Financial planning industry thought leader Michael Kitces CFP® , CLU® , ChFC® , RHU, REBC and professor of retirement income at the American College Wade D. Pfau Ph.D., CFA, penned a seminal work for the Journal of Financial Planning titled “Reducing Retirement Risk with a Rising Equity Glide Path.”

During the accumulation stage as personal wealth is building and human capital potential is high, a financial planner will assess risk attitude, time frame, and create a portfolio asset allocation accompanied by a method to rebalance on a periodic basis.

I call this “Plan A” for accumulation. 

In addition, an ongoing saving and investment plan needs to be fine-tuned and monitored to help a client achieve an important financial life benchmark such as creating an inflation-adjusted income stream that will continue throughout a 20 to 30-year retirement period.

It’s customary for a financial professional, depending on individual circumstances, to reduce portfolio equity exposure as a retirement date approaches and ostensibly increase the allocation to conservative selections like fixed income (bonds) cash and ultra-short duration bond holdings earmarked as reserve for withdrawals.

Is this the right thing to do?

On the surface, the portfolio strategy appears to be effective; it’s appropriate to shield a retiree from future (or current) unfavorable stock market conditions and the subsequent time required to recover from an unfavorable sequence of market returns (below-average or negative), especially in the face of periodic portfolio withdrawals. 

However, the common tendency for planners to maintain a reduced exposure to equities as the retiree ages can be a mistake per the analysis.

From experience, financial planners have a tendency to decrease equity exposure in retirement portfolios as life expectancies and time frames shorten. According to the research, this common tactic of employing a declining equity glide path can generate worse results than maintaining an ongoing, reduced allocation to stocks.

Reducing equity exposure over time is a very common “Plan B” strategy. B stands for boring. Planners don’t intend for retirees to deal with the distress and loss of wealth that can occur with an aggressive allocation to stocks so boring is appealing.

Retirees feel vulnerable enough as their human capital or ability to generated wage income decreases and they need to depend on the portfolio to satisfy living expenses.

The study results are counterintuitive to traditional thinking: To maximize the level of sustainable income in retirement, it appears best to raise equity exposure throughout retirement. Retiree portfolios that begin with a 20-40% allocation to stocks and increase to 60-80% generally increase the success of retirement income sustainability and reduce the impact of shortfalls compared to static rebalanced asset allocations.

The heart of Kitces’ and Pfau’s research is “Plan U” (for unorthodox in my opinion) – or a “U-shaped” allocation. Here’s how it works: Stocks are a greater share of a portfolio through the accumulation/increasing human capital (earning power) stage, decrease at the beginning of retirement, and then increase as a lifecycle strategy throughout the retirement period.

Intuitively, the “U” makes sense.

I have been employing this U-shaped glide path since 2001.

I implemented it initially based on the loss I felt clients could experience as they retired in the face of lofty price/earnings valuations for stock markets during the dot-com boom. I also believed we were at the beginning of a secular sideways market cycle reminiscent of 1966-1982.

I never discount luck when I make an accurate assessment of the macro-environment. The process keeps me humble and open-minded to change when cycles do.

Today, before clients retire, I analyze stock market valuation using the Lance Roberts’ CAPE 5- Ratio as a method to estimate investment, specifically stock market risk a retiree will experience for a given level of return. Based on the analysis, stock returns will be driven by headwinds which comes down to increased odds of lower forward returns.

Based on Lance’s post-World War 2 CAPE-5 average of 17.27x and a current deviation of 44.19% above the historical earnings average, it makes sense for those 5 years or sooner from retirement to reduce equity exposure in preparation for retirement.

Prospective and new retirees can tempt fate by maintaining an aggressive portfolio stance. However, keep in mind, once distributions begin, investments must be closely monitored and a sell discipline enforced. Stocks should be trimmed into market strength to keep the cash bucket full and avoid a forced liquidation of investments through periods of market weakness.

For investors brave enough to take on this portfolio risk, there have been only three times over the last 70 years such a deviation has been experienced: 1996, 2003 and 2013. I personally believe this is a gamble you should walk from.

Although valuation metrics like Lance’s are far from perfect when it comes to short-term market performance, I would rather err on the side of caution. Per the study, I feel better about the occasional underperformance in the face of sequence of returns risk, especially during the first decade of retirement.

“As Kitces (2008) showed, in the case of a 30-year time horizon, the outcome of a withdrawal scenario is dictated almost entirely by the real returns of the portfolio for the first 15 years. If the returns are good, the retiree is so far ahead relative to the original goal that a subsequent bear market in the second half of retirement has little impact. Although it is true that final wealth may be highly volatile in the end, the initial spending goal will not be threatened. By contrast, if the returns are bad in the first half of retirement, the portfolio is so stressed that the good returns that follow are absolutely crucial to carry the portfolio through to the end.” 

The researchers placed an academic stamp of approval on what I’ve been doing for years to help clients emotionally deal with stocks through a period they feel most vulnerable to not only market, but big life transitions.

Once retirees have confidence in their retirement plans, many are amenable to adding equity exposure back into the allocation. Some are reluctant.

As a retiree, how do you deal with the findings?

Academic-based analysis is one thing, adding stocks to a portfolio during retirement when you feel psychologically or vulnerable to household financial shocks, is another.

