashing the shadow and Eurodollar beasts that are “theoretically unlimited”. Even though this was a big part of the problem in the 2008 financial crisis, many investors seem to be overlooking the potential for trouble now. The system has not changed in any material way.

So how should investors handicap markets and monetary policy? 

The Financial Times reports, “The financial crisis has left many of us hypnotised by existential risks to the banking system.”

Indeed, much of the monetary policy implemented by major central banks since has been aimed at averting just such an existential event.

Such priorities, however, have created something of a Faustian bargain. Each time monetary authorities intervene to lower rates or to provide additional liquidity, they help prevent a sudden freeze-up in the financial system. In doing so, however, they also create longer term problems. Among those problems, in the words of Steven Alexopoulos, JPMorgan’s regional bank analyst, is “a near perfect environment for banks to have let down their guard and become less sensitive to risk.”  

As the economic recovery gets into the late innings and as more indicators suggest slowing growth, it is useful to remember that “regular non-crisis, non-fatal credit downturns hurt like hell too and this one might be worse than most.” Or, in more vivid terms:

Last time we had a heart attack, so this time it will be cancer.”

Whether the prognosis for economic “cancer” is correct or not, there are some overarching lessons for long-term investors. One is that placing too much faith in the Fed and short-term ructions from monetary policy comes at the expense of preparing for longer-term consequences. Also, the condition of a high level of government debt constrains the effectiveness of monetary policy. Finally, all of this is happening in a financial system that has greater systemic risk.

All signs point to lower exposure to risk assets. 

Half-Point Rate Cut Odds Explode To 71%! Does It Really Matter?

The odds of a 50 basis point rate cut on July 31 topped the 70% mark in the wake of a dive in leading indicators.

CME Fedwatch notes a huge jump in the odds of a 50 basis point cut by the Fed on July 31.

This is an edited post. In the hour or so that it took me to write this, the odds jumped from 49% to 71%.

Increasing Odds of 50 BPs Cut

  • Today (one hour ago) 49.3%
  • Now (2:48 PM central) 71.0%
  • Yesterday: 34.3%
  • 1 Week ago: 19.9%
  • 1 Month Ago: 17.9%

Why?

  1. The odds jumped yesterday from the prior week on news Housing Slowly Rolling Over: June Permits Down 6.1%, Starts Down 0.9%
  2. The odds jumped today from yesterday on news Leading Economic Indicators (LEI) Unexpectedly Dive Into Negative Territory

What’s Really Happening?

  • Traders are front-running the Fed.
  • History shows the Fed is highly likely to cooperate with what traders want.

That’s it in a nutshell.

Four Easy Predictions

  1. Powell gets his name in lights
  2. Trump will praise the rate cuts while saying they may be too late. And if so, the Fed is to blame. Trump will have his scapegoat: Fed chair Jerome Powell.
  3. The market will not like a 25 basis point cut.
  4. The market will not like a 50 basis point cut either, although the initial reaction may be positive. Look for a gap and crap, if not immediately, within a couple days, but I expect the same day.

What About the Insurance Theory?

A number of Fed governors and economic writers want a big cuts for insurance purposes.

These people are economic illiterates.

Too Late for Insurance

Rate cuts now as economic insurance is like trying to buy insurance on your car after you wrecked it.

The bubbles have been blown.

Rate cuts cannot unblow economic bubbles any more than they can unblow a horn.

Rate Cuts Don’t Matter

The bottom line at this point is an economic recession is baked in the cake. The global economy is slowing and the US will not be immune.

It’s possible the US is in recession already, but consumer spending does not point that way, unless it’s revised.

It’s all moot.

Fed Deflation Boogeyman

The Fed has been fighting the deflation boogeyman.

Yet, the BIS did a historical study and found routine deflation was not any problem at all.

Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the study.

For a discussion of the BIS study, please see Historical Perspective on CPI Deflations: How Damaging are They?

Deflationary Bust Baked in the Cake

In the Fed’s foolish attempt to stave off consumer price deflation, the Fed sowed the seeds of a very destructive set of asset bubbles in junk bonds, housing, and the stock market.

The widely discussed “everything bubble” is, in reality, a corporate junk bond bubble on steroids sponsored by the Fed.

For discussion, please see Junk Bond Bubble in Pictures: Deflation Up Next

A 50 or even 100 basis point cut won’t matter now.

It’s too late to matter. The debt deflation horn has already sounded.

Counting Cards In The Casino

In some ways, Wall Street is like a casino.  Both have shiny lights, bells and whistles, with distractions galore and a myriad of different bets for the making.  Wall Street and Vegas both profit from volatility, liquidity, distractions, and volume. Unfortunately for you, Wall Street and Vegas have the odds in their favor, and they don’t really care if you win or lose.  The bottom line is that both Wall Street and Vegas will turn big profits as long as enough people play their games.

The casino analogy doesn’t “walk on all fours.”  For one, not all investors and traders are gamblers.  Great investors are more like “entrepreneurs” than “gamblers,” in that they take measured risk within a disciplined system.  In the long run, most gamblers lose money.  In the long-run, most disciplined investors make money.  

In my daily newsletter, I report over-bought and over-sold signals based upon key signals of financial risk.  My goal for the newsletter is simple: to help subscribers achieve their financial goals.  Zig Ziglar says, “you can have everything in life you want if you just help enough other people get what they want.” 

Side Bets and Synthetic Securities

Often in most casino games, side bets are more important and/or lucrative than the actual game itself.  A perfect example of this is typified in the movie The Big Short.  Selena Gomez is playing blackjack and explaining how the side bets she placed on her hand are like synthetic securities that are now pervasive throughout the financial markets.  Both in the movie and in the real-world financial markets, the synthetic side bets are many orders of magnitude larger than the “real” bets.

In most financial markets, synthetic transactions dwarf the actual physical supply and demand of a security or commodity.  This is true for stock certificates, barrels of oil, ounces of gold, and bushels of grain, to name a few. 

As an example, each day the NYMEX WTI crude oil futures contracts trade as much as ONE HUNDRED TIMES the actual daily physical supply of crude oil.  Think about this, the paper trading of crude oil IN ONE LOCATION (Cushing, OK), traded ON A SINGLE exchange (NYMEX) – not including any over-the-counter or other exchange trading – is often ONE HUNDRED TIMES the actual physical supply of crude oil over the ENTIRE United States.  Such enormous differences hold true for almost every commodity.

Since trading activity in synthetic paper markets often overwhelm the physical markets, it is important for investors to stay informed of factors that highlight derivative risks and potential order flows. The options market often provides these clues and this is the crux of my analysis.

Option expiration (op-ex) is a key moment in time when profit is realized and risk is purged.  All options bets and hedges on the books settle, roll over, close, or expire worthless on the op-ex timestamp.  My work shows the repeatability of a few different dynamics as the date of op-ex gets closer. These include:

  • Mean reversion of market price prior towards delta neutral on or before op-ex.
  • Forced selling and/or buying following a spike in market gamma. 

Counting Cards in the Casino

“Synthetic paper”, including options and derivatives, are very complicated topics even for financial professionals. As such I believe it is essential to make my daily report as user-friendly as possible. I compile and process reams of data and boil it down to simple actionable advice.  When a market price is in the top 10% of aggregate risk to call sellers, I report an over-bought signal.  When a market price is in the top 10% of aggregate risk to put sellers, I report an over-sold signal.  This doesn’t provide a definitive “answer,” but it does give a unique and potentially actionable perspective with defined risk measures.

If we are sticking with the Blackjack analogy, the program that I run each morning is a card-counting machine.  I “count the cards” so you don’t have to.

Bloomberg and the Wall Street Journal Agree

I am not the only one who sees the relationship between option risk and market price.  Over the past year, there has been an increasing awareness in the financial mainstream media about “gamma” as a measure of market risk.  In November 2018, Bloomberg suggested that intelligence on market gamma can give advance notice of an oil market plunge.   In July 2019, the Wall Street Journal reported that intelligence on market gamma can explain why markets “suddenly go crazy.” 

Bloomberg and the Wall Street Journal agree that gamma is an important concept for investors, however you cannot find actionable gamma data on a $25,000 per year Bloomberg terminal.

I know of no other service where you can get information as comprehensive and inexpensive as I offer it.  Give my service a try with a free two week trial and see if helps you become a better investor and trader.

Long-Short Idea List: 07-18-19

HOW TO READ THE CHARTS

There are four primary components to each chart:

  • The price chart is contained within the shaded area which represents 2-standard deviations above and below the short-term moving average.  
  • The Over Bought/Over Sold indicator is in orange at the top.
  • The Support/Resistance line (green) is the longer-term moving average which also acts as a trailing stop in many cases.
  • The Buy / Sell is triggered when the green line is above the red line (Buy) or vice-versa (Sell).

LONG CANDIDATES

ALB – Albermarle Corp.

  • Value stocks have been out of favor for a long-time. ALB has gotten extremely cheap and beaten up.
  • With a buy signal close to registering from an oversold condition there is a decent setup for a trade with a tight stop loss.
  • Buy at current levels.
  • Stop level is $63

GOOG – Alphabet, Inc.

  • We previously recommended going long GOOG, then shorting GOOG, and last we suggested going back long again.
  • GOOG has gotten oversold and is lagging the rest of the tech market currently. With earnings season approaching there is upside potential for a trade.
  • A break above the 50-dma, currently testing, gives GOOG decent upside.
  • Buy at current levels as stop loss levels are very close.
  • Stop-loss is currently $1100

CRM – Salesforce.com

  • We noted last week that CRM has been holding support and consolidating for the last few months.
  • With earnings season approaching, an upside surprise could give the position a lift and stop-loss levels are very close.
  • CRM broke above the 50-dma last week, which opens up old highs as a target.
  • Add a position at current levels.
  • Stop loss is set at $150.

INTC – Intel Corp.

  • After a brutal beating following last earnings, the semi-conductor space has shown some signs of life.
  • With INTC above its 50- and 200-dma there is a potential trade with a tight stop loss.
  • While on a sell signal currently, that signal is beginning to reverse.
  • Buy 1/2 position at current levels.
  • Stop loss is tight at $47.50

CVS – CVS Health Corp.

  • We recently added a position in CVS to our portfolio as the buy signal is approaching.
  • CVS has now triggered a buy signal so we are re-recommending a long-position for now.
  • A break above $60 will give CVS legs to the upside.
  • Buy at current levels.
  • Stop is set at $50 – honor thy stop.

SHORT CANDIDATES

BLK – Blackrock, Inc.

  • BLK is very overbought and at the top of the trading range.
  • If the market gets sloppy over the next couple of months we will likely see downside in the shares.
  • Short at current levels.
  • Target for trade is $410
  • Stop-loss is set at $485

CFG – Citizens Financial Group.

  • CFG has been in a long-term consolidation pattern.
  • With a sell signal approaching and very tight parameters, there is a decent short-setup currently.
  • Short on a break below $34
  • Target for trade is $28
  • Stop loss is $36

GPC – Genuine Parts, Co.

  • GPC has been running along its bullish trend line for quite some time.
  • Currently on a sell signal, and struggling with support, a break of that trendline will provide a reasonable downside target.
  • Short on a break below $101
  • Target is $90
  • Stop loss is $105

SPG – Simon Property Group

  • SPG has been struggling relative to REIT’s as a whole.
  • Currently on a fairly major sell signal and sitting on important support, shorting parameters are fairly tight.
  • Short on break of support at $160
  • Stop is set at $165
  • Target for the trade is $140

TIF – Tiffany and Co.

  • TIF is flirting with an important sell signal combined with the potential break of a downtrend.
  • Sell short on a break of support at $92.50
  • Target is $75
  • Stop is set at $96

Debt & The Failure Of Monetary Policy To Stimulate Growth

A fascinating graphic was recently produced by Oxford Economics showing compounded economic growth rates over time.

What should immediately jump out at you is that the compounded rate of growth of the U.S. economy was fairly stable between 1950 and the mid-1980s. However, since then, there has been a rather marked decline in economic growth.

The question is, why?

This question has been a point of a contentious debate over the last several years as debt and deficit levels in the U.S. have soared higher.

Causation? Or Correlation?

As I will explain, the case can be made the surge in debt is the culprit of slowing rates of economic growth. However, we must start our discussion with the Keynesian theory, which has been the main driver both of fiscal and monetary policies over the last 30-years.

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

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

Keynes’ was correct in his theory. In order for deficit spending to be effective, the “payback” from investments being made must yield a higher rate of return than the debt used to fund it.

The problem has been two-fold.

First, “deficit spending” was only supposed to be used during a recessionary period, and reversed to a surplus during the ensuing expansion. However, beginning in the early ’80s, those in power only adhered to “deficit spending part” after all “if a little deficit spending is good, a lot should be better,” right?

Secondly, deficit spending shifted away from productive investments, which create jobs (infrastructure and development,) to primarily social welfare and debt service. Money used in this manner has a negative rate of return.

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

Here is the real kicker. In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in

Do you see the problem here? (In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.”)

Debt Is The Cause, Not The Cure

This is one of the issues with MMT (Modern Monetary Theory) in which it is assumed that “debts and deficits don’t matter” as long as there is no inflation. However, the premise fails to hold up when one begins to pay attention to the trends in debt and economic growth.

I won’t argue that “debt, and specifically deficit spending, can be productive.” As I discussed in American Gridlock:

“The word “deficit” has no real meaning. Dr. Brock used the following example of two different countries.

Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures, but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.

There is no disagreement about the need for government spending. The disagreement is with the abuse, and waste, of it.”

The U.S. is Country A.

Increases in the national debt have long been squandered on increases in social welfare programs, and ultimately higher debt service, which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

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

The irony is that debt driven economic growth, consistently requires more debt to fund a diminishing rate of return of future growth. It now requires $3.02 of debt to create $1 of real economic growth.

However, it isn’t just Federal debt that is the problem. It is all debt.

When it comes to households, which are responsible for roughly 2/3rds of economic growth through personal consumption expenditures, debt was used to sustain a standard of living well beyond what income and wage growth could support. This worked out as long as the ability to leverage indebtedness was an option. Eventually, debt reaches levels where the ability to consume at levels great enough to foster stronger economic growth is eroded.

For the 30-year period from 1952 to 1982, debt-free economic growth was running a surplus. However, since the early 80’s, total credit market debt growth has sharply eclipsed economic growth. Without the debt to support economic growth, there is currently an accumulated deficit of more than $50 Trillion.

What was the difference between pre-1980 and post-1980?

From 1950-1980, the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%.

There were a couple of reasons for this.

  1. Lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy.
  2. The economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy.  

The obvious problem is the ongoing decline in economic growth. Over the past 35 years, slower rates of growth has kept the average American struggling to maintain their standard of living. As wage growth stagnates, or declines, consumers are forced to turn to credit to fill the gap in maintaining their current standard of living. (The chart below is the inflation-adjusted standard of living for a family of four as compared to disposable personal incomes and savings rate. The difference comes from debt which now exceeds $3400 per year.)

It isn’t just personal and corporate debt either. Corporations have also gorged on cheap debt over the last decade as the Fed’s “Zero Interest Rate Policy” fostered a scramble for cash for diminishing investment opportunities, such as share buybacks. These malinvestments ultimately have a steep payback.

We saw this movie play out “real-time” previously in everything from sub-prime mortgages to derivative instruments. Banks and institutions milked the system for profit without regard for the risk. Today, we see it again in non-financial corporate debt. To wit:

“And while the developed world has some more to go before regaining the prior all time leverage high, with borrowing led by the U.S. federal government and by global non-financial business, total debt in emerging markets hit a new all time high, thanks almost entirely to China.”

“Chinese corporations owed the equivalent of more than 155% of Global GDP in March, or nearly $21 trillion, up from about 100% of GDP, or $5 trillion, two decades ago.”

The Debt End Game

Unsurprisingly, Keynesian policies have failed to stimulate broad based economic growth. Those fiscal and monetary policies, from TARP, to QE, to tax cuts, only delayed the eventual clearing process. Unfortunately, the delay only created a bigger problem for the future. As noted by Zerohedge:

“The IIF pointed out the obvious, namely that lower borrowing costs thanks to central banks’ monetary easing had encouraged countries to take on new debt. Amusingly, by doing so, this makes rising rates even more impossible as the world’s can barely support 100% debt of GDP, let alone 3x that.”

Ultimately, the clearing process will be very substantial. As noted above, with the economy currently requiring roughly $3 of debt to create $1 of economic growth, a reversion to a structurally manageable level of debt would involve a nearly $40 Trillion reduction of total credit market debt from current levels. 

This is the “great reset” that is coming.

The economic drag from such a reduction in debt would be a devastating process. In fact, the last time such a reversion occurred, the period was known as the “Great Depression.”

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns, and a stagflationary environment as wages remain suppressed while cost of living rise.

The problem of debt will continue to be magnified by the changes in structural employment, demographics, and deflationary pressures derived from changes in productivity. As I showed previously, this trend has already been in place for the last decade and will only continue to confound economists in the future.

“The U.S. is currently running at lower levels of GDP, productivity, and wage growth than before the last recession. While this certainly doesn’t confirm Shelton’s analysis, it also doesn’t confirm the conventional wisdom that $33 Trillion in bailouts and liquidity, zero interest rates, and surging stock markets, are conducive to stronger economic growth for all.”

Correlation or causation? You decide.

RIA Pro Supplement for Beware of the Walking Dead

In Beware of the Walking Dead, we revealed an analysis illustrating those companies in the S&P 1500 that qualify as zombie corporations. As promised in the article, we are providing a full list of those companies here for RIA Pro members.

According to James Grant of Grant’s Interest Rate Observer, zombie companies fail to generate enough operating income to cover the interest on their outstanding debt. The screen we used evaluates companies based on their three-year average for that metric. Those companies highlighted in yellow in Table 1 are the worst offenders with three consecutive years of a negative zombie metric. The remaining zombie companies are in Table 2.

The list of stocks that qualify as zombies under this definition is based on Bloomberg data through Q1 2019, revealing a total of 128 companies or 9% of the S&P 1500. The listing below also includes the three-year annualized total rate of return on those stocks as well as S&P rating and rating outlook when available.

INTERVIEW: Raoul Pal – The Coming Debt-Driven Crisis & Why The Fed Can’t Stop It.

I recently had the privilege to visit with Raoul Pal, the founder of Real Vision, to discuss a variety of topics including:

  • The risk of recession in the U.S.
  • What Trump’s nomination of Judy Shelton to the Fed means.
  • Can you have a gold standard AND zero interest rates.
  • The future of the ECB and monetary policy in Europe
  • The real value of gold.

After we stopped rolling tape on the interview Raoul and I kept going and discussed Facebook’s Libra, cypto currency, and how much you should own. The cameras kept rolling so we have a great bonus clip for you.

Check out the new FREE version of Real Vision at www.realvision.com/free

I hope you enjoy our interview with Raoul Pal.


RECESSION: Can The U.S. Have A Recession Without GDP Showing It?


The Future Of The Fed, Monetary Policy, Rates, Judy Shelton, IMF, and the ECB


The True Value Of Gold


BONUS TRACK: Crypto Currency, Facebook’s LIBRA, & How Much You Should Own.


Beware of the Walking Dead

In a previous article, The Fed’s Body Count, we stated:

“Markets and economies, like nature itself, are beholden to a cycle, and part of the cycle involves a cleansing that allows for healthy growth in the future. Does it really make sense to prop up dead “trees” in the economy rather than allow them to fall and be used as a resource making way for new growth?”

We come back to that thought in this article inspired by the notion that investors find themselves in a forest increasingly littered with dead trees. In today’s market parlance, the dead trees (corporations) are called zombies.  This article details the corporate zombie concept in-depth and provides a few examples to illustrate the topic.

The Walking Dead

It is no small irony that one year after the end of the great recession, a television show about the zombie apocalypse quickly became one of the most successful shows on TV. The Walking Dead features a large cast of “survivor” characters under near-constant threat of attack from mindless zombies, or “walkers” as they are called.

In the investment world, the term zombie has a special connotation generally referring to a company that might otherwise not be around had the Federal Reserve not suppressed interest rates for so long. The zombie label is fitting as these companies do not die as they should and at the same time, they devour capital and resources that could otherwise be used by healthy companies. They are a drain on the economy.

Although not a matter of life and death, investing in zombie companies or failing to understand the implications of their existence poses a unique risk to one’s economic well-being.

Zombies Defined

The generic description used for zombified companies is too obtuse to use to precisely identify such companies. If the suppression of interest rates served a key role in maintaining these firms, what would be the circumstances fundamental to that condition?

Corporate zombies are generally described as companies that cannot function without bailouts and/or those firms that can only afford to service the interest on their debt while deferring repayment of principal indefinitely. In our view, those definitions do not go far enough.

In a recent interview, James Grant of Grant’s Interest Rate Observer offered what seems to be the most precise definition – zombie companies fail to generate enough operating income to cover the interest on their outstanding debt. Furthermore, that condition would have to persist for more than one year to eliminate any anomalous results.

In other words, a corporation that fails to cover its interest expense can, for a time, keep borrowing to make up the shortfall, especially if money is cheap. On the other hand, true zombie status is revealed, and the “headshot” of demise ultimately comes, when the company runs out of borrowing runway. That circumstance can unfold rather quickly in an economic downturn or a period of rising interest rates when the negative differential between operating income and interest expense widens further.

Operating Income is defined as gross revenue minus wages, cost of goods sold, and selling, general and administrative expenses (SG&A). Operating income does not include items such as investments in other companies, taxes, or interest expense. Isolating the difference between operating income and interest expense is a way of comparing the revenue that a company expects to become profit versus the cost incurred for borrowed funds. It is a variation of a leverage ratio.

Zombie Hunt

We analyzed the broad S&P 1500 to identify companies having zombie characteristics under Grant’s definition. Namely, does their interest expense exceed their operating income and has it done so when averaged over the last three years?

The list of stocks that qualify as zombies under this definition using Bloomberg data through Q1 2019 reveals 204 companies or 13.5% of the S&P 1500. Some of these companies do not show any interest expense but have operating income losses, so we removed those companies. That leaves 128 companies or 9% of the members of the index. Using a stricter methodology of requiring three consecutive years of interest expense exceeding operating income returns 43 companies that meet the criteria or roughly 3% of the index. These 43 companies are the worst in class of the zombie population.

While defining and identifying the zombies is a good start, what we care about is a divergence between fundamentals and valuations. In other words, we want to truly protect ourselves from the zombies who appear alive due solely to a well-performing share price. In doing this, we find that 34% of the 128 companies have positive 3-year annualized total returns. Of these firms, the average 3-year annualized return of that population through June 30, 2019, is 13.6%. There are also another 11 companies that have been relatively stable as defined by annualized total returns of zero to -5%.

Such returns do not reflect the underlying fundamentals of companies that cannot service their debt and are a recession away from going bankrupt. The graph below charts operating income less interest expense with the three-year total returns for the 128 zombie companies.

Data Courtesy Bloomberg

For the 128 companies represented in the graph, they either have weak revenue generation and/or onerous debt levels. That, however, raises another issue for consideration – just how bad is the situation if the company cannot cover the interest expense on their debt due to weak demand for their products and/or services? Equally concerning, what if there is so much debt that even solid demand for their products and accompanying revenues do not cover that expense?

Deeper Dive

Awareness of this issue and quantifying it is useful and important to help us understand the kinds of imbalances that exist in the economy. At the same time, while most zombie companies would not exist were it not for years of suppressed interest rates, those that do should be priced for the uncertainty of an economic downturn and the higher probability of their demise in that event. As mentioned, many are not. Out of the 128 companies whose operating income cannot cover interest expense, many are priced at valuations that imply they are a normal going concern.

To gain a better perspective of zombies, we selected three individual candidates to explore in-depth. As discussed, the market is crawling with these companies that bear very similar characteristics. A table of the relevant fundamental statistics for each company is shown below each summary.

RIA Pro subscribers are being provided a complete list of zombie companies beyond the three detailed below.

Rent-A-Center, Inc. (RCII)

RCII, a BB-rated company with a stable outlook, operates and franchises rent-to-own merchandise stores offering electronics, appliances, and furniture under “flexible rental purchase agreements” (lucrative financing plans). Based in Plano, Texas, they have 14,000 employees and a market capitalization of $1.3 billion. RCII stock has a three-year annualized return of 30.7% and three-year average EBITDA (earnings before interest taxes depreciation and amortization) through the end of 2018 of $51.2 million. Meanwhile, three-year average net income and free cash flow are negative $30.0 million and negative $106.2 million respectively.

Their zombie metric of operating income less interest expense was positive $18.3 million in 2018, but the three-year average is negative $69.9 million. Additionally, revenue for 2018 was the lowest since 2006 at $2.66 billion and total debt for the company increased by 52% (from $540 million to $825 million) in the first quarter of this year alone. It is hard to imagine the consumer showing enough strength to bail out the circumstances facing RCII. However, apart from us, most analysts are constructive in their outlook.

Scientific Games Corp. (SGMS)

Based in Las Vegas, Nevada, SGMS is a single-B-rated company with a stable outlook that provides gambling products and services under four operating divisions of gaming, lottery, digital, and social. The company has 9,700 employees and a market cap of $1.7 billion. Despite a significant correction since June 2018, SGMS stock has a stellar three-year annualized return of 29.2%. Given their negative earnings per share, the current price-to-earnings (PE) multiple cannot be calculated, but the expected PE for the end of the year based on earnings projections is 1,693. The company generated over $3.3 billion in revenue in 2018 but had net income of negative $352 million. The company sports a net debt obligation (net of cash) of $8.8 billion at the end of 2018.

Their zombie metric is -$332 million and has been negative every year since 2008. Despite their fundamentals, through June 30, 2018, SGMS produced a 47% 3-year annualized return showing the power and irrationality of momentum investing. The enthusiasm for SGMS revolves around the legalization and commercialization of nation-wide sports betting. Over the last ten years, insider selling dominated executive transaction flows. Our guess is they will wish they had sold even more.

The Williams Companies (WMB)

WMB, based in Tulsa, Oklahoma, is an energy infrastructure company focused on connecting North America’s hydrocarbon resources to markets for natural gas. The company owns and operates midstream gathering and processing assets, and interstate natural gas pipelines. It has 5,300 employees and a market cap of $33 billion. WMB is rated BBB by Standard & Poors with a negative outlook. Through the end of June 2019, WMB shares have a 3-year annualized total return of 14.0%. Net income for 2018 was -$155 million on revenue of $8.7 billion. Revenue grew at a three-year average of 5.7%, but net income was negative in three of the past four years. The company has net debt outstanding of over $22 billion, which is up 200% from $7.4 billion in 2011. Interest expense on that debt has exceeded operating income (zombie metric) in each of the past four years. Since 2017, insider selling of company shares was 4.4 times larger than insider purchases.

The following table compares our three zombies:

Data Courtesy Bloomberg

Summary

Loose monetary policy contributed to the financial crisis as the Fed held interest rates at 1.0% in 2003-2004 despite an economy that was rebounding and a housing bubble that was inflating well beyond its natural means. The Fed also imprudently used forward guidance to keep rates low for “a considerable period” which further prompted investors to speculate. In a troubling parallel, and proving lessons learned in finance are cyclical, not cumulative, the Fed has maintained and extended emergency policies following the crisis for nearly a decade. New bubbles have since replaced those that popped in 2008.

Upon receiving the Alexander Hamilton award in 2018, Stan Druckenmiller said, “If I were trying to create a deflationary bust, I would do exactly what the world’s central banks have been doing for the past six years.” The important point of his comment is that the deflationary episodes most feared by central bankers are caused by imploding asset bubbles. Those asset bubbles are invariably caused, in large part, by imprudent monetary policies that encourage market participants – households, corporations, and governments – to misallocate resources.

Corporate zombies are but one example. Their existence is evident, but the true extent to which they populate the market landscape cannot be known. Our analysis here reveals only the easiest to identify but rest assured, when economic twilight comes, many more zombies will be fully exposed.

The Economy Left Millions Of Americans Behind

Remember “No Child Left Behind,” George W. Bush’s education reform plan? Congress passed it in 2001.

Whether that law actually helped is subject to debate, but Bush picked a good name for it. Humans are social creatures. Our instincts tell us to make sure no one in our tribe gets “left behind,” economically or otherwise.

That instinct breaks down sometimes. Or we disagree about who belongs in our tribe. It’s a big problem in either case.

Hence, when people say even the poorest Americans live better than their grandparents did, or better than those in other countries, they miss the point.

Past generations and people overseas are the wrong comparison. We get angry when our own group leaves us behind.

Millions of Americans feel that way. And the data say they aren’t wrong.

Unhappy Quarter

In 2013, the Federal Reserve began conducting a yearly “Survey of Household Economics and Decisionmaking,” under the catchy acronym “SHED.” It measures the economic well-being of US families and identifies possible risks.

The latest SHED found 34% of adult Americans say they are “living comfortably.” Another 41% report they are “doing okay.” So 75% of us are generally satisfied, economically.

That sounds great, and in one sense it is. The 2013 SHED found only 62% were in those two groups. So to now have three-quarters satisfied is a significant improvement.

The problem is 75% ≠ 100%, and millions of people aren’t economically satisfied.

Specifically, 18% of us think we are “just getting by,” and 7% are “finding it difficult to get by.”

We lack historical data for comparison, but to me, this seems high.