A behavioral cheat sheet is in order to follow the advice laid out by the researchers:

1). Decrease your stock exposure the first year in retirement and don’t worry about missed opportunities. Focus on your overall emotional state which may change as you move from an accumulation to portfolio distribution mindset. You’ll experience what I call “the black hole.” A period immediately after retirement where you’ll feel a bit displaced and not in control over your future. This time of uneasiness ostensibly fades as cash-flow mechanisms are put into place and new lifestyle habits emerge.

Special attention should be paid to monitoring household cash flow, budgeting, fixed expense (rent, mortgage) coverage and the worrisome mental impact I’ve noticed that goes along with establishing systematic, tax-effective portfolio withdrawals to re-create the paycheck in retirement.

In other words, focus on the issues that create uncertainty (don’t let greater stock exposure add to stress), pay special attention to the basics and monitor progress with a financial partner or objective party at least every quarter.

Each step, if completed successfully, will build confidence and help you feel in control of the present situation. The first year of retirement should be a time to step back from stocks when you feel most unsure about your personal financial footing.

2). As you build confidence, increase equities when valuations are favorable. Depending on your circumstances– including your systematic withdrawal rate, coverage of household expenses and how the portfolio has progressed–consider increasing equities beginning year three. After two years of analysis, education and monitoring, I have discovered clients gain enough confidence to add additional stock exposure to their asset allocation programs.

3). Gain an understanding of how to maximize Social Security. Social Security is difficult to grasp. Deciding how and when to claim benefits are crucial decisions especially when spouses are involved. To gain an understanding of the present value of your estimated benefits and to run different scenarios to maximize what’s available, ask your financial advisor to help you crunch the numbers.

Recently, I was able to add stock exposure for a client after we increased total lifetime Social Security by postponing the receipt of benefits until age 70 for the higher wage earner. Social Security can be considered part of a fixed income allocation thus allowing you to expand your allocation to stocks throughout retirement.

4). Life expectancy. The conundrum. Obviously, nobody has a crystal ball when it comes to life expectancy. A decade ago a client “predicted” he’d be “gone in five years.” He’s still here and healthy.

We held 30% in equities ten years ago. Today his portfolio equity allocation is at 45%. Those in good health and long life expectancies in their families also have additional time to weather out stock market volatility.

Want to estimate how long you’re going to live? Go through the 40 questions at which uses the latest research and medical data to estimate how old you’ll live to be. Clients with good health habits are amenable to adding equity exposure over the years. Their optimistic attitude and active lifestyle motivates them to believe that living to 100 is achievable – therefore achieving returns above inflation is important to them.

5). Remain sensitive to your portfolio withdrawal rate. An unfortunate series of portfolio returns during the first half of retirement can result in a fast, unrecoverable depletion of wealth in the second half. To stay on track and remain confident in a plan to boost equity exposure, complete a portfolio withdrawal rate checkup every two years.

Total your cumulative net gains minus withdrawals. If a surplus exists, which means you’ve experienced more gains than withdrawals, move forward and increase your equity exposure. Work with your financial adviser or planner to determine which equity asset classes require additional exposure.

Over the last three years, the retiree portfolios I’ve examined share common themes – They are over-weighted in large-cap U.S. stocks and bonds and underexposed to international equities.

Increasing equity risk to “make up” for a deficit (you’ve spent more than you’ve gained), is a big mistake. In this case, a complete assessment is needed to review expenses, the current market environment and future withdrawal rates before stocks are increased.

The research in this study will prove to be a game changer regarding how retiree portfolio asset allocations are constructed in the future.

Most important are the methods employed to ease into equities which include enhanced sensitivity to the emotional state of clients, possible addition of annuitization strategies and consistent monitoring of household cash flows.

Last, the financial services industry will need to be up for the challenge of breaking free from much of the outdated thinking which feeds and nurtures it. T

The study mentioned and others by Kitces and Pfau, are breaking ground for fresh thinking in the retirement income distribution arena.

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

As I discussed this past weekend:

Immediately Wall Street spun this very negative news [failure to pass health care reform] into the ‘positive’ as noted by Margaret Patel via Wells Fargo Asset Management:

‘It looked like the market was worried that the Trump agenda would get completely bogged down in the health care issue, and now that they’ve taken the health care issue off the table, I think the market is more optimistic that they can do other things that are more doable that are not so complicated, such as regulatory reform and lowering taxes.’

This “shift in sentiment” was the same as we saw on election night as the general expectation of “a Trump election will crash the markets,” to “a Trump election is great for the markets,” fueled the post-election surge in the markets. Wall Street’s ability to “pivot” to provide a reason for investors to remain “long” equities has been effective and has been supported by the shift in consumer sentiment as well. As I noted previously:

“There is little doubt that since the election both investor and consumer confidence has soared. In fact, confidence (soft data) has become extremely detached from the actual activity (hard data) within the economy.”

“Historically, this deviation has not lasted long, and it has always been ‘hope’ giving up ground to the underlying ‘reality.’ But nonetheless, it is ‘hope,’ which is more commonly known as ‘animal spirits,’ which drives markets higher in late stage market advances.”

While Wall Street’s media machine has been hard at work spinning a new narrative “forget health care, it’s all about tax reform,” here’s the problem for investors and the economy:

“Ignoring the fact that work on tax reform in earnest won’t start for 6-8 weeks as House Ways and Means member Merchant said moments ago, and may not even take place until fiscal 2018 (after August), the reality is that since Obamacare and tax reform are both parts of the Reconciliation process, as a result of not freeing up hundreds of billions from the deficit that the CBO estimated repealing Obamacare would do, it means that Trump’s tax cuts have been hobbled – by as much as $500 billion – before even starting.