Note, being satisfied doesn’t require any particular income or net worth. Lots of well-paid people think they are just getting by, and some low-income folks believe they’re doing okay.

But however you slice it, one-fourth of the adult population thinks it is being left behind. This is a problem.

No Cushion

This month the current expansion became the longest in postwar history. Unemployment is historically low. So why are so many people unsatisfied?

SHED has some other data that helps explain.

Just as seat cushions let you sit more comfortably, a financial cushion helps you feel more secure. Conversely, lack of a cushion makes you more anxious.

The SHED researchers asked respondents how they would cover a $400 unexpected expense. That’s really not much. A toothache, an emergency room visit (even if you’re insured), a minor car repair—all can easily run $400 or more.

Some 61% of Americans say they could cover such an emergency with cash, savings, or a credit card they paid off the next month.

But almost four out of ten Americans would have to borrow the money, sell something, turn to relatives, or just give up.

That’s not all. Even without emergencies, 17% of adults said they expected to miss some of their routine bill payments that month. And not always for luxuries; 7% expected to leave rent, mortgage, or utilities at least partially unpaid.

Adding it all together, the SHED data show about one-third of US adults either can’t pay all their bills or are one small problem away from it.

If you’re reading this, you probably aren’t in that group. But don’t rest easy.

Tight Spot

Some of these people who can’t pay their bills probably made unwise choices. But it is still the case that…

  • Even life’s basic necessities often cost more than they should.

So before you condemn them, consider the possibility you may join them.

While the SHED data show some improvement since 2013, it coincided with a growing economy and falling unemployment. Neither will continue once the next recession strikes. Which could be soon.

If a third of the population can’t pay its bills today, how big will that group be when unemployment rises to 8% or more?

That’s not a crazy idea. It was reality as recently as 2013.

When (not if) that happens, the number of economically distressed Americans is going to rise considerably. Probably to more than half the population—enough to force major political change in an attempt to ease its pain.

Those who are perceived to have caused that pain will be in a tight spot. Their best move: Act now to help those millions of left-behind Americans.

As far as I can tell, most aren’t. They’re too busy enjoying their own good fortune.

This isn’t likely to end well.

Selected Portfolio Position Review: 07-17-19

Each week we produce a chart book of 10 of the current positions we have in our equity portfolio. Specifically, we are looking at the positions which warrant attention, or are providing an opportunity, or need to be sold.

While the portfolios are designed to have longer-term holding periods, we understand that things do not always go the way we plan. This monitoring process keeps us focused on capital preservation and long-term returns.

HOW TO READ THE CHARTS

There are four primary components to each chart:

  • The price chart is contained within the shaded area which represents 2-standard deviations above and below the short-term moving average.  
  • The Over Bought/Over Sold indicator is in orange at the top.
  • The Support/Resistance line (green) is the longer-term moving average which also acts as a trailing stop in many cases.
  • The Buy / Sell is triggered when the green line is above the red line (Buy) or vice-versa (Sell).

When the price of a position is at the top of the deviation range, overbought and on a buy signal it is generally a good time to take profits. When that positioning is reversed it is often a good time to look to add to a winning position or looking for an opportunity to exit a losing position.

With this basic tutorial let’s get to the sector analysis.

AEP – American Electric Power

  • Despite what has been a bit of a “risk on” rally over the last couple of week, defensive positions continue to hold up as well.
  • AEP is extremely overbought and on an elevated “buy” signal so we are keeping a close stop on the position currently.
  • Hold current position for now with a “profit-stop” at $89
  • Stop loss now moves up to $82.

BA – Boeing Co.

  • We added BA several months ago after the initial plunge from the 737 MAX crash.
  • Since then BA has continued to consolidate within a fairly tight range. With a bulk of the concerns now behind the company, we need to see earnings to see what the damage has actually been.
  • A break above resistance at $365-370 should allow BA to move markedly higher given the deeply depressed “sell signal” in the lower panel.
  • Stop is being moved up from $300 to $320.
  • The recent rise has not yet triggered a “buy” signal so we can’t add to the position yet, however, the deep oversold condition currently suggests plenty of upside.

CMCSA – Comcast Corp.

  • CMCSA has broken above resistance and sprinted to new highs.
  • We continue to carry a full position currently and with the stock extremely overbought, with a very extended “buy signal,” we are going to be patient for a better opportunity to add to our holdings.
  • CMCSA is back on our list for profit taking the next time we do a portfolio rebalance.
  • Stop-loss is moved up to $41

XOM – Exxon Mobil Corp.

  • Oil continues to struggle with resistance at the $60 level failing once again this week.
  • We sold 1/2 of our position in XOM at the end of April. We currently remain underweight our holding for the time being.
  • XOM is close to registering a “buy signal” which would give us the opportunity to add back to our holding. We would like to see the “buy signal” initiate with a break above $78 to add to our position.
  • Our stop remains at $66 given we sold 1/2 of the position.

MSFT – Microsoft Corp.

  • With MSFT continuing to drift higher, we continue to hold our position.
  • The buy signal on MSFT is extremely extended and is very overbought to boot.
  • We would like to add to our position on a reversal of those conditions which do not violate the long-term trends.
  • MSFT is on our list to take-profits in when we run our rebalance process.
  • Stop-loss remains at $120

JPM – J.P. Morgan Chase & Co.

  • JPM announced better than expected earnings and is currently wrestling with a “triple top” resistance level.
  • There is a risk to JPM when the Fed starts cutting rates as it will impact their Net Interest Income levels.
  • However, for now we are holdings our position and will look to take profits when we rebalance.
  • Stop loss is moved up to $107.50

PEP – Pepsi Inc.

  • PEP, has been making us smile more than Coca-Cola as of late.
  • Kidding aside, PEP has done well along with the consumer staple sector but, like many other stocks in our portfolio, is extremely extended and overbought.
  • We will look to take profits on a portfolio rebalance as the extension above long-term moving averages is now at extremes.
  • Stop-loss is moved up to $120.00

JNJ – Johnson & Johnson

  • Along with our defensive themes, JNJ continues to hold up.
  • JNJ sold off last week on news of a potential criminal probe into the recent “Talc” case, however, such an investigation has limited effects longer-term.
  • The earnings release yesterday was very encouraging and we think there is an opportunity forming to add to our holding.
  • We continue to hold our weighting in JNJ and may look to increase exposure if the “buy signal” turns up and current support levels hold.
  • Stop-loss remains at $130

VZ – Verizon Communications

  • VZ has been trapped in an extremely tight trading range over the last several weeks. This will be resolved sooner rather than later.
  • Earnings will likely be the deciding factor and VZ is likely to beat current earnings estimates.
  • A break above triple-top resistance at $59 will be an opportunity to add to our holdings.
  • We will take profits in the position when we rebalance the portfolio.
  • Stop loss remains at $53.00

PPL – PPL Corp.

  • PPL simply hasn’t performed as expected since adding it to the portfolio. However, we continue to collect the 5% yield in the meantime.
  • As noted last week, with the recent addition of WELL, we are carrying an extra position in the portfolio.
  • During our next profit taking/rebalancing exercise, PPL will most likely be removed from the portfolio.
  • We are moving our stop-loss up to $30

How “FaceApp” Can Help You Save More For Retirement

FaceApp is taking over social media.

It also may help procrastinators focus on long-term goals, like retirement.

The face recognition smartphone application is available for free download; a Pro version is available for a fee. The features available in the free version are enough to motivate you to immediately (possibly dramatically), increase your retirement account contribution percentages.

So, what is FaceApp?

FaceApp is artificial intelligence facial software which allows users to change up their face – add smiles, beards, impressions, change hair colors, hair styles, add glasses, tattoos, makeup. All in a manner that appears hauntingly realistic. Users can also hit the ‘age editor,’ to see how they look young and most important, old.

Whether it’s off the mark or not, staring at an eerily-realistic, much older, future, frailer-looking iteration of self in a mirror today may be compelling enough for financial procrastinators to face a future reality (literally), motivate one to ask – Am I saving enough for retirement? Am I taking care of my health?

To see yourself in a physically vulnerable state of being, to immediately pull a future into the present day, may jumpstart a brain to also clarify long-term nebulous inevitabilities like aging (in my case you’ll see, not so gracefully), and push a user to get serious about finances, complete a comprehensive financial plan, get that estate plan updated, increase contributions to retirement accounts.

You get the picture. It sure scared me straight to consider the viability of my long-term goals and examine the pitfalls in my financial strategy and I create financial plans for a living!

Listen, this isn’t a new concept. Years ago, Merrill Lynch launched an application which ages a picture of a user and shows how one may look even after 100 years old. Along with the aging photos, Merrill also showcased messages about the impact of inflation on everyday goods like milk and bread. Smart.

The idea of linking facial recognition software to financial viability was founded through experiments conducted at Stanford University and published in a November 2011 edition of the Journal of Marketing Research. Stanford’s studies discovered that people who viewed their aged selves, considered allocating more money to their retirement vehicles.

From the study:

“Many people fail to save what they will need for retirement. Research on excessive discounting of the future suggests that removing the lure of immediate rewards by precommitting to decisions or elaborating the value of future rewards both can make decisions more future oriented. The authors explore a third and complementary route, one that deals not with present and future rewards but with present and future selves. In line with research that shows that people may fail, because of a lack of belief or imagination, to identify with their future selves, the authors propose that allowing people to interact with age-progressed renderings of themselves will cause them to allocate more resources to the future. In four studies, participants interacted with realistic computer renderings of their future selves using immersive virtual reality hardware and interactive decision aids. In all cases, those who interacted with their virtual future selves exhibited an increased tendency to accept later monetary rewards over immediate ones.”

I don’t believe FaceApp is going to magically turn financial profligates into saints. However, I do believe that a long-term financial dilemma which weighs on one’s mind coupled with a photo of one’s aged self, may push a procrastinator to take a positive, financial action.

Try it and let me know if the application helped you get out of the fiscal foxhole and make a run at a financial goal that has been weighing on your mind.

Sector Buy/Sell Review: 07-16-19

Each week we produce a chart book of the S&P 500 sectors to review where money is flowing within the market as whole. This helps refine not only decision making about what to own and when, but what sectors to overweight or underweight to achieve better performance.

HOW TO READ THE CHARTS

There are three primary components to each chart:

  • The price chart is in orange
  • The Over Bought/Over Sold indicator is in gray
  • The Buy / Sell indicator is in blue.

When the gray indicator is at the TOP of the chart, there is typically more risk and less reward available at the current time. In other words, the best time to BUY is when the short-term condition is over-sold. Likewise when the buy/sell indicator is above the ZERO line investments have a tendency of working better than when below the zero line.

With this basic tutorial let’s get to the sector analysis.

Basic Materials

  • XLB is back to extreme overbought and failed at resistance last week.
  • XLB is testing support which must hold.
  • With the trade deal put on hold, temporarily, XLB got a boost on hopes one may be completed someday. However, it is likely more tariffs are coming so take profits and rebalance portfolio risk.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions with a tighter stop-loss.
    • This Week: Hold current positions with tighter stop-loss
    • Stop-loss moved up to $57
  • Long-Term Positioning: Bearish

Communications

  • XLC has mustered a decent rally which has been less than inspiring relative to other sectors.
  • While on a buy signal, XLC is back to extreme overbought. If you are still long positions, take profits and reduce exposure.
  • Short-Term Positioning: Neutral
    • Last Week: Hold trading positions, but take profits.
    • This Week: Hold trading positions, but take profits.
    • Hard Stop set at $47.50
  • Long-Term Positioning: Bearish

Energy

  • Currently, XLE is wrestling with the 200-dma. While, as noted yesterday, $WTIC has broken above resistance, energy shares are still lagging behind a bit.
  • With XLE back to overbought, take profits and rebalance risk accordingly.
  • A convincing break above the 200-dma would clear the way for a move higher, but wait for the break first.
  • The sell signal is being reversed to a “buy” which is a good sign.
  • Short-Term Positioning: Neutral
    • Last week: Hold current position
    • This week: Hold current position, add to holding on a break above the 200-dma.
    • Stop-loss adjusted to $62
  • Long-Term Positioning: Bearish

Financials

  • XLF has rallied and is now testing, and trying to clear previous resistance.
  • XLF remains on a “buy” signal currently but is back to extreme overbought.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss moved up to $25.00
  • Long-Term Positioning: Bearish

Industrials

  • XLI has rallied and is now testing a “quadruple top.” It is now, or never, for industrials to breakout and move higher.
  • XLI is extremely overbought, but a break above $70 will set up a move higher.
  • As stated previously, with the “trade war” on hold for now, there is upside to the “triple top.”
  • Take profits for now and wait for the next setup.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position.
    • Stop-loss moved up to $76 to protect gains.
  • Long-Term Positioning: Neutral

Technology

  • XLK has reversed back to an overbought condition and has pushed out to new highs although the breadth of that breakout remains suspect.
  • XLK has been driven by the largest cap-weighted companies so it may be prudent to remain cautious for now.
  • The buy signal remains intact, which is bullish, but is back to extreme overbought. Risk vs reward is not optimal currently.
  • Short-Term Positioning: Bullish
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss moved up to $75 to protect gains.
  • Long-Term Positioning: Neutral

Staples

  • Defensive positions cooled off a bit after an exceptionally strong rally. It didn’t last long as “defensive positioning” continues to lead the markets higher.
  • XLP is grossly extended. and the buy signal is very elevated.
  • We previously recommended taking profits but maintaining holdings.
  • The “buy” signal (lower panel) is still in place and is back to very extended. We continue to recommend taking some profits if you have not done so.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Profit stop-loss moved up to $58
  • Long-Term Positioning: Bullish

Real Estate

  • XLRE also broke out to “new highs,” retested support and is now testing old highs once again.
  • If XLRE can break out to new highs, that will confirm the previous breakout and keep allocations in place.
  • We previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected.
  • That correction did not last long and real estate is back testing all-time highs, take profits and rebalance once again.
  • Buy signal is being reduced along with the “buy signal” but more works needs to be done.
  • Short-Term Positioning: Bullish
    • Last week: Holding position.
    • This week: Hold position.
    • Stop-loss adjusted to $36.00 for profits.
    • Long-Term Positioning: Bullish

Utilities

  • XLU, is back to extremely overbought so a correction is expected again.
  • Like XLRE, XLU is testing highs once again.
  • Long-term trend line remains intact and the recent test of that trend line with a break to new highs confirms the continuation of the bullish trend.
  • Buy signal worked off some of the excess. (bottom panel) and the overbought condition is also on the mend.
  • Short-Term Positioning: Bullish
    • Last week: Hold overweight position
    • This week: Hold overweight position
    • Stop-loss moved up to $57.50.
  • Long-Term Positioning: Bullish

Health Care

  • Sell-signal (bottom panel), as anticipated, has reversed to a buy signal.
  • XLV performance improved markedly but after a big run, the current correction was expected.
  • XLV is back to overbought so $90 is important support.
  • Short-Term Positioning: Neutral
    • Last week: Hold current position (overweight)
    • This week: Hold current position (overweight)
    • Stop-loss moved up to $90 to protect profits.
  • Long-Term Positioning: Neutral

Discretionary

  • With AMZN and AAPL now considered discretionary stocks, it is not surprising to see XLY rise and fall with XLK and XLC as those two major stocks rallied last week and on Monday.
  • The “buy” signal has been reduced and is holding up and XLY is now breaking out to all-time highs although participation remains weak.
  • XLY is back to extreme overbought, so take profits on this rally and wait to see what happens next.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 of position.
    • This week: Hold 1/2 position
    • Stop-loss adjusted to $107.50 after sell of 1/2 position.
  • Long-Term Positioning: Neutral

Transportation

  • XTN has continued to lag the overall market and continues to suggest there is “something wrong” economically.
  • XTN has triggered a “buy” signal but remains confined to an overall downtrend.
  • There is still no compelling reason at this juncture to add XTN to portfolios. We will watch and see what happens.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: Fed “Hopes” Spark Return Of Bullish Complacency

In this past weekend’s newsletter, I laid out the bull and bear case for the S&P 500 rising to 3300. In summary, the basic driver of the “bull market thesis” essentially boils down to Central Bank policy, as noted by the WSJ yesterday:

“U.S. indices hit record highs last week on rate cut expectations. We’ve shifted from fiscal stimulus to monetary stimulus as the driver of the rally.”

In other words, it is all about “rate cuts.”

This reliance on the Fed has led to a marked rise in “complacency” by investors in recent weeks despite a burgeoning list of issues. As shown in the chart below, the ratio of the “volatility index” as compared to the S&P 500 index is near it’s lowest level on record going back to 1995.

(Of course, exceedingly low levels of volatility relative to the S&P 500 have historically denoted periods of price corrections or worse.)

The following considerations fly in the face of the high level of complacency ruling the financial markets:

  • The global economy is slowing.
  • Growth in European economies is slowing dramatically, including Germany where 10-year bond yields dropped below zero for the first time since 2016. (There is currently a record level of nearly $13 Trillion in negative yielding debt globally.)
  • China, representing 30% of global GDP growth, is weakening rapidly.
  • Domestic GDP is expected to rise by only 1.50% in the second quarter, which is a sharp reversal from last year.
  • The trade war with China, and to a lesser degree Europe, has not been resolved and could accelerate on a Tweet.
  • Despite being ten years into an expansion, markets at record highs, and unemployment near 50-year lows, the Fed is talking about cutting rates at the end of the month. What does the Fed know that we do not? 
  • The potential for a hard BREXIT is still prevalent.
  • Earnings expectations have fallen markedly along with actual earnings and revenues.

There is much more, but you get the idea.

As we previously wrote for our RIA PRO Subscribers:  (Get A 30-day FREE Trial)

“Based solely on today’s levels of implied volatility, the media, central bankers and uninformed cocktail chatter would have us conclude that there is little to worry about. We see things quite differently and believe current indicators offer far more reason for fear than when implied volatility is high and fear is more acute.

The graph below is constructed by normalizing VIX (equity volatility), MOVE (bond volatility) and CVIX (US dollar volatility) and then aggregating the results into an equal-weighted index. The y-axis denotes the percentage of time that the same or lower levels of aggregated volatility occurred since 2010. For instance, the current level is 1.91%, meaning that only 1.91% of readings registered at a lower level.”

What both charts above show is that when these complacency has previously reached such low levels, a surge occurred soon thereafter. This does not mean the index will bounce higher immediately, but it does suggest we should expect higher volatility over the next few months.

Furthermore, prices are ultimately constrained by longer-term moving averages. At the beginning of May, I wrote “A Warning About Chasing This Bull Market,” and in particular noted the deviations above long-term means which were at 8% at that time.  Of course, that preceded the May slide which knocked about 5% off of stock prices at the time.

Currently, prices are almost 10% above the long-term mean.

As I stated back in May, this doesn’t mean the market will begin a mean reversion process tomorrow; but, it is suggestive of a market that is certainly at risk of a reversal.

Millennial Soccer

There is one thing the Fed can’t fix by lowering rates – corporate earnings. Next week, the markets will begin to face the quarterly barrage of reports. Don’t worry, as always, we will see a high percentage of companies “beating estimates.”

As I discussed previously, such shouldn’t be a surprise given the massive reduction in expectations leading up to reporting season.

This is why I call it “Millennial Soccer.” 

“Earnings season is now a ‘game’ where scores aren’t kept, the media cheers, and everyone gets a ‘participation trophy’ just for showing up.”

Another warning sign for investors, and something they should be paying attention to, is the rather dramatic decline in net income from a year ago.

While it is currently expected the slowdown in earnings this quarter is a temporary anomaly, the reality is it may not be. The ongoing trade war with China, potential for additional tariffs, and slower economic growth suggest earnings weakness may be with us longer than many suspect.



The chart below shows the changes in estimates a bit more clearly.

It compares where estimates were on January 1st, 2018 versus April, May, and July of 2019. You can see the massive downward revisions to estimates over the last year.

As I stated above, this is why a high percentage of companies ALWAYS beat their estimates. Had analysts been required to stick with their original estimates, the beat rate would be close to zero. 

Here is another way to look at it. In June of 2017, I wrote “The Drums Of Trade War” stating:

“Wall Street is ignoring the impact of tariffs on the companies which comprise the stock market. Between May 1st and June 1st of this year, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the ‘beat the estimate game’).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.

However, the red dashed line denotes an 11% reduction to those estimates due to a ‘trade war’ where an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies and, thus, completely offset the positive fiscal stimulus from tax reform.”

As of the end of the Q1-2019 reporting period, guess where we are? Exactly 11% lower than where we started which, as stated then, has effectively wiped out all the benefit from the tax cuts.

However, note that analysts are still widely optimistic of a sharp “hockey stick” rebound in earnings by year-end. These estimates, and the ones into 2020, still need to be revised sharply lower.

Since we are playing “Millennial Soccer,” let’s look at data which is devoid of much of the manipulation. Corporate profits, rather than earnings, is what is reported to the Internal Revenue Service for taxation purposes. It strips out the accounting gimmicks found in operating earnings, share buybacks, and other obscuring factors.

As noted previously, corporate profits have declined over the last two quarters and are at the same level as in 2014 with the stock market higher by almost 60%. 

In other words, investors are paying a very high price for ownership currently. In fact, it is not just price-to-corporate profits which is elevated, but rather the majority of measures of valuation are at historic extremes. As noted by Zerohedge yesterday:

While valuations may not seem to matter at the moment, they eventually will. In fact, the lack of concern about valuations is simply another byproduct of extreme complacency. 

The End Of Complacency

The current levels of complacency will end. It is only a function of when, not if. As noted by the WSJ on Monday, fund managers have been piling into beta as markets have risen to garner more exposure to “risk.” 

The same is true for hedge funds which are also piling into equity risk in order to generate returns. (It is worth noting previous peaks in equity increases which has been a good contrarian indicator in the past.)

This rush back into equities should not be surprising.

The one thing about bullish sentiment is that it begets more bullish sentiment. The more the market rises, the more ingrained the belief comes that it can only go higher. In a “Pavlovian” manner, as each “dip” is bought, the “fear” of loss is eliminated repeatedly teaching investors they should “only buy” and “never sell.”

This is why, as I noted over the weekend, we remain bullishly biased in portfolios for now.

We are well aware of the present risk. Stop loss levels have been moved up to recent lows and we continue to monitor developments on a daily basis. With the trend of the market positive, we want to continue to participate to book in performance now for a ‘rainy day’ later.”

That “rainy day” is coming.

As noted above, while market participants are “giddy” about the prospects for the markets based on the Fed cutting rates, there is a laundry list of things issuing warning signals. We can add to the list above:

  • Growing divergences between the U.S. and abroad
  • Peak autos, peak housing, peak GDP.
  • Political instability and a crucial Presidential election.
  • The failure of fiscal policy to ‘trickle down.’
  • An important pivot towards restraint in global monetary policy.
  • An unprecedented lack of coordination between super-powers.
  • Short-term note yields now eclipse the S&P dividend yield.
  • A record levels of private and public debt.
  •  Near $3 trillion of covenant light and/or sub-prime corporate debt. (eerily reminiscent of the size of the subprime mortgages outstanding in 2007)
  • Narrowing leadership in the market.

But, for now, this “wall of worry” has yielded little concern.

The more the market rises, the more reinforced the belief “this time is different” becomes.

As I wrote previously:

“This is why we have been saying for the last two weeks – the market is rising and you need to be invested…FOR NOW. However, this is not the next great leg of a bull market so this will be a good rally to liquidate positions into and begin setting your portfolio up for more protectionary investments going into [next year].”

That was on December 7, 2007.

Are we complacent?

Absolutely not.

The One Lesson Investors Should Have Learned From Pension Funds

Just recently I ran a 3-part series on the variety of things individuals believe about saving and investment which is either erroneous or misunderstood. (Part 1, Part 2, Part 3)

The feedback I get when challenging some of the more commonly held beliefs is always interesting. In almost every single case, the arguments against “mathematical realities” comes down to either:

  1. An inability, or unwillingness, to sacrifice today to save more for the future, or;
  2. A “hope” that markets will continue to create returns which will offset the lack of savings.

Okay, it is just a reality that most people don’t want to sacrifice today, for the future tomorrow.

“Live like no one else today, so that you can live like no one else tomorrow.” – Dave Ramsey

Unfortunately, that is the same problem that plagues pension funds all across America today.

As I discussed in “Pension Crisis Is Worse Than You Think,”  it has been unrealistic return assumptions used by pension managers over the last 30-years, which has become problematic.

“Pension computations are performed by actuaries using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. The biggest problem, following two major bear markets, and sub-par annualized returns since the turn of the century, is the expected investment return rate.

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating returns, it has artificially inflated future pension values and reduced the required contribution amounts by individuals and governments paying into the pension system

Pensions STILL have annual investment return assumptions ranging between 7–8% even after years of underperformance.”

However, why do pension funds continue to have high investment return assumptions despite years of underperformance? It is only for one reason:

To reduce the contribution (savings) requirement by their members.

As I explained previously:

“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 of reduction in the assumed rate of return, it 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.

The chart below is the S&P 500 TOTAL REAL return from 1995 to present. I have projected an average return of every period in history where the market peaked following P/E’s exceeding 20x earnings. This provides for variable rates of market returns with cycling bull and bear markets out to 2060. I have also projected “average” returns from 3% to 8% from 1995 to 2060. (The average real total return for the entire period is 6.56% which is likely higher than what current valuation and demographic trends suggest it should be.)

This is also the same problem for the average American faces when planning for 6-8% annual returns on their investment strategy.

Clearly, there is no reason you should save money if the market can do the work for you? Right?

This is a common theme in much of the mainstream advice. 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, while very optimistic, 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 certainly isn’t very realistic.

More importantly, as I explained previously, $1 million today, and $1 million in 30-years, are two very different issues due to a rising cost of living over time (a.k.a. inflation.) 

Pick a current income level on the left chart, the number on the right is the current income inflated at 2.1% (average inflation rate) over 30-years. Then pick that level of income on the right chart to see how much is needed to fund that amount annually in retirement at 4% (projected withdrawal rate.) Click to enlarge

What pension funds have now discovered, and unfortunately it is far too late, is that using faulty assumptions, and not requiring higher contributions, has led to an inability to meet future obligations.

“Pensions across the U.S. are falling deeper into a crisis, as the gap between their assets and liabilities widens at the same time that investment returns are falling, according to Bloomberg

The average U.S. plan has only 72.5% of its future obligations in 2018, compared to more than 100% in 2001. The Center for Retirement Research at Boston College attributes the deficit to recessions, insufficient government contributions, and generous benefit guarantees. Importantly, the underfunded status is still based on 7% annual return assumptions. 

Unfortunately, the problem will only get worse between now and 2050, according to Visual Capitalist:

“According to an analysis by the World Economic Forum (WEF), there was a combined retirement savings gap in excess of $70 trillion in 2015, spread between eight major economies…The WEF says the deficit is growing by $28 billion every 24 hours – and if nothing is done to slow the growth rate, the deficit will reach $400 trillion by 2050, or about five times the size of the global economy today.”

It isn’t just Pension Funds

Importantly, this is the same trap that individual investors have fallen into as well. By over-estimating future returns, future retirement values are artificially inflated, which reduces the required savings rates. Such also explains why 8-out-of-10 American’s are woefully underfunded for retirement currently.

Using the long-term, total return, inflation-adjusted chart of the S&P 500 above, the chart below compares $1000 compounded at 7% annually to the variable-rate of return model above. The bottom part of the chart shows the difference between actual and compounded rates of return.

This is the “pension problem” the majority of individuals have gotten themselves into currently.

As I wrote previously:

“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.”

Excuses Will Leave You Short

I get it.

I am an average American too.

Here are the most common excuses I hear:

  1. I “need” to be able to enjoy my life today. 
  2. I have “plenty of time” to save up for retirement.
  3. “Budget,” what ‘s that?
  4. I have social security (or a a pension plan), so I don’t really need to save much.

Let’s talk about that last point.

If you have a public pension plan, congratulations, you are in the 15% of workers that do. Future generations won’t be as fortunate. Moreover, with the underfunded status of pensions funds running between $4-5 Trillion, this may not be a “safety net” to bet your entire retirement on.

Social security is also underfunded and payout cuts are expected by 2025 if actions are taken to resolve its issue. The same demographic trends which are plaguing pension funds also weigh heavily on the social security system.

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

It is highly unlikely the latter will happen.

Demographic trends are fairly easy to forecast and predict. Each year from now until 2025, we will see successive rounds of boomers reach the 62-year-old threshold.

Excuses aside, continuing to under-save, and counting on social security and a pension fund to make up the difference, may have very different outcomes than many are currently planning on.

Simple Is Not Always Better

“All you have to do is buy an index fund, dollar cost average into it, and in 30-years you will be set.”

See, it’s simple.

It is why our world has been reduced to sound bytes and 280-character compositions. Financial, retirement, and investment planning, while complicated issues in reality, have become “click bait.”

But a “simple and optimistic” answer belies the hard-truths of investing and market dynamics.

It’s what Pension Funds banked on.

Simple isn’t always better.

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

The analysis above reveals the important lessons individuals should have learned from the failure of pension funds:

  • Lower expectations for future returns and withdrawal rates due to current valuations, interest rates, and long-run economic growth forecasts.
  • With higher rates of 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, or average, annual rates of return for plans using variable rates of future returns.

The myriad of advice suggesting one can undersave and invest their way into retirement has a long and brutal history of leaving individuals short of their goals.