Furthermore, with the Freedom Caucus flexing its muscle and openly defying Trump, another major headache for Trump’s tax reform is that the Border Adjustment Tax – an aspect of the reform that the Caucus has been vocally against – is likely off the table. And since BAT was expected to generate over $1 trillion in government revenues, it means that a matched amount in tax cuts is also now off the table.

In summary, between Obamacare repeal and BAT being scrapped, roughly $1.5 trillion in budget ‘buffers’ are wiped out.”

This point should not be lost on investors.

Prior to the election, earnings estimates were previously $130/share for 2017. But reality crushed those hopes with the collapse of oil prices. However, based on Trump’s tax cuts and infrastructure spending program, those $130/share estimates were revived but pushed out to the end of 2018. As I wrote at that time:

“In particular, is the repeated impact of tax cuts on earnings over the next year as recently reiterated by Bob Pisani:

‘Even before the election, analysts were anticipating a roughly 9 percent increase in earnings for the S&P 500, from roughly $118 in 2016 to $131 in 2017. But I noted back on Dec. 1 that Thomson Reuters estimated that every 1 percentage point reduction in the corporate tax rate could “hypothetically” add $1.31 to 2017 earnings. So with a full 20 percentage point reduction in the tax rate (from 35 percent to 15 percent), that’s $1.31 x 20 = $26.20.

That implies an increase in earnings of close to 20 percent, or $157. Even a modest boost to, say, $140, would bring the S&P to 2400 at the current 17 multiple, nearly 7 percent above where it is now.’”

Three Problems

First, earnings for 2016 did not come in at $118/share but rather $94.54, or a -25.5% shortfall.

Secondly, as noted by the Government Accountability Office, the average tax rate paid by U.S. corporations is not 35% but closer to 12.5%.

“Large, profitable U.S. corporations paid an average effective federal tax rate of 12.6% in 2010, the Government Accountability Office said Monday.

The federal corporate tax rate stands at 35%, and jumps to 39.2% when state rates are taken into account. But thanks to things like tax credits, exemptions, and offshore tax havens, the actual tax burden of American companies is much lower.

Even when foreign, state and local taxes were taken into account, the companies paid only 16.9% of their worldwide income in taxes in 2010.”

Therefore, the reduction in the legislative tax rates to 15-20% is likely to be far less impactful to earnings growth than what is currently estimated by Reuters.

Lastly, a math problem.

As discussed above, the expectations of a $1.31 boost to earnings for each percentage point of reduction in tax rates is also a bit “squishy.” The premise WAS based on the expected earnings in 2017 of $131.00 for the entirety of the S&P 500. The $1.31 increase is simply 1% of $131.00 in total operating earnings.

Since actual earnings for 2016 was $94.54/share, this implies a $0.9454 increase per point, or an earnings boost of $18.91 (.9454 * 20) at best which would bring total 2017 estimates to $113.45. This is $5.38 less than what is currently estimated for 2017 and brings into serious question of 2018 estimates of $130.03.  

Based on this math, forward valuations (assuming prices don’t move from yesterday’s close) would be 20.63x.  This is far more expensive than the 17x earnings expected previously. But unfortunately, the news is already getting worse as estimates have continued to slide just in the last month.

Here is the issue.

IF analysts are correct, and they never are, and earnings do rise to $130/share in 2018, which is based on tax reform and infrastructure spending hopes, earnings will be at the same level as they were projected to be at the end of 2017 at the beginning of 2016

Add to this, the offset of the Border Adjustment Tax (BAT), the remaining ACA taxes on both corporations and individuals, and the reality that corporate tax reform will likely be less than advertised (25% vs 15-20%), and you have the makings of a substantial shortfall in current forward earnings estimates. As we saw with the Bush tax cuts in 2001, and the repatriation holiday in 2004, the impacts from policy changes are more “psychological” short-term boosts which are quickly absorbed by economic realities.

Bullish For Now, Bearish Later

On Monday, the market was able to hold support at the 50-dma which keeps the bullish bias of the market intact. While the market currently remains on a short-term SELL signal, the ability for the market to hold the 50-dma while the overbought condition is reduced sets the market up for additions to equity allocations in the near future. This is assuming a “buy signal” is issued with the markets still in a bullish trend and without having broken previous support.

Given that Wall Street is now currently underpinning the market with views on short-term tax reform taking place, this bullish bias could very well continue. It is NOT WISE to try and counter-trade this trend currently as “exuberance” is still extremely prevalent in the market. As noted by JPM on Monday:

Stocks are obviously weak but flows are orderly and not particularly busy (and the major indices have bounced well off their opening lows). Recalibrating political expectations is the main reason for the softness as investors debate the timing and scope of a tax bill, although the market isn’t abandoning hope of action on the tax front by any means and until that happens the SPX will struggle to sustain significant weakness.

It seems like many are circling ~2300 as an approximate area of support (premised on the SPX’s ability to earn ~$133-135 in ’18 w/o anything happening in Washington) and thus sentiment isn’t alarmed or panicked.”

Again, note that last sentence.

Earnings for 2018 were cranked up to $130.03 from $94.54 (a 37.54% increase) based on the impact of tax reforms. Now, that seems to have been forgotten as the $130/share earnings mark has become the norm and anything from tax cuts is now an extra boost.

Someone is going to be very disappointed.

It is likely going to be you. 

Below The Surface

Below the surface of the major indices, which are capitalization weighted and prices can be skewed by a few major components like Apple, Microsoft, Google, etc., the underlying technicals continue to show short-term weakness. However, it was small capitalization stocks that took the lead following the election. That outperformance has significantly faded as investors have lost confidence in the “Trump Trade” particularly as the “hard economic data” has failed to follow suit.

But it is not just the deterioration of small caps that is concerning, but also the lack of participation by stocks below the surface. While markets continue to hover near all-time highs, the number of advancing issues and volume continue to weaken. 

While on a very short-term, daily, basis the market is nearing an oversold, and potentially tradeable, condition, the longer-term dynamics still argue for a larger correction.

However, such a corrective process on a longer-term basis could very well come after a short-term rally back towards previous highs.

Lastly, the rotation from equities to fixed income (risk to safety trade) continues with bonds nearing a very important “buy signal.” Previous signals have given way to fairly large rallies in bonds. Given the post-election surge in rates, the reversal of that trade could be substantial and would also likely coincide with a further correction in equity prices.

Lastly, Jason Goepfert via made a very interesting observation last week:

“Over the past week, we’ve seen an increasing amount of risk aversion, with streaks of low volatility ending and momentum waning. That means, of course, that investors are decreasing their exposure. They have a ways to go.

Last week, we looked at hedger positions in index futures, which was near an all-time record bet against stocks. Speculators take the other side of those trades and a large percentage of those are trend-following funds. So it’s safe to say that speculative funds were holding near-record exposure to stocks, which means that if stocks slip to multi-week lows again and volatility spikes, then we will likely see increased pressure from these funds to lower their exposure.

The 20-day average of Hedge Fund Exposure has just started to roll over after nearing 60%, one of the highest readings in 15 years. The indicator is calculated by looking at changes in the performance of macro hedge funds versus changes in the S&P 500.”

“We can see that the three other times that Exposure got as high as it recently was over the past month, stocks did not manage to add much, if anything, on the upside, and fell 15%-20% over the next several months.”

So, while I am still bullish on the markets short-term (few days to weeks), I am becoming much more cautious. Over the longer-term (few weeks to several months), I am much more bearish.

Hedging risk continues to remain a prudent course of action.

In “Part 1” of this series, I discussed at length whether Dr. Robert Shiller’s 10-year cyclically adjusted price-earnings ratio was indeed just “B.S.”  The primary message, of course, was simply:

“Valuation measures are simply just that – a measure of current valuation. If you ‘overpay’ for something today, the future net return will be lower than if you had paid a discount for it.

Valuation models are not, and were never meant to be, ‘market timing indicators.'”

With that said, in this missive I want to address some of the current, and valid, arguments against a long term smoothed price/earnings model:

  • Beginning in 2009, FASB Rule 157 was “temporarily” repealed in order to allow banks to “value” illiquid assets, such as real estate or mortgage-backed securities, at levels they felt were more appropriate rather than on the last actual “sale price” of a similar asset. This was done to keep banks solvent at the time as they were being forced to write down billions of dollars of assets on their books. This boosted banks profitability and made earnings appear higher than they may have been otherwise. The ‘repeal” of Rule 157 is still in effect today, and the subsequent “mark-to-myth” accounting rule is still inflating earnings.
  • The heavy use of off-balance sheet vehicles to suppress corporate debt and leverage levels and boost earnings is also a relatively new distortion.
  • Extensive cost-cutting, productivity enhancements, off-shoring of labor, etc. are all being heavily employed to boost earnings in a relatively weak revenue growth environment. I addressed this issue specifically in this past weekend’s newsletter:

“What has also been stunning is the surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 221%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 28% during the same period.”

  • The use of share buybacks improves underlying earnings per share which also distorts long-term valuation metrics. As the WSJ article stated:

“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. 

Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”

This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to either flatter, or depress, earnings.

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big “restructuring charge” that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

As shown, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.

  • The extensive interventions by Central Banks globally are also contributing to the distortion of markets.

Due to these extensive changes to the financial markets since the turn of the century, I do not completely disagree with the argument that using a 10-year average to smooth earnings volatility may be too long of a period.

Duration Mismatch

Think about it this way. When constructing a portfolio that contains fixed income one of the most important risks to consider is a “duration mismatch.”  For example, let’s assume an individual buys a 20-year bond, but needs the money in 10-years. Since the purpose of owning a bond was capital preservation and income, the duration mismatch leads to a potential loss of capital if interest rates have risen at the time the bond is sold 10-years prior to maturity.

One could reasonably argue, due to the “speed of movement” in the financial markets, a shortening of business cycles, and increased liquidity, there is a “duration mismatch” between Shiller’s 10-year CAPE and the financial markets currently.

The first chart below shows the annual P/E ratio versus the inflation-adjusted (real) S&P 500 index.

Importantly, you will notice that during secular bear market periods (green shaded areas) the overall trend of P/E ratios is declining.  This “valuation compression” is a function of the overall business cycle as “over-valuation” levels are “mean reverted” over time.  You will also notice that market prices are generally “sideways” trending during these periods with increased volatility.

You can also see the vastly increased valuation swings since the turn of the century, which is one of the primary arguments against Dr. Shiller’s 10-Year CAPE ratio.