If even half of the mainstream commentary on investing were true, wouldn’t there be a large majority of individuals well saved for retirement? Instead, there are mountains of statistical data which show the majority of American’s don’t even have one-year’s salary saved for retirement, much less $1 million.

Yes, please be optimistic about your future and “hope for the best.”

However, if you plan for the “worst,” the odds of success become much higher.

It’s a lesson we can all learn from Pension Funds.

Major Market Buy/Sell Review: 07-15-19

Each week we produce a chart book of the major financial markets to review whether the markets, as a whole, warrant higher levels of equity risk in portfolios or not. Stocks, as a whole, tend to rise and fall with the overall market. Therefore, if we get the short-term trend of the market right, our portfolios should perform respectively.

HOW TO READ THE CHARTS

There are three primary components to each chart:

  • The price chart is in orange
  • The Over Bought/Over Sold indicator is in gray
  • The Buy / Sell indicator is in blue.

When the gray indicator is at the TOP of the chart, there is typically more risk and less reward available at the current time. In other words, the best time to BUY is when the short-term condition is over-sold. Likewise when the buy/sell indicator is above the ZERO line investments have a tendency of working better than when below the zero line.

With this basic tutorial let’s review the major markets.

S&P 500 Index

  • Last week, the market cracked 3000 driven by hopes of a “Fed rate cut” at the end of the month.
  • On a technical basis the breakout is constructive and suggests higher highs. However, in the near-term the market is extremely overbought so a bit of a correction is needed to add to our position.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position.
    • Stop-loss adjust to $275
    • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

  • Last week, we noted DIA did break out to new highs and triggered a short-term buy signal.
  • DIA is very overbought short-term, so like SPY above, we will look for a better entry point to suggest adding weighting to portfolios.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions
    • This Week: Hold current positions.
    • Stop-loss moved up to $252.50
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • QQQ rallied from the oversold condition and is now back to EXTREMELY overbought.
  • While QQQ did breakout to new highs along with DIA and SPY it is lagging in terms of relative performance.
  • With the “buy signal” getting elevated towards levels that have previously signaled short-term peaks, use corrections that do not violate support to add to positions.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $175
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • SLY continues to be a technical disaster. Small-caps are also not confirming the exuberance of its large-cap brethren because small-caps do not engage in massive stock repurchase programs.
  • Last week, SLY did break above the 200-dma but remains confined to a very negative downtrend.
  • SLY has triggered a short-term buy signal so that could help small-caps gain ground if they can hold up.
  • There are a lot of things going wrong with small-caps currently so the risk outweighs the reward of a trade at this juncture.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position.
    • Stop loss violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY, like SLY, is technically not in great shape. Mid-caps, like small-caps, also do not participate in major share repurchase programs and are economically sensitive. Both suggest the overall market environment is weaker than headlines suggest.
  • MDY did regain its 200-dma but the rally has been weak and has failed at resistance.
  • Mid-caps are also very overbought so take profits if you are long and tighten up stops.
  • Short-Term Positioning: Neutral
    • Last Week: Use any further rally this week to sell into.
    • This Week: Use any further rally this week to sell into.
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM rallied back to the top of its downtrend channel on news that the ECB will potentially cut rates and increase QE programs.
  • EEM is back on a “buy signal” but is confined to a more major downtrend currently.
  • We previously added a small trading position to the long-short portfolio which has minimal success so far.
  • Short-Term Positioning: Bearish
    • Last Week: Hold current position
    • This Week: Hold current position
    • Stop-loss set at $41
  • Long-Term Positioning: Neutral

International Markets

  • Like EEM, EFA rallied on news the ECB will leap back into action to support markets.
  • Last week, EFA broke above its downtrend line while maintaining a “buy signal.” That “buy signal” is now very extended.
  • We did add a trading position to our long-short portfolio model, and will see if support at the previous downtrend can hold.
  • Short-Term Positioning: Neutral
    • Last Week: Hold position
    • This Week: Hold position.
    • Stop-loss is set at $64
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • Oil finally was able to push above the 50% retracement line on a bigger than expected crude draw and “Tropical Storm Barry” shutting down production in the Gulf.
  • Oil is back into overbought conditions and a “buy signal” has been registered suggesting a push towards $64-65 is likely.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: Add trading position on pullback that holds $58.
    • Stop-loss for new positions is $54.
  • Long-Term Positioning: Bearish

Gold

  • Gold has quickly reversed its oversold condition to extreme overbought including its longer-term “buy signal.”
  • The rally could be done for the moment, so look for a pullback to add gold to portfolios if you haven’t done so already.
  • Gold is too extended to add to positions here. Look for a pullback to $126-127 to add.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole set at $126
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • As noted previously,
    • “Bond prices have gone parabolic and are now at extremes. Even the “buy” signal on the bottom panel has reached previous extremes which suggests a reversal in rates short-term is likely.”
  • That correction started last week.
  • Prices could pullback to the $126-127 range which would be an ideal entry point.
  • Strong support at the 720-dma (2-years) (green dashed line) which is currently $119.
  • Short-Term Positioning: Bullish
    • Last Week: Take profits and rebalance risks. A correction IS coming which will coincide with a bounce in the equity markets into the end of the month.
    • This Week: Hold positions after taking profits.
    • Stop-loss is moved up to $125
    • Long-Term Positioning: Bullish

U.S. Dollar

  • Comments from the Fed about more accommodative policies tripped up the dollar previously, but as noted last week, the dollar has gotten extremely oversold.
  • The dollar did rally and is currently trying to hold support at its 200-dma. There is likely more rally to go next week particularly if it looks like the Fed will not reduce rates in July.
  • The dollar is starting to reverse its oversold condition, and the rally to $97 last week has put the dollar back on our radar as suggested last week.
  • Short-Term Positioning: Bullish
    • Last Week: No Position
    • This Week: No Position

RIA PRO: S&P 3300 – The Bull Vs. Bear Case


  • Review & Market Update
  • The Case For 3300
  • Sector & Market Analysis
  • 401k Plan Manager

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Market Review & Update

We had suggested last week that:

“With a majority of short-term technical indicators extremely overbought, look for a correction next week. What will be important is that any correction does not fall below the early May highs.”

Monday and Tuesday were indeed a bit sloppy, as shown below, but “fireworks” started on Wednesday as Jerome Powell said everything possible to ensure Wall Street a “rate cut” in July without actually saying so.

As we will discuss in a moment, almost 18-months after I originally discussed it, the market finally cleared the psychological level of 3000.

That is the good news.

The “not-so-good” news is the market continues to rally into a more extreme overbought condition with a rather extreme deviation above the 200-dma. Also, the negative-divergences in indicators which suggest further upside to the current rally may be limited. In particular, the divergence between small-cap and large-cap performance is typical of periods leading to corrections.

Also, since the September peak in the market, every other major index is lagging the performance of the S&P 500 index which suggests a narrower rally.

With that said, the markets are on a “buy signal,” which suggests further upside is likely in the near-term. This is why we continue to maintain our long-equity bias for now.

However, once we get past the end of the month, and assuming the Fed does indeed cut rates and no “trade deal” with China, the markets will return their focus to economics and earnings. As we said last week, such continues to suggest the August/September time frame for a larger corrective cycle is still in play.

Bonds Retreat

My colleague Patrick Hill asked me to address the retreat in bond prices over the last week or so. While many are assigning a variety of reasons for the recent reversal in rates including a resurgence on inflationary pressures, Central Bank demands, to a lack of buying by foreigners, I think the reason is much more simplistic.

Ever since rates spiked up to 3.25% at the beginning of 2018, we have repeatedly been discussing why rates would fall, and economic weakness and deflation would be the driver. Such has indeed been the case, and our long-bets on bonds have paid off nicely.

However, bonds are also a “safety” trade in times of uncertainty. The rotation from “risk” to “safety” has been THE trade since September of last year and rates, as I have discussed over the last several weeks, had become “egregiously” overbought. A correction was inevitable as money began chasing equities on hopes of a Fed rate cut. 

However, as shown below, we need to keep the recent reversal in the context of the broader move. It is kind of hard to spot.

This sell-off in bonds WILL provide another terrific buying opportunity most likely by the end of July. Look for rates to retrace back to previous resistance between 2.4% to 2.6%. Also, it is advisable to increase the duration of bond holdings for the yield curve steepening, which will occur as the economy slips closer to the recession.

That is how we are playing it.

So, let’s talk about S&P 3300!



The Case For 3300

It only took eighteen-months longer than expected, but the markets finally reached 3000 on the S&P 500 index this past week.

“What do you mean ‘expected?’ You are always bearish.” 

I am just going to save our “reading impaired” individuals some time by reminding them of what I wrote in January of 2018:

“While the record-breaking pace is certainly breathtaking, it should not be surprising as we discussed in the June 9th, 2017 edition of the weekly newsletter.

Let me state this VERY clearly. The bullish bias is alive and well, and a move to 2500 to 3000 on the S&P 500 is viable.All that will be needed is some piece of legislative agenda from the current administration, which provides a positive surprise. However, without a sharp improvement in the underlying fundamental and economic backdrop soon, the risk of something going ‘wrong’ is rising markedly. The chart below shows the Fibonacci run to 3000 if ‘everything goes right.’”

Of course, that piece of legislative agenda was ‘tax reform.’

With investors now betting on a sharp rise in earnings to reduce the current levels of overvaluation, the seems to be little in the way of the next major milestones for 30,000 for the Dow and 3000 for the S&P 500.”

In March, we followed up that post stating:

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

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

As we know now, the market wound up following our mid-2017 accelerated projection trend.

So, here we are 18-months later, and the market finally hit 3000.

What is interesting, however, is the advance to 3000 incorporated both the original bull and bear projections.

The 20% slide from the September highs came on concerns the Fed was tightening too aggressively as Trump’s “trade war” took a bite out of economic growth and profitability. The subsequent rally back, which brutally reminded investors what “volatility” is, was based on “hope” that Trump would find a resolution with China and the Fed would cut rates.

Neither has happened yet, but the markets remain hopeful.

“But you missed out on the whole rally because you have been all in cash.”

Again, for those that cannot read more than 280-characters at a time:

“Portfolios have remained allocated toward equities, although we did shift to more defensive holdings earlier this year. We had also been aggressive buyers of bonds at 3% and higher on the 10-year bond which has added to portfolio performance this year. “

The Bull & Bear Case

As we face down the last half of 2019, we can once again run some projections on the bull and bear case going into 2021, as shown in the chart below:

Let us break down both potential pathways into the “bull” and “bear” case.

The Bull Case For 3300

  • Momentum
  • Stock Buybacks
  • Fed Rate Cuts
  • Stoppage of QT
  • Trade Deal

Price momentum has been in control of the markets over the last several months. Given that “an object in motion, tends to stay in motion,” momentum is a hard thing to stop without a bigger event triggering a reversal in investor attitudes.

While Fed rate cuts, and stopping QT, will be seen as “accommodative” to asset prices, the “efficacy” of monetary policy has likely reached its limits. We have a decent understanding this is likely the case given that nearly 100% of all “net new equity purchases” have come from share buybacks in recent years. As I wrote last week

“So, how is it that stocks remain near record highs? The primary culprit, as discussed previously, remains corporate buybacks which remain the primary source of market support in 2019. This is especially the case after US banks announced $129 bn in buybacks over the next 4-quarters.

Buybacks, according to BofA, are on pace for a record at $43B so far this year versus just $75B for the entirety of 2018. This suggests a record of over $1 trillion in S&P 500 buybacks for 2019.”

A “Trade Deal” will also be helpful as it will take the pressure off of bottom-line corporate earnings. As J.P. Morgan’s chief equity strategist Dubravko Lakos-Bujas recently told MarketWatch:

“If you have a trade deal, and if the trade deal coincides with one or two rate cuts from the Fed, we see an upside scenario of 3,200-3,300.”

Yep, the same number we came up with.

However, as investors, we must also analyze what could go wrong and derail our investment strategy. Unfortunately, the “bearish” case has “sharper teeth” to it. (Yes, pun intended.)

The Bear Case Against 3300

  • Earnings Deterioration
  • Recession
  • No Trade Deal/Higher Tariffs
  • Credit Related Event (Junk Bonds)
  • Mean Reversion
  • Volatility / Loss Of Confidence

Earnings have already deteriorated markedly since 2018, as I discussed previously.

“However, the red dashed line denotes an 11% reduction to those estimates due to a ‘trade war’ where an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies and, thus, completely offset the positive fiscal stimulus from tax reform.

Surprise! As of the end of the Q4-2018 reporting period, guess where we are? Exactly 11% lower than where we started which, as stated then, has effectively wiped out all the benefit from the tax cuts.”

Since then, 2019 earnings have been downgraded substantially. As Ian Harnett, chief investment strategist at Absolute Strategy Research recently noted:

“We do not think insurance cuts will be enough, we think earnings growth is not going to be 7% this year, it is going to be -5%, and maybe even -10. We are looking at these recession risk models rising, credit impulse numbers in the states are weak, that tends to bring unemployment up and tends to bring equity markets down.”

Given there has been no “trade deal” as of yet, the increase in tariffs in June to 25% have yet to show up in reports just yet, and global growth slowing, there is an elevated risk of an “earnings recession” currently.

There is also just the simple issue that markets are very extended above their long-term trends, as shown in the chart below. A geopolitical event, a shift in expectations, or an acceleration in economic weakness in the U.S. could spark a mean-reverting event which would be quite the norm of what we have seen in recent years.

Then there are the tail-risks of a credit-related event caused by a dollar funding shortage, a banking crisis (Deutsche Bank), or a geopolitical event, or a surge in defaults on “leveraged loans” which are twice the size of the “sub-prime” bonds liked to the “financial crisis.”  (Read more here)

Just remember, bull-runs are a one-way trip. 

Most likely, this is the final run-up before the next bear market sets in. However, where the “top” is eventually found is the big unknown question. We can only make calculated guesses.

Currently, the “math” suggests there are just 200 points of upside to our next target, but there is roughly 800-points of downside.

Be careful how you bet; these are odds that Vegas would love to give you.

I know. I know.

It is easy to get wrapped up in the bullish advance. However, it is worth remembering that making up a loss of capital is not only hard to do, but the “time” lost cannot.

The point is while the media, and bulk of the commentary continue, to “urge you to ride the bull,” they are not going to tell you when to get off.

Moreover, when the ride does come to an end, the media will ask first “why no one saw it coming?”

Then they will ask “why YOU did not see it coming when it so obvious.” 

In the end, being right, or wrong, does not affect the media as they are not managing your money. Nor are they held responsible for consistently poor advice. However, being right, or wrong, has a very big effect on you.

Let me repeat for all of those who continue to insist I am bearish and somehow am missing out on the “bull market” advance:

“While our portfolios remain long currently, we do so with hedges and stops in place, a thorough methodology of analysis, and a strict investment discipline we follow to mitigate the risk of long-biased exposure. In other words, whenever the market does turn, we will sell and move to cash.”

If you are going to “ride this bull,” make sure you do it with a strategy in place for when, not if, you get thrown.



Tending The Garden

Here are some guidelines to follow.

It is worth remembering that portfolios, like a garden, must be carefully tended to otherwise the bounty will be reclaimed by nature itself.

  • If fruits are not harvested (profit taking), they ‘rot on the vine.’ 
  • If weeds are not pulled (sell losers), they will choke out the garden.
  • If the soil is not fertilized (savings), then the garden will fail to produce as successfully as it could.

So, as a reminder, and considering where the markets are currently, here are the rules for managing your garden:

1) HARVEST: Reduce “winners” back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole plant from the ground.

2) WEED: Sell losers and laggards and remove them from the garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing “nutrients” that could be used for more productive plants. The first rule of thumb in investing “sell losers short.”

3) FERTILIZE AND WATER: Add savings on a regular basis. A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NEVER LOSE money investing in the markets…then STOP investing immediately.

4) WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that did not occur. Likewise, a portfolio protected against “risk” in the short-term, never harmed investors in the long-term.

With the overall market trend still bullish, there is little reason to become overly defensive in the very short-term. However, I have this nagging feeling that the “spring” is now wound so tightly, that when it does break loose, it will likely surprise most everyone.

Just something to think about.

If you need help or have questions, we are always glad to help. Just email me.

See you next week.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels

Sector-by-Sector

Improving – Healthcare, Materials

Improving – Healthcare, Materials

We have maintained an overweight position in Health Care as part of our defensive positioning. However, Materials have now begun to improve its performance relative to the S&P 500. We are currently carrying 1/2 weight in Materials due to the “trade war” and without a resolution at hand, just hope, there remains a risk to the sector. However, the technical picture is improving, and we will likely increase our exposure accordingly.

Current Positions: Overweight XLV, 1/2 XLB

Outperforming – Staples, Real Estate, Financials, Utilities

As noted last week, the rotation in defensive positioning has continued, and these sectors are currently leading overall market performance. We are maintaining our target portfolio weight in Financials for now. Take profits and rebalance across sectors accordingly.

Current Positions: Overweight XLP, XLU, Target weight XLF, XLRE

Weakening – Technology, Discretionary, Communications

As noted previously, the previous “leaders” have been lagging in terms of relative performance. That started to improve this past week, and with Discretionary, Communications, and Technology breaking out to new highs, we will need to increase our exposure on short-term weakness. The sectors are grossly overbought so look for weakness to add to current holdings.

Current Position: 1/2 weight XLY, Reduced from overweight XLK, Target weight.

Lagging – Energy, Materials, Industrials

Energy began to improve this past week with the pick up in oil prices. Industrials have been relatively weak in terms of relative performance, so no rush to increase exposure currently. For now, we are maintaining our “underweight” holdings in these two sectors until more evidence of improvement is available.

Current Position: 1/2 weight XLE & XLI

OVERALL RECOMMENDATION

The entire market is back to an extreme “overbought.” Take some action to rebalance portfolio risk if you have not done so previously.

As noted last week:

“We may have some follow-through rally this week, but use any further rise to take action accordingly.”

That remains good advice heading into next week.

Market By Market

Small-Cap and Mid Cap – While small-cap did finally break above its 50- and 200-dma is to join Mid-caps in a late-stage catchup rally, the move was quite unimpressive on a relative strength basis. With small and mid-caps back to extremely overbought conditions, this is likely a great opportunity to rebalance portfolio risk and reducing weighting to an underperforming asset class for now until things improve.

Current Position: No position

Emerging, International & Total International Markets

We are still watching these positions for a potential add to portfolios, but the extreme overbought condition keeps us sidelined for the movement. A pullback that reduces the overbought condition but does not violate support will provide the right entry point.

Current Position: No Position

Dividends, Market, and Equal Weight – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with economic growth and inflation. Currently, the short-term bullish trend is positive, and our core positions are providing the “base” around which we overweight/underweight our allocations based on our outlook.

The rally over the last three weeks has fully reversed the previous oversold condition. Make sure and rebalance weightings in portfolios if you have not done so already.

Current Position: RSP, VYM, IVV

Gold – Gold has continued to consolidate at elevated levels despite the market rally and hopes for a Fed rate cut. This is a good sign for “gold bulls.” Hold positions for now and look for a better entry point on a pullback.

Current Position: GDX (Gold Miners), IAU (Gold)

Bonds 

Bonds took a hit last week as money rotated out of bonds and back into equities. The retracement back to the 50-dma, combined with the reduction in the overbought condition, is going to provide a good opportunity to add to existing holdings. As we noted last week:

“Bonds are EXTREMELY overbought, take some profits and rebalance weightings but remain long for now.”

Stay long current positions for now and look for an opportunity to add to holdings.

Current Positions: DBLTX, SHY, TFLO, GSY, IEF

High Yield Bonds, representative of the “risk on” chase for the markets have been consolidating despite the rally in equities. This is not the time to add to holdings just yet, but a good time to like take profits and reduce risk short-term. Given the deteriorating economic conditions, this would be a good opportunity to reduce “junk-rated” risk and improve credit quality in portfolios. 

OVERALL RECOMMENDATION

The entire market is back to an extreme “overbought.” Take some action to rebalance portfolio risk if you have not done so previously.

As noted last week:

“We may have some follow-through rally this week, but use any further rise to take action accordingly.”

That remains good advice heading into next week.

Sector / Market Recommendations

The table below shows thoughts on specific actions related to the current market environment. 

(These are not recommendations or solicitations to take any action. This is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

Portfolio/Client Update:

No change this past week.

With the market setting new highs, and breaking above previous resistance, we need to add some exposure short-term to portfolios.

However, given the market is extremely overbought, we need to be patient wait for a correction to take action. While our focus continues to remain on “risk control” and “capital preservation strategies” over “capital growth and risk-taking strategies,” we do recognize the need to participate when markets are rallying.

We will be looking to either add a larger trading position to the portfolio, add to existing holdings, or a combination of both. However, we need to evaluate the markets early next week to see if the “Fed Hope” rally can persist.

There are indeed some short-term risks while we await the Fed to “actually” cut rates at the end of the month. Furthermore, there is a very high chance that Trump is going to lash out at China and hike tariffs again since they are not complying by buying more product from the U.S. as promised at the G-20.

Lastly, we are going to be in the “gale force winds” of earnings season over the next few weeks, so there will be much news-driven movement in the market which could provide us the opportunity we need to add positions. In the meantime, we continue to carry tight stop-loss levels, and any new positions will be “trading positions” initially until our thesis is proved out.

  • New clients: Our onboarding indicators have reverted to “risk on” so new accounts will be onboarded selectively into their models where risk can be controlled. Positions that were transferred in are on our global review list and being monitored. We will use this rally to liquidate those positions to raise cash to transition into the specific portfolio models.
  • Equity Model: No changes this past week. We are looking to potentially sell JNJ and PPL. We are actively looking for replacements if we do take action.
  • ETF Model: No change. Looking to add either a trading position in SPY, or increase weight in sectors and core holdings. 

Note for new clients:

It is important to understand that when we add to our equity allocations, ALL purchases are initially “trades” that can, and will, be closed out quickly if they fail to work as anticipated. This is why we “step” into positions initially. Once a “trade” begins to work as anticipated, it is then brought to the appropriate portfolio weight and becomes a long-term investment. We will unwind these actions either by reducing, selling, or hedging if the market environment changes for the worse.


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.

401k-PlanManager-AllocationShift

Fed All But Promises To Cut Rates

Despite stronger than expected inflation and employment numbers, an uptick in economic activity indices, and markets at record highs, Jerome Powell all but promised to cut rates at the end of this month.

Our suspicion is the Fed is either aware of the potential exogenous risk to markets, like Deutsche Bank, and has been called on by the ECB to provide liquidity to the financial markets, or Powell has just completely given up independence to the White House wishes.

Our best guess is the former. If that is indeed the case, there is likely not much the Fed can do to stem the next decline. However, in the meantime, markets are rising, and we need to continue to participate.

With the breakout to new highs and the reaffirmation of our buy signal, we can look to increase exposure to portfolios on any market action that reduces the current extreme overbought condition.

With Q2 reporting season going into full swing next week, as noted above, there is a potential short-term risk to share prices which could provide a better entry point to add to equity exposure. Be patient for that confirmation.

As stated previously, July and August tend to be challenging months for the market, so we want to be careful, particularly with the economic backdrop weakening.

Take the following actions on Monday.

  • If you are overweight equities – Hold current positions but remain aware of the risk. Take some profits and rebalance risk to some degree if you have not already. 
  • If you are underweight equities or at target – rebalance risks, look to increase holdings in domestic equities opportunistically. 

With the markets back to extremely overbought conditions, patience will likely be rewarded.

If you need help after reading the alert; do not hesitate to contact me.

401k Plan Manager Beta Is Live

We have rolled out a very early beta launch to our RIA PRO subscribers

Be part of our Break It Early Testing Associate” group by using CODE: 401

The code will give you access to the entire site during the BETA testing process, so not only will you get to help us work out the bugs on the 401k plan manager, you can submit your comments about the rest of the site as well.

We have several things currently in development we will be adding to the manager, but we need to start finding the “bugs” in the plan so far.

We are currently covering more than 10,000 mutual funds and have now added all of our Equity and ETF coverage as well. You will be able to compare your portfolio to our live model, see changes live, receive live alerts to model changes, and much more.

We are building models specific to company plans. So, if you would like to see your company plan included specifically, send me the following:

  • Name of the company
  • Plan Sponsor
  • A print out of your plan choices. (Fund Symbol and Fund Name)

I have gotten quite a few plans, so keep sending them and I will include as many as we can.

If you would like to offer our service to your employees at a deeply discounted corporate rate, please contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principle. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)


Model performance is based on a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. This is strictly for informational and educational purposes only and should not be relied upon for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril. 

The Problem With Keynesian Economics

In The General Theory of Employment, Interest and Money, John Maynard Keynes wrote:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

I think Lord Keynes himself would appreciate the irony that he has become the defunct economist under whose influence the academic and bureaucratic classes now toil, slaves to what has become as much a religious belief system as an economic theory.

Men and women who display appropriate skepticism on other topics indiscriminately funnel facts and data through a Keynesian filter without ever questioning the basic assumptions. Some go on to prescribe government policies that have profound effects upon the citizens of their nations.

And when those policies create the conditions that engender the income inequality they so righteously oppose, they often prescribe more of the same bad medicine. Like 18th-century physicians applying leeches to their patients, they take comfort that all right-minded people will concur with their recommended treatments.

This is an ongoing series of a discussion between Ray Dalio and myself (read Part 1Part 2Part 3, and Part 4) . Today’s article addresses the philosophical problem he is trying to address: income and wealth inequality.

Last week I dealt with the equally significant problem of growing debt in the United States and the rest of the world. The Keynesian tools much of the economic establishment wants to use are exacerbating the problems. Ray would like to solve it with a blend of monetary and fiscal policy, what he calls Monetary Policy 3.

The Problem with Keynesianism

Let’s start with a classic definition of Keynesianism from Wikipedia, so that we can all be comfortable that I’m not coloring the definition with my own bias (and, yes, I admit I have a bias). (Emphasis mine.)

Keynesian economics (or Keynesianism) is the view that in the short run, especially during recessions, economic output is strongly influenced by aggregate demand (total spending in the economy). In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

The theories forming the basis of Keynesian economics were first presented by the British economist John Maynard Keynes in his book The General Theory of Employment, Interest and Money, published in 1936 during the Great Depression. Keynes contrasted his approach to the aggregate supply-focused “classical” economics that preceded his book. The interpretations of Keynes that followed are contentious, and several schools of economic thought claim his legacy.

Keynesian economists often argue that private sector decisions sometimes lead to inefficient macroeconomic outcomes which require active policy responses by the public sector, in particular, monetary policy actions by the central bank and fiscal policy actions by the government, in order to stabilize output over the business cycle. Keynesian economics advocates a mixed economy—predominantly private sector, but with a role for government intervention during recessions.

Central banks around the world and much of academia have been totally captured by Keynesian thinking. In the current avant-garde world of neo-Keynesianism, consumer demand—consumption—is everything. Federal Reserve policy is clearly driven by the desire to stimulate demand through lower interest rates and easy money.

And Keynesian economists (of all stripes) want fiscal policy (essentially, government budgets) to increase consumer demand. If the consumer can’t do it, the reasoning goes, then the government should step into the breach. This of course requires deficit spending and borrowed money (including from your local central bank).

Essentially, when a central bank lowers interest rates, it is encouraging banks to lend money to businesses and telling consumers to borrow money to spend. Economists like to see fiscal stimulus at the same time, as well. They point to the numerous recessions that have ended after fiscal stimulus and lower rates were applied. They see the ending of recessions as proof that Keynesian doctrine works.

This thinking has several problems.

The Flaws of Keynesian Stimulus

First, using leverage (borrowed money) to stimulate spending today must by definition reduce consumption in the future. Debt is future consumption denied or future consumption brought forward. 

Keynesian economists argue that bringing just enough future consumption into the present to stimulate positive growth outweighs the future drag on consumption, as long as there is still positive growth.

Leverage just equalizes the ups and downs. This has a certain logic, of course, which is why it is such a widespread belief.

Keynes argued, however, that money borrowed to alleviate recession should be repaid when growth resumes. My reading of Keynes does not suggest he believed in the unending fiscal stimulus his disciples encourage today.

Secondly, as has been well documented by Ken Rogoff and Carmen Reinhart, there comes a point at which too much leverage becomes destructive. There is no exact way to know that point.

It arrives when lenders, typically in the private sector, decide that borrowers (whether private or government) might have some difficulty repaying and begin asking for more interest to compensate for their risks.

An overleveraged economy can’t afford the higher rates, and economic contraction ensues. Sometimes the contraction is severe, sometimes it can be absorbed. When accompanied by the popping of an economic bubble, it is particularly disastrous and can take a decade or longer to work itself out, as the developed world is finding out now.

Every major “economic miracle” since the end of World War II has been a result of leverage. Often this leverage has been accompanied by stimulative fiscal and monetary policies. Every single “miracle” has ended in tears, with the exception of the current recent runaway expansion in China, which is still in its early stages.

Insufficient Income Causes Recessions

I would argue (along, I think, with the “Austrian” economist Hayek and other economic schools) that recessions are not the result of insufficient consumption but rather insufficient income.

Fiscal and monetary policy should aim to grow incomes over the entire range of the economy. That is best accomplished by making it easier for entrepreneurs and businesspeople to provide goods and services. When businesses increase production, they hire more workers and incomes go up.