Introducing The CAPE-5 Ratio

The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor’s periods of “valuation expansion” are where the bulk of the gains in the financial markets have been made over the last 116 years. History shows, that during periods of “valuation compression” returns are much more muted and volatile.

Therefore, in order to compensate for the potential “duration mismatch” of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.

There is a high correlation between the movements of the CAPE-5 and the S&P 500 index. However, you will notice that prior to 1950 the movements of valuations were more coincident with the overall index as price movement was a primary driver of the valuation metric. As earnings growth began to advance much more quickly post-1950, price movement became less of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overall price changes.

A key “warning” for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market. The recent decline in the CAPE-5, which was directly related to the collapse and recovery in oil prices, has so far been an outlier event. However, complacency “this time is different,” will likely be misplaced as the corrective trend currently remains intact.

To get a better understanding of where valuations are currently relative to past history, we can look at the deviation between current valuation levels and the long-term average. The importance of deviation is crucial to understand. In order for there to be an “average,” valuations had to be both above and below that “average” over history. These “averages” provide a gravitational pull on valuations over time which is why the further the deviation is away from the “average,” the greater the eventual “mean reversion” will be.

The first chart below is the percentage deviation of the CAPE-5 ratio from its long-term average going back to 1900.

Currently, the 56.97% deviation above the long-term CAPE-5 average of 15.86x earnings puts valuations at levels only witnessed five (5) other times in history. As stated above, while it is hoped “this time will be different,” which were the same words uttered during each of the five previous periods, you can clearly see that the eventual results were much less optimal.

However, as noted, the changes that have occurred Post-WWII in terms of economic prosperity, changes in operational capacity and productivity warrant a look at just the period from 1944-present.

Again, as with the long-term view above, the current deviation is 44.19% above the Post-WWII CAPE-5 average of 17.27x earnings. Such a level of deviation has only been witnessed three times previously over the last 70 years in 1996, 2005 and 2013. Again, as with the long-term view above, the resulting “reversion” was not kind to investors.

Is this a better measure than Shiller’s CAPE-10 ratio?

Maybe, as it adjusts more quickly to a faster moving marketplace. However, I want to reiterate that neither the Shiller’s CAPE-10 ratio or the modified CAPE-5 ratio were ever meant to be “market timing” indicators.

Since valuations determine forward returns, the sole purpose is to denote periods which carry exceptionally high levels of investment risk and resulted in exceptionally poor levels of future returns.

Currently, valuation measures are clearly warning the future market returns are going to be substantially lower than they have been over the past eight years. Therefore, if you are expecting the markets to crank out 10% annualized returns over the next 10 years for you to meet your retirement goals, it is likely that you are going to be very disappointed.

Shiller’s CAPE: Is It Really B.S. – Part 1

In this past weekend’s missive I wrote:

“Speaking of low volatility, the market has now gone 108-trading days without a drop of 1% for both the Dow and the S&P 500. This is the longest stretch since September of 1993 for the Dow and December of 1995 for the S&P 500.

The issue becomes, of course, which way the market breaks when volatility returns to the market. Over the course of the last three years, in particular, those breaks have been to the downside as shown below.”

“Given the particularly extreme overbought condition that currently exists, the strongest odds suggest the next pickup in volatility will be in the form of a corrective action to reverse some of that condition.”

Of course, on Tuesday afternoon that long streak of complacency came to an end as all major U.S. markets tumbled by more than 1% by the close.

While such an event has been expected, it still seemed to catch investors by surprise. Of course, given such a long period of upwardly trending prices with exceptionally low volatility, investors had been lulled into very high levels of complacency. The media had also fallen into the trap, as noted by the graphic above, suggesting the one-day correction had been a major mean reverting event.

It wasn’t.

As shown in the chart above, updated through Thursday, all indicators remain extremely overbought. While the markets may indeed rally into Friday’s close, it is quite likely the correction that began on Tuesday is not complete as of yet.

Furthermore, after such a long period of low volatility, the sharp decline in asset prices is one day FELT much worse than it actually was. 

This is the important, and often missed point about “passive indexing.”

While a 10% decline in the market certainly does SOUND that bad, with a 2000 point loss on the Dow, or a 230 point loss on the S&P 500, FEELS entirely different. This is where investors start making emotionally bad investment decisions where “passive investing” ultimately becomes “panic selling.”

It is the “lack of perspective” by investors that eventually lead them into the myriad of investment mistakes which destroys investment capital. Think about it this way. If a 1% decline causes this much angst in the market, what happens when you multiply that by 10?

While it is often said it is only “time IN the market” that matters, investors must remember “time” is the one commodity we can not replace. 

Just some things I am thinking about this weekend as I catch up on my reading.



Research / Interesting Reads

“Successful preservation of capital must overcome the handicaps of socialistic governments to supposedly help the masses.” – Gerald Loeb

Questions, comments, suggestions – please email me.

There has been much debate about the current low levels of interest rates in the economy today. The primary argument is that the “30-year bull market in bonds”, due to consistently falling interest rates, must be near its end.

Of course, this debate has devastated the “bond bears” who have consistently been frustrated by lower interest rates despite their annual predictions to the contrary. However, just because interest rates are currently low, does this necessarily mean that they must rise?

The chart below shows a VERY long view of interest rates (equivalent rates to the Federal Funds Rate and 10-year Treasury) back to 1854.

While there is much data contained in the chart above, there are a couple of important points to consider in this debate. The first is that interest rates are a function of the general trend of economic growth and inflation. Stronger rates of growth and inflation allow for higher borrowing costs to be charged within the economy.  As shown, interest rates have risen during three previous periods in history; during the economic/inflationary spike in early 1860’s, again just prior to 1920 and during the prolonged manufacturing cycle in the 1950-60’s following the end of WWII. Secondly, interest rates tend to fall for very extended periods.

However, notice that while interest rates fell during the depression era economic growth and inflationary pressures remained robust. This was due to the very lopsided nature of the economy at that time; the wealthy prospered while the middle class suffered, which did not allow money to flow through the system (monetary velocity).

Currently, the economy is once again bifurcated. The upper 10% of the economy is doing well while the lower 90% remain affected by high levels of joblessness, stagnant wage growth and a low demand for credit. For only the second time in history, short-term rates are at zero and monetary velocity is non-existent.

The difference is that during the “Great Depression” economic growth and inflationary pressures were at some of the highest levels in history, while today the economy struggles along at a 2% growth rate with inflationary pressures that detract from consumptive spending. 

Let’s look at the fall of interest rates since the 1980’s in a slightly different manner.

As stated above, since interest rates are ultimately a reflection of economic growth, inflation, and monetary velocity, the fact that the globe is awash in deflation, caused by weak economic output and exceedingly low levels of monetary velocity, there is no pressure to push rates higher. In fact, interest rates in the U.S. continue to fall as money is fleeing other countries and associated risk for safety. Let’s take a look at the chart of 10-year equivalent treasury rates once again. The dashed black line is the median interest rate during the entire period.

(Note: Notice that a period of sustained low interest rates below the long-term median, as shown in the chart above, averaged roughly 40 years during both previous periods. We are only currently 4-years into the current secular period of sub-median interest rates.)

As shown, there have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed. But that was just the start of it as innovations leaped forward as all eyes turned toward the moon.

Today, the U.S. is no longer the manufacturing epicenter of the world.  Labor and capital flows to the lowest cost providers so that inflation is effectively exported from the U.S. and deflation can be imported. Technology and productivity gains ultimately suppress labor and wage growth rates over time. The chart below shows this dynamic change which begin in 1980. A surge in consumer debt was the offset between lower rates of economic growth and incomes in order to maintain the “American lifestyle.”

The Economic Challenge

The chart below shows both the long-view of real, inflation-adjusted, annual GDP growth and on a per-capita basis. I have also included the annual growth rates of the U.S. population. I have highlighted significant historical events for some context as well as notating the depression era and the current “Great Recession.” [Data Source:]

However, there are some interesting differences between the “The Great Depression” and the “Great Recession.” During the depression, the economy experienced extremely strong annual rates of growth reaching peaks of 13% and 18% on an annualized basis as opposed to peaks during the current economic cycle of 2.5% and 2.7%. What plagued the economic system during the depression was the real loss of wealth following the “Crash of 1929” as a rash of banks went bankrupt leaving depositors penniless, unemployment soaring and consumption drained. While the government tried to provide assistance it was too little, too late. The real depression, however, was not a statistical economic event, but rather a real disaster for “Main Street.”

During the current period, real economic growth remains lackluster, real unemployment remains high with millions of individuals simply no longer counted or resorting to part-time work just to make ends meet and roughly 100-million Americans are on some sort of government assistance. The pressure on “Main Street” remains.

One important difference is the rate of population growth which, as opposed to the depression era, has been on a steady and consistent decline since the 1950’s. This decline in population growth and fertility rates will potentially lead to further economic complications as the “baby boomer” generation migrates into retirement and becomes a net drag on financial infrastructure.

I have also noted the average rates of economic growth for various periods throughout history.

  • During the “agricultural age,” prior to 1900, the average rate of real economic growth, although very volatile due to weather, disaster and economic events, averaged 4.2% annually.
  • As the world entered the 20th century the impact of WWI, the massive inflationary spike that followed which led to a depression, the “Crash of 1929” and the “Great Depression” saw economic growth slip to 2.62% annually.
  • From the depths of this turmoil rose an economic powerhouse from 1940-1980 as the U.S. became the epicenter for manufacturing and production worldwide. During this period economic growth surged to 4.51% annually.
  • Since 1980, as the U.S. became addicted to credit, leverage, and debt, the economic growth rate has continued to weaken as the U.S. shifted from its production basis to an economy built on finance and services which have lower economic multipliers. Despite the rise of technology, a surging “secular bull market,” and increasing standards of living; the 1980’s and 1990’s saw real economic growth drop to 3.2% annually.
  • That rate of growth has continued to decline since the turn of the century as the bursting of the technology bubble and the housing/credit crisis has led to an annual growth rate of just 1.94%.

Despite trillions of dollars of interventions and zero interest rates by the Federal Reserve, combined with numerous bailouts, supports, and assistance from the Federal Government, the economy has yet to gain any real traction particularly on “Main Street.” Are we currently experiencing the second “Great Depression?” That is a question that we can continue to debate currently, however, it will only be answered for certain when future historians judge this period. It will also be that same group of historians who will ultimately determine whether the actions undertaken by the Federal Reserve, and the Government, were ultimately a success or failure.

One thing is for certain. With the lowest rate of annualized economic growth on record, there is a problem currently which is not being adequately recognized. Despite ongoing interventions and hopes for economic recovery, the rate of population growth has now fallen to levels not seen since the early 1930’s. The long term consequences of an aging population, lower incomes and savings rates and a declining rate of population growth is a problem that is likely to continue to hamper the economy going forward. Of course, these are the same problems that currently plague Japan.