Without income, there are no tax revenues to redistribute. Without income and production, nothing of any economic significance happens. Keynes was correct when he observed that recessions are periods of reduced consumption, but that is a result and not a cause.

Entrepreneurs must be willing to create a product or offer a service in the hope there will be sufficient demand for their work. There are no guarantees, and they risk economic peril with their ventures, whether we’re talking about the local bakery or hairdressing shop or Elon Musk trying to compete with the world’s largest automakers. If government or central bank policies hamper their efforts, the economy stagnates.

The Reason Keynesianism Sticks

Many politicians and academics favor Keynesianism because it offers a theory by which government actions can become decisive in the economy. It lets governments and central banks meddle in the economy and feel justified.

It allows 12 people sitting in a board room in Washington DC to feel they are in charge of setting the most important price in the world, the price of money (interest rates) of the US dollar and that they know more than the entrepreneurs and businesspeople who are actually in the market risking their own capital every day.

This is essentially the Platonic philosopher king conceit: the hubristic notion that a small group of wise elites is capable of directing the economic actions of a country, no matter how educated or successful the populace has been on its own.

And never mind that the world has multiple clear examples of how central controls eventually slow growth and make things worse over time. It is only when free people are allowed to set their own prices of goods and services and, yes, even interest rates, that valid market-clearing prices can be determined. Trying to control them results in one group being favored over another.

In today’s world, savers and entrepreneurs are left to eat the crumbs that fall from the plates of the well-connected crony capitalists and live off the income from repressed interest rates. The irony of using “cheap money” to drive consumer demand is that retirees and savers get less money to spend, and that clearly drives their consumption down.

Why is the consumption produced by ballooning debt better than the consumption produced by hard work and savings? This is trickle-down monetary policy, which ironically favors the very large banks and institutions.

If you ask Keynesian central bankers if they want to be seen as helping the rich and connected, they will stand back and forcefully tell you “NO!” But that is what happens when you start down the road of financial repression. Someone benefits. So far it has not been Main Street.

The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

Kahn: 6-Ways To Prepare For The Next Market Decline

This article was originally published at Kiplinger and submitted by Michael Kahn


The U.S. economy is putting up some impressive numbers in GDP, jobs and wages, but many pundits fear that a slowdown is pending. Trade-war fears with China and the European Union remain front and center in the news. And the yield curve is threatening to invert, meaning short-term interest rates may be moving higher than long-term rates. That’s often a sign of pending recession on its own.

By some measures, the current expansion is now 10 years old, making it one of the longest on record. That seems ancient, but there’s no rule that says it can’t continue. Australia is in its 28th consecutive year of economic growth.

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Even so, all good things do eventually come to an end. And for the U.S. (and for Australia, for that matter), economists are looking for slowdowns. Even the Federal Reserve has indicated it is ready to lower short-term interest rates to combat any problems that may arise.

Professional investment managers may look to sell a good deal of their holdings to step aside as the market falls. However, for most individuals, timing the market by selling when conditions seem dicey, and buying back when conditions firm up, is a big mistake. Even the pros don’t always get it right, and they have armies of analysts and rooms full of technology at their disposal.

Here are six ways to prepare for the next stock market decline. The key is to make smaller adjustments to your portfolio to reduce risk and still be ready to participate when the market resumes its upward march.

Sell Speculative Stocks

Investors often have stocks in their portfolios that come with a bit more risk than they might like. What might have seemed like a good idea – think General Electric (GE) in 2015 – may have been all smoke and mirrors. The market has a way of punishing these types of companies when times get shaky.

Uber-investor Warren Buffett famously said,

“You only find out who is swimming naked when the tide goes out.”

A bull market tends to hide the sins of weak companies; when the bear comes knocking, they are the first to get hit.

Even if they’re not a disaster-in-waiting like GE was, some companies just may not have the financial resources to withstand a prolonged period of hard times. They might have too much debt on their books. Or they might be in a cyclical business, such as steel or oil drilling, that will seriously contract should the economy stumble. Perhaps you have shares in a company where legal battles, instead of their increasing market share, dominate their headlines.

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If you are getting nervous about the health of the stock market, lighten up on some of these weaker positions.

Here’s a quick test: Any stock that hit a 52-week low in April or May as the Standard & Poor’s 500 hit a 52-week (and all-time) high probably will not fare well on a market swoon. The same goes for stocks at 52-week lows at today’s highs.

Raise More Cash

Raising more cash simply means reducing the overall size of your invested portfolio. This could mean selling speculative stocks, as mentioned above, but keeping the proceeds in a money market fund.

It also could mean cutting each sector of your portfolio by a fixed percentage.

Let’s say you have four mutual fund positions – a large-cap growth fund, a small-cap fund, a growth-and-income fund and an international stock fund. (It really does not matter what they are but this is a typical illustration of how investors might diversify across stock categories.) If you trim each fund by 5% or 10%, keeping the proceeds in cash, you have reduced your risk without having to worry about which individual holding to sell. Of course, the percentage is up to you.

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Just remember that this is a tweak of your portfolio. You are not timing the market, pe se, because you will remain largely invested.

Give More Weight to Defensive Sectors

If you do not want to take any money out of the market, you still can reduce your risk by shifting more money away from aggressive sectors and into defensive ones.

Aggressive sectors typically include technology, consumer discretionary and arguably financials. Defensive sectors typically include consumer staples, healthcare and utilities.

What makes a sector defensive is that its businesses are less affected by economic swings. Their products and services enjoy relatively stable demand and are the last that a consumer might give up in hard times. This includes food, medicine and soap. That big vacation and flat-screen TV would be examples of discretionary items that are often the first to get cut from a budget.

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Defensive sectors lower your portfolio risk, but this comes with a price: When the market recovers, aggressive sectors usually outperform. The good news is that you still will be invested and should see gains without having to worry about timing your re-entry.

The strategy could be as simple as adding a small portion of Select Sector SPDR exchange-traded funds (ETFs) in consumer staples (XLP), health care (XLV) or utilities (XLU).

Raise Allocation to Bonds

Portfolios benefit from owing a percentage of bonds or other fixed-income investments. While bonds typically do not offer the same capital appreciation potential as stocks, their relative price stability and income streams can offset weakness in stocks.

One rule of thumb for a diversified portfolio across different asset classes is 55% stocks, 35% bonds and 10% cash. Of course, this will look a little or very different depending on your risk tolerance and how close you are to retirement.

But let’s just say that you did not get this advice and you are all in stocks. The easiest thing to do is to sell a portion of your stocks and buy high-quality corporate bonds, Treasury bonds or a mutual fund that invests in them. Remember: We previously looked at raising 5% or 10% cash. Taking that money and moving it to a bond fund would go a long way toward reducing your portfolio’s volatility and smoothing your returns over time.

Perhaps a Touch of Gold

If you follow the typical method of allocating your money across asset classes, you might hold 5% or 10% in gold or other precious metals instead of cash.

Gold does not pay interest or dividends. What it does offer is a hedge against several headwinds, including inflation, economic calamity or war. None of these seem imminent, but if you are truly worried about the economy pulling back in a big way, a little gold would help you sleep better at night.

That could be worth the price, right there. But we can probably do better.

Gold stocks – that is, mining companies that seek out the yellow metal – are intimately tied to the price of gold but they still are stocks. They can pay dividends, though most pay very little. But they do have price appreciation potential, and that means you can remain fully invested, if that is your choice.

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Shifting some money to gold stocks is very similar to shifting money into other defensive areas. Gold is different enough to warrant its own consideration.

Don’t Panic!

Remember why you invested in the first place. You are trying to build wealth over time, not try to trade in and out of the market based on trade wars, interest rates, tweets or punditry. That means you will necessarily have to weather a few storms, but over time, the stock market (and investing in general) is the greatest wealth-building machine out there.

For most investors, controlling risk is more important than trying to catch every wiggle in the market. If you stick in solid companies within the major trends in the world – life-changing technology, aging-population health care or new energy – and allocate a small portion for that potential home run, you will be able to have a long, successful career as an investor.

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Control your risk. The rest will take care of itself.

#WhatYouMissed On RIA: Week Of 07-12-19

We know you get busy and don’t check on our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything that you might have missed.


The Best Of “The Lance Roberts Show”

Podcast Interview Of The Week

Our Best Tweets Of The Week


Our Latest Newsletter


What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

See you next week!

Steepening Yield Curve Could Yield Generational Opportunities : Michael Lebowitz on Real Vision

On July 1st, Michael Lebowitz was interviewed by Real Vision TV. In the interview he discussed our thoughts on the yield curve, corporate bonds, recession odds, the Federal Reserve, and much more. In particular, Michael pitched our recent portfolio transactions NLY and AGNC, which were both discussed in the following RIA PRO article: Profiting From a Steepening Yield Curve.

Real Vision was kind enough to allow us to share their exclusive video with RIA Pro clients. We hope you enjoy it.

To watch the Video please click HERE

Will History Repeat Itself in the Gold Market?

Mark Twain once said, “history doesn’t repeat itself, but it often rhymes.”  Since President Nixon removed the gold standard in the early 1970s, gold has seen several significant rallies, all of which have similar wave characteristics.  Gold rallies seem to rhyme.

The first two price rallies began in 1971 and 1977, during and after the de-linking of the U.S. dollar from gold. The most recent price rally has its seeds in the dot-com bubble in the early 2000s.  The chart below shows two long-term monthly gold rallies, with the second rally appearing to be an amplified but similar version of the first.  I have overlaid Fibonacci sequence numbers to demonstrate how the price of gold has spiked upward in expanding, fractal waves during these prior surges. 

In the 1970s, gold traveled through four Fibonacci levels (by this measure) in less than a decade after the removal of the gold standard. From 2000 through 2012, amid the dot-com and housing bubbles, gold also traveled through four Fibonacci levels on the way to $1,900.  

If history rhymes again, and I believe it will, then the price of gold will again spike upward through three or four Fibonacci extensions to the upside, but then re-trace 50% to 70% of that upward move.   If so, then the next upward spike could peak in the range between $7,000 and $11,000 per ounce.

Investors tend to make rash decisions based on fear and greed. These emotions are typically amplified during times of financial stress. It is during such times that gold solicits fear and greed motivated buyers.  During a crisis, fear investors will rotate into gold to hold value, and greed investors see the upward momentum and jump on the train. The upward momentum of the next gold rally might feel like the Bitcoin surge in 2017.

“Striking Out” in the 1980s

In baseball, its “three strikes and you’re out.”  After the 1970’s surge and blow-off top in 1980, gold failed three key technical tests.  After these failures, the gold market floundered for another decade.  Let’s take a closer look at those three technical failures.

First, in early 1983, gold failed to retake and hold the psychologically important $500/oz price level.  This rejection resulted in sideways to lower movement for another year before gold failed again, breaking below its upward trend line near $360/oz.  After falling to a low in early 1985, gold moved higher over the next three years, only to fail a third key resistance test near $500/oz in late 1987.  After “striking out” in the 1980s, gold fell throughout the next decade back to $250/oz.

Current Technical Structure Is Bullish

Unlike the gold bear market of the 1980s, gold has been passing periodic tests of support and resistance since its sharp decline in 2013.  Gold’s price retracement from a high above $1,900 to a low near $1,040 kept the price above a 61.8% Fibonacci retracement level as well as the psychologically important $1,000 per ounce level. 

The monthly wave structure of gold is bullish, and the price is now trading above key resistance levels, with solid support at $1,379 and $1,250. Even if the price of gold falls back to support at $1,250 per ounce, the long term technical picture remains bullish.  I view the recent breakout over $1,380 to be significant and has likely opened the door towards the $1,580 resistance area.

To the downside, technical breakdowns below $1,250 could lead the way to $1,211 and $1,043.  If history does indeed rhyme, a breakdown below $1,043 could lead to another decade of futility.  This downside scenario does not appear likely, especially not with the uber-accommodative interest rate policies worldwide.  High U.S. dollar interest rates broke the back of the gold rally in the 1980s, and there does not appear to be any such risk of this happening again anytime soon. 

Short-term Indicator

In addition to my longer-term view on gold, I also track shorter-term price signals to locate areas of accumulation and/or hedging.  An indicator I developed shows a mean-reversion relationship between price and the point of Neutral Delta in the options market.  Essentially, the point of Neutral Delta shows where the options market participants have placed their bets and hedges.  At the moment, Neutral Delta is near $1,345 per ounce for the options which expire on July 25th

When the price is over-bought in relation to Neutral Delta (as it is now), we tend to see headwinds for further price increases.  Interpreting the current data, I am led to believe that the price of gold will re-test the $1,380 price level before July 25th, and this will give the options hedgers an opportunity to optimize their hedge book ahead of the next few option expirations.  A lower probability event would be a price spike again towards $1,450 which would like force a short-covering rally by the call option sellers who may already be out-of-the-money.

If we are in the opening innings of a new rally in gold, a retest of $1,380 or even $1,250 will represent great opportunities to buy or add to your gold positions.

You can learn more about my research by clicking this link: Introduction to Options Sentiment.

Final Thoughts

Gold can be best viewed as financial insurance.  If you believe that you should own insurance, then you should also own gold.  In terms of investment performance, gold will do best during times of international financial stress.  In the past, the price of gold has moved exponentially higher during these periods as demand for the ultimate safe haven goes viral. 

The world is slowly but steadily transitioning from a U.S. dollar-backed financial system to a multi-currency, multi-polar system.  One day, the leaders of our world will let the rest of us know the plan for a modified financial system, and we will have to admit that we were warned many times in advance.  I expect that the gold price spike will happen before, during, and after a new Bretton Woods-type conference.  While there are many signs that a new financial order is imminent, the transition to this new financial order could take more time than many have been led to believe.

From a short-term perspective, I use gold puts to protect my current precious metal allocations.  This is like purchasing insurance on the value of my current insurance policy. It also helps preserve my wealth allowing me to buy more gold if prices do in fact, drop to $1,380 or $1,250.

Disclaimer and Notes

This article was written for informational purposes and is not a recommendation to buy or sell any securities. All my articles are subject to the disclaimer found here.

Questions About The “Stellar” June Jobs Report (Which Also Confirm The Fed’s Concerns)

On Wednesday, Jerome Powell testified before Congress the U.S. economy is “suffering” from a bout of uncertainty caused by trade tensions and slow global growth. To wit:

“Since [the Fed meeting in mid-June], based on incoming data and other developments, it appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook.”

That outlook, however, would seem to be askew of the recent employment report for June from the Bureau of Labor Statistics last week. That report showed an increase in employment of 224,000 jobs. It was also the 105th consecutive positive jobs report, which is one of the longest in U.S. history.

However, if employment is as “strong” as is currently believed, which should be a reflection of the underlying economy, then precisely what is the Fed seeing?

Well, I have a few questions for you to ponder concerning to the latest employment report which may actually support the Fed’s case for rate cuts. These questions are also important to your investment outlook as there is a high correlation between employment, economic growth, and not surprisingly, corporate profitability.