The End Of The Bond Bubble

The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds.

However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.

While there is not much downside left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment.

Will the “bond bull” market eventually come to an end?  Yes, eventually. However, the catalysts needed to create the type of economic growth required to drive interest rates substantially higher, as we saw previous to 1980, are simply not available today. This will likely be the case for many years to come as the Fed, and the administration, come to the inevitable conclusion that we are now caught in a “liquidity trap” along with the bulk of developed countries.

I am long bonds and continue to buy more whenever someone claims the “Great Bond Bull Market Is Dead.”

The financial terrain is strewn with robust fables cleverly disguised as facts.

The setbacks to financial security due to stock market returns never realized, the precious time and human capital necessary to make up for market losses, the ingenious data-mining undertaken by populist gurus that want you to believe that stocks are a panacea; talking heads at big-box brokerage firms disguised as fiduciaries who make fortunes convincing investors to feel silly for being cautious.

The deck is stacked against the retail investor.

Now more than ever.

As the majority, this marketing force cranks out stories and grinds down the painful past of market events into the mist of averages. They so want investors to forget the past.

And like the destruction of so many pebbles on this road, your retirement and other financial life benchmarks are left as rubble.

The tenacious nature of outdated financial tenets is never questioned.

These rules of thumb, words that should weigh a thousand pounds each, roll off the tongues of financial pros and layman alike as lightly today as they did generations ago.

Rancid bits of wisdom preached as gospel.

Thank goodness this isn’t medicine.

Sickness would still be drained by leeches.

Let’s bust open the stories and myths that place your efforts to build wealth in danger.

Myth #1 – Compound interest will make you rich. 

Compound interest is the coolest story ever, but that’s about it

You so want to believe it.

And there was a time you could.

But not so much today.

Albert Einstein is credited with saying “compound interest is the eighth wonder of the world.”  Well, that’s not the entire quote.

Here’s the rest: “He who understands it, earns it; he who doesn’t pays it.”

I’m not going to argue the brilliance of Einstein although I think when it comes down to today’s interest-rate environment he would be quite skeptical (and he was known for his skepticism) of the real-world application of this “wonder.”

First, Mr. Einstein must have been considering an interest rate with enough “fire power” to make a dent in your account balance.

Over the last eight years, short-term interest rates have remained at close to zero, long term rates are deep below historical averages and are expected to remain that way for some time.

Indeed, compounding can occur as long as the rate of reinvestment is greater than zero, but there’s nothing magical about the “snowballing” effect of compounding in today’s rate environment.

Most important: Compounding only works when there is NO CHANCE of principal loss. It’s a linear wealth-building perspective that no longer has the same effectiveness considering two devastating stock market collapses which have inflicted long-term damage on household wealth.

What good is compounding when the foundation of what I invested in is crumbling?

Perhaps you should focus on the “he who understands it, earns it; he who doesn’t pays it.”

What does that adage mean to you?

Empowerment comes from living simply, avoiding credit card debt, and searching out deals on big ticket items like automobiles and appliances.

Don’t give compound interest another precious thought.

If it comes along, consider it a great gift.  A bounty.

Fine tune what you can control and that primarily has to do with outflow or household expenses.

I believe the eighth wonder of the world is human resolve in the face of economic reality post-Great Recession.

Not compound interest.

Myth #2 – Ditch that latte and energize your wealth. 

This advice is as bitter as the gas station brew that languishes in stained pots poised hot burners way too long.

Mega-money celebs like Suze Orman and Dave Ramsey fall all over themselves with wisdom that attempts to make you feel guilty for waiting in the coffee line at Starbucks. Listeners and readers of these two customarily are served swill like this on a regular basis.

A sweet topping on the sentiment is the tempting promise of consistent, annual investment returns of 10 to 11% in the market which is as far from reality as a broker without a sales quota.

Re-directing $2.50 from simple, daily enjoyment into risk assets is not going to move your wealth needle but you may wind up with a heck of a headache from caffeine withdrawals.


In the book, “Pound Foolish” author and financial blogger Helaine Olen investigates and busts open the myths of personal finance in an entertaining yet thorough tell-all.  Helaine discovered the latte factor surfaced as far back as 1994 in a Money Magazine article.

Touted by Suze Orman in her 1999 bestseller The Courage To Be Rich” the perky, blonde-top advocate for savvy personal financial choices was downright polemic about the subject (perhaps from overloading on caffeinated beverages whilst writing).

There’s no doubt your uptown caffeine addiction is under siege by pundits who take themselves so seriously they believe they can peddle trivial watered-down financial Pablum and you’ll take it in, bask in epiphany, see a white light.  Frankly, the only thing high-octane about this wisdom is the egos it took to deliver it.

With close to three decades of financial services industry experience under my belt, I have yet to witness anyone pump an arm in victory over the wealth they’ve accumulated by reducing coffee intake.

To place it in perspective, $2.50 a day, invested for 30 years at 4% will provide a whopping $52,197.65 (2.50/day, 10800 days @ .0001% daily rate) “windfall” not adjusted for inflation, investment fees and charges.

What’s your return on satisfaction for $2.50 a day? I think it’s a bargain if a small purchase provides a big breather, peace of mind, and a recharge to carry on with important tasks.