Let’s get started.

Prelude: The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current annual rate of employment growth is 1.5%, which is lower than any previous employment level prior to a recession in history.

More importantly, as noted by Lakshman Achuthan and Anirvan Banerji via Bloomberg:

“A key part of the answer lies with jobs ‘growth,’ which has been slowing much more than most probably realize. Despite the better-than-forecast jobs report for June, the fact is the labor force has contracted by more than 600,000 workers this year. And we’re not just talking about the disappointing non-farm payroll jobs numbers for April and May.

Certainly, that caused year-over-year payroll growth, based on the Labor Department’s Establishment Survey – a broad survey of businesses and government agencies – to decline to a 13-month low. But year-over-year job growth, as measured by the separate Household Survey – based on a Labor Department survey of actual households – that is used to calculate the unemployment rate is only a hair’s breadth from a five-and-a-half-year low.”


Question: Given the issues noted above, does it seem as if the entirety of the economy is as robust as stated by the mainstream media? More importantly, how does 1.5% annualized growth in employment create sustained rates of higher economic growth going forward?


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


Question: Just how “strong” is employment growth? Does it seem that 96%+ of the working-age population is gainfully employed?


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

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


Question: With jobless claims at historic lows, and the unemployment rate below 4%, then why is full-time employment relative to the working-age population at just 50.10% (Only slightly above the 1980 peak)?


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

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


Question: At 50.38%, and the lowest rate since 1981, just how big of an impact are “retiring baby boomers” having on the employment numbers?


Prelude: One of the reasons the retiring “baby boomer” theory is flawed is, well, they aren’t actually retiring. Following two massive bear markets, weak economic growth, questionable spending habits, and poor financial planning, more individuals over the age of 55 are still working than at any other time since 1960.

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


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


Prelude: Of course, there are some serious considerations which need to be taken into account about the way the Bureau of Labor Statistics measures employment. The first is the calculation of those no longer counted as part of the labor force. Beginning in 2000, those no longer counted as part of the labor force detached from its longer-term trend. The immediate assumption is all these individuals retired, but as shown above, we know this is not exactly the case.


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


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

Following the financial crisis, the number of “Births & Deaths” of businesses unsurprisingly declined. Yet, each month, while the market is glued to the headline number, they additions from the “birth/death” adjustment go both overlooked and unquestioned.

Every month, the BLS adds numerous jobs to the non-seasonally adjusted payroll count to “adjust” for the number of “small businesses” being created each month, which in turns “creates a job.”  (The total number is then seasonally adjusted.)

Here is my problem with the adjustment.

The BLS counts ALL business formations as creating employment. However, in reality, only about 1/5th of businesses created each year actually have an employee. The rest are created for legal purposes like trusts, holding companies, etc. which have no employees whatsoever. This is shown in the chart below which compares the number of businesses started WITH employees from those reported by the BLS. (Notice that beginning in 2014, there is a perfect slope in the advance which is consistent with results from a mathematical projection rather than use of actual data.)

These rather “fictitious” additions to the employee ranks reported each year are not small, but the BLS tends even to overestimate the total number of businesses created each year (employer AND non-employer) by a large amount.

How big of a difference are we talking about?

Well, in the decade between 2006 and 2016 (the latest update from the Census Bureau) the BLS added roughly 7.6 million more employees than were created in new business formations.

This data goes a long way in explaining why, despite record low unemployment, there is a record number of workers outside the labor force, 25% of households are on some form of government benefit, wages remain suppressedand the explosion of the “wealth gap.” 


Question: If 1/3rd of the working-age population simply isn’t counted, and the birth-death adjustment inflates the employment roles, just how accurate is the employment data?


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

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


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


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

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

Or, does the fact the Fed is considering cutting interest rates to stimulate economic growth suggests the economy may already be weaker than headlines suggest?

One important note to all of this is the conclusion from Achuthan and Banerji:

“But there’s even more cause for concern. Months from now, the Establishment Survey will undergo its annual retrospective benchmark revision, based almost entirely on the Quarterly Census of Employment and Wages conducted by the Labor Department. That’s because the QCEW is not just a sample-based survey, but a census that counts jobs at every establishment, meaning that the data are definitive but take time to collect. 

The Establishment Survey’s nonfarm jobs figures will clearly be revised down as the QCEW data show job growth averaging only 177,000 a month in 2018. That means the Establishment Survey may be overstating the real numbers by more than 25%.”

These facts are in sharp contrast to strong job growth narrative.

But then again, maybe the yield-curve is already telling the answer to these questions.

Long-Short Idea List: 07-11-19

HOW TO READ THE CHARTS

There are four primary components to each chart:

  • The price chart is contained within the shaded area which represents 2-standard deviations above and below the short-term moving average.  
  • The Over Bought/Over Sold indicator is in orange at the top.
  • The Support/Resistance line (green) is the longer-term moving average which also acts as a trailing stop in many cases.
  • The Buy / Sell is triggered when the green line is above the red line (Buy) or vice-versa (Sell).

LONG CANDIDATES

BRK.B – Berkshire Hathaway

  • If the market is going to continue its rally on the expectation of “Fed rate cuts” then BRK.B is a way to play the broader market in a stock position.
  • Just turning up onto a buy signal from fairly low levels is attractive.
  • Buy at current levels.
  • Stop level is $205

GOOG – Alphabet, Inc.

  • We previously recommended going long GOOG, then shorting GOOG, and now we are suggesting going back long again.
  • GOOG has gotten oversold and is lagging the rest of the tech market currently. With earnings season approaching there is upside potential for a trade.
  • Buy at current levels as stop loss levels are very close.
  • Stop-loss is currently $1100

CRM – Salesforce.com

  • CRM has been holding support and consolidating for the last few months.
  • With earnings season approaching, an upside surprise could give the position a lift and stop-loss levels are very close.
  • Add a position at current levels.
  • Stop loss is set at $150.

FAST – Fastenal Co.

  • After a big run earlier this year, FAST has pulled back and is sitting on support.
  • While on a sell signal currently, we want to remain cautious with positioning.
  • Buy 1/2 position at current levels.
  • Stop loss is tight at $30.50
  • Add to position if FAST moves above #33
  • Currently the position is not overbought and is close to registering a buy signal.
  • Add a position to portfolios with a tight stop at $87

CVS – CVS Health Corp.

  • We recently added a position in CVS to our portfolio as the buy signal is approaching.
  • CVS is extremely beaten up and oversold after a brutal few months of selling.
  • We are looking for a tradeable bounce in CVS back to the mid-70’s.
  • Buy at current levels.
  • Stop is set at $50 – honor thy stop.

SHORT CANDIDATES

AMTD – TD Ameritrade

  • We had previously recommended a short-sell on AMTD and the recent break below consolidation suggests more downside to come.
  • Short at current levels.
  • Target for trade is $40
  • Stop-loss is set at $52

CAT – Caterpillar

  • CAT has been in a long-term downtrend but with earnings approaching a disappointing announcement due to China weakness and “Trade” will not be surprising.
  • Short on a break below $130
  • Target for trade is $110
  • Stop loss is $140

AVGO – Broadcom, Inc.


  • AVGO recently made an acquisition of a weak company with old technology. I think this will ultimately prove to be a mistake.
  • With AVGO on a sell signal and close to breaking important support and decent short setup seems to be forming.
  • Short on a break below $270
  • Target is $210
  • Stop loss is $290

AMC – AMC Entertainment

  • We previously recommended a short on AMC.
  • It is time to close that position out.
  • Buy back and close the short position tomorrow.
  • Short at current levels.
  • Stop is set at $15.50
  • Target for the trade is $13

HBI – HanesBrands

  • HBI has been “taking it in the shorts” for a while. (I know, bad joke, but I couldn’t help it.)
  • HBI is very close to registering a “sell signal” and remains overbought from the recent rally.
  • Sell short on a break of support at $16
  • Target is $12
  • Stop is set at $17.50

Investors Are Grossly Underestimating The Fed – RIA Pro UNLOCKED

 If you think the Fed may only lower rates by .50 or even .75, you may be grossly underestimating them.  The following article was posted for RIA Pro subscribers two weeks ago.

For more research like this as well as daily commentary, investment ideas, portfolios, scanning and analysis tools, and our new 401K manager sign up today at RIA Pro and test drive our site for 30 days before being charged.


Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more.

The prospect of three 25 basis point rate cuts is hard to grasp given that the unemployment rate is at 50-year lows, economic growth has begun to slow only after a period of above-average growth, and inflation remains near the Fed’s 2% goal.  Interest rate markets are looking ahead and collectively expressing deep concerns based on slowing global growth, trade wars, and diminishing fiscal stimulus that propelled the economy over the past two years. Meanwhile, credit spreads and stock market prices imply a recession is not in the cards.

To make sense of the implications stemming from the Fed Funds futures market, it is helpful to assess how well the Fed Funds futures market has predicted Fed Funds rates historically. With this analysis, we can hopefully avoid getting caught flat-footed if the Fed not only lowers rates but lowers them more aggressively than the market implies.

Fed Funds vs. Fed Funds Futures

Before moving ahead, let’s define Fed Funds futures. The futures contracts traded on the Chicago Mercantile Exchange (CME), reflect the daily average Fed Funds interest rate that traders, speculator, and hedgers think will occur for specific one calendar month periods in the future. For instance, the August 2019 contract, trades at 2.03%, implying the market’s belief that the Fed Funds rate will be .37% lower than the current 2.40 % Fed Funds rate. For pricing on all Fed Funds futures contracts, click here.

To analyze the predictive power of Fed Funds futures, we compared the Fed Funds rate in certain months to what was implied by the futures contract for that month six months earlier. The following example helps clarify this concept. The Fed Funds rate averaged 2.39% in May. Six months ago, the May 2019 Fed Funds future contract traded at 2.50%. Therefore, six months ago, the market overestimated the Fed Funds rate for May 2019 by .11%. As an aside, the difference is likely due to the recent change in the Fed’s IOER rate.

It is important to mention that we were surprised by the conclusions drawn from our long term analysis of Fed Funds futures against the prevailing Fed Funds rate in the future.

The graph below tracks the comparative differentials (Fed Funds vs. Fed Fund futures) using the methodology outlined above. The gray rectangular areas represent periods where the Fed was systematically raising or lowering the Fed funds rate (blue line). The difference between Fed Funds and the futures contracts, colored green or red, calculates how much the market over (green) or under (red) estimated what the Fed Funds rate would ultimately be. In this analysis, the term overestimate means Fed Funds futures thought Fed Funds would be higher than it ultimately was. The term underestimate, means the market expectations were lower than what actually transpired.

To further help you understand the analysis we provide two additional graphs below, covering the most recent periods when the Fed was increasing and decreasing the Fed Funds rate.

Data Courtesy Bloomberg

Data Courtesy Bloomberg

Looking at the 2004-2006 rate hike cycle above, we see that the market consistently underestimated (red bars) the pace of Fed Funds rate increases.

Data Courtesy Bloomberg

During the 2007-2009 rate cut cycle, the market consistently thought Fed Funds rates would be higher (green bars) than what truly prevailed.

As shown in the graphs above, the market has underestimated the Fed’s intent to raise and lower rates every single time they changed the course of monetary policy meaningfully. The dotted lines highlight that the market has underestimated rate cuts by 1% on average, but at times during the last three rate-cutting cycles, market expectations were short by over 2%. The market has underestimated rate increases by about 35 basis points on average.

Summary

If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?

We remind you that equity valuations are at or near record highs, in many cases surpassing those of the roaring 1920s and butting up against those of the late 1990s. If the Fed needs to cut rates aggressively, it will likely be the result of an economy that is heading into an imminent recession if not already in recession. With the double-digit earnings growth trajectory currently implied by equity valuations, a recession would prove extremely damaging to stock prices.

Treasury yields have fallen sharply recently across the entire curve. If the Fed lowers rates and is more aggressive than anyone believes, the likelihood of much lower rates and generous price appreciation for high-quality bondholders should not be underestimated.

The market has a long history of grossly underestimating, in both directions, what the Fed will do. The implications to stocks and bonds can be meaningful. To the extent one is inclined and so moved to exercise prudence, now seems to be a unique opportunity to have a plan and take action when necessary.

Recession Probability Charts: Current Odds Now About 33%

The New York Fed has the odds of a recession within the next year at 33%. Some of the other models are humorous.

New York Fed Treasury Spread Model

The New York Fed Recession Model is based on yield curve inversions between the 10-year Treasury Note and the 3-Month Treasury Bill.

I added the highlights in yellow and the dashed red line.

The model uses monthly averages.

Smoothed Recession Odds

I do not know the makeup of the smoothed recession chart but it is clearly useless. The implied odds hover around zero, and are frequently under 20% even in the middle of recession.

GDP Recession Model

The GDP-based recession model is hugely lagging. The current estimate is 2.4%. This model will not spike until there is at least one quarter of negative or near-zero GDP.

Estimated Recession Probabilities

Predicting Recessions

The above chart is from the Yield Curve as a Predictor of U.S. Recessions by Arturo Estrella and Frederic S. Mishkin. It is from 1996 so the table may have been revised.

Practical Issues

One might also wish to consider the 2006 discussion the Yield Curve as a Leading Indicator: Some Practical Issues.

With regard to the short-term rate, earlier research suggests that the three-month Treasury rate, when used in conjunction with the ten-year Treasury rate, provides a reasonable combination of accuracy and robustness in predicting U.S. recessions over long periods.

Maximum accuracy and predictive power are obtained with the secondary market three-month rate expressed on a bond-equivalent basis, rather than the constant maturity rate, which is interpolated from the daily yield curve for Treasury securities.

Spreads based on any of the rates mentioned are highly correlated with one another and may be used to predict recessions. Note, however, that the spreads may turn negative—that is, the yield curve may invert—at different points and with different frequencies.

Our preferred combination of Treasury rates proves very successful in predicting the recessions of recent decades. The monthly average spread between the ten-year constant maturity rate and the three-month secondary market rate on a bond equivalent basis has turned negative before each recession in the period from January 1968 to July 2006 (Chart1). If we convert this spread into a probability of recession twelve months ahead using the probit model described earlier (estimated with Treasury data from January 1959 to December 2005), we can match the probabilities with the recessions (Chart 2). The chart shows that the estimated probability of recession exceeded 30 percent in the case of each recession and ranged as high as 98 percent in the 1981-82 recession.

Other Spreads

The article mentions “The ten-year minus two-year spread tends to turn negative earlier and more frequently than the ten-year minus three-month spread, which is usually larger.

That is certainly not the case today.

The 2-year yield is 1.882 whereas the 10-year yield is 2.041.

Chalk this up to QE, Fed manipulation, taper tantrums, and hedge funds front-running expected rate cut moves.