Purchase the coffee. Buy a cup for me while you’re at it.

Deprivation of simple pleasures is not a path to financial fulfillment. While you’re partaking, place the time aside with pen and paper (put the smartphone away), and in a sentence, describe your ongoing relationship with money.

In simple sentence number two, identify a single financial action that achieves three-digit success each month. In other words, if you’re going to make a change, do it with gusto. Consider how can you cut $100 a month in expenses and direct the funds into an emergency savings account first, investments after you’ve accumulated three to six months of living expenses in financial cushion.

Last, create a rule for the big stuff. This could be tough (and ostensibly may require that brain boost from that make-or-break-your-finances latte).

A tenet I created is featured in a new book titled “WORTH IT,” by Amanda Steinberg a friend and fintech thought leader with a passion to help girls and women begin, improve and prosper in their relationships with money and debt:

“Never take on a mortgage that exceeds twice your gross income.” 


“House Mortgage = 2X Gross Salary.” 

It’s simple. To the point. If you earn $50,000 a year, the mortgage you obtain cannot exceed $100,000. This is not house price. It’s the mortgage. For most it’s going to mean a much greater down payment or smaller dwelling.

Obey and respect your personal formula. You’re going to hate the boundaries and that means they’ll be uncomfortable and successful if consistently followed.

Avoiding house-poor will super-charge your ability to build wealth. Now, that end result I have indeed witnessed from people I’ve been grateful to counsel over the last three decades.

Myth #3 – The Rule of 72 

Where do I begin with this rule after I’m done hemorrhaging from disappointment?

Recently, a well-known financial showman was lamenting, stretching the meaning (again) and hitting sound effect buzzers over this pearl.

As a reminder, the Rule of 72 is a method to determine how long an investment will take to double given a fixed annual rate of interest. Just divide 72 by an annual rate of return.

When working with low rates of return, interestingly, the rule is precise. As returns increase, the rule gets less precise per Investopedia.

Yet, this rule is bandied about when it comes to stock investing where rates of return are anything but fixed.

As of the morning of this writing I had met with two couples who still maintain carryforward losses from the tech bubble that popped in 2000.

Perhaps, the Rule of 72 should be reworked to consider how long it may take to recover from investment setbacks.

Could it be plausible that it may take 72 years to fully utilize losses incurred during the tech bubble and the financial crisis?

Hey, that’s nowhere near as farfetched as applying the Rule of 72 to volatile investments.

When you come across this rule again (and if you haven’t yet, you will), I need you to remember that it only holds water for fixed, low rates of return which clearly rules out stocks.

Myth #4 – I read somewhere that I should use the formula 100 minus my age to determine how much of my money needs to be invested in stocks. 

I abhor this creation.

What does age have to do with how much of a portfolio is allocated to riskier investments like stocks?

I’m not willing to believe those who are younger should be more exposed or increasingly vulnerable to market risk than anybody else, when the reward from stocks is less for every investor going forward.

This rule is a clear disadvantage for all including beginners.

An investment allocation must be customized for your life, needs, and your sheer will to withstand volatility. Most important, it should be based on the valuation conditions that exist at the time you’re looking to place dollars into the market.

I witness cookie-cutter dogma blindly followed and money invested immediately regardless of where stocks are valued. Ultimately, the forward returns are anemic or wealth destroyed altogether.

Financial consultants and brokers have needles deep stuck in thought grooves. It’s not just this rule per se. It’s the belief that younger people must, MUST be more aggressive because they have time to weather through disaster.

Risk couldn’t care less about how old you are. When the environment is favorable to take on greater risk for higher returns, then why be so focused on age?

How would you perceive my advice if I explained that you should fasten your seatbelt before driving however, your 18-year-old child doesn’t need to be concerned about doing the same?

I mean, after all, if there’s an accident and injuries suffered, common sense tells me you may require a longer convalescence period, correct?

Not to be flippant, but I can make a formidable case that based on savings accumulated, earning power, and driver (investment) experience, that the older, wiser navigator may forgo the seat belt but the novice cannot. Never.

Think about it.

Myth #5 – Stocks always outperform bonds. 

They do?

I heard this gem from an industry pro on CNBC the early morning of 3/17.

Hey if a financial guru proclaims it, and a powerhouse backs it up, it must be truth.

Over the long term, stocks do better. Since 1926, large stocks have returned an average of 10 % per year; long-term government bonds have returned between 5% and 6%, according to investment researcher Morningstar.

Don’t ask me why 1926 is so magical a launching pad for the formation of those colorful charts every broker whips out at every meeting. You’ve seen them.

Perhaps, it’s because there’s limited data set and deciding to preach from an arbitrary point in time just feels right?

Seems plausible.

The gatekeepers of finance who make rules for investors and professionals to follow like lemmings, create pretty pictures that we’re never to question.

Frankly, I don’t care why 1926 is so special. Neither should you.

It’s irrelevant to your situation and the cycle you’re either accumulating or distributing wealth through.

The coolest tidbits of 1926 involve increased gangster warfare and bloodshed employed to establish territory for illegal alcohol distribution.

Depending on how I slice and dice the data, I can show a magnificent run for bonds when compared to stocks.

The chart above outlines the performance of the PIMCO Total Return Bond fund, an intermediate duration bond fund offering (and one of the most popular), compared to S&P 500 beginning in 1999.

Why 1999?

Because I wanted to, that’s why.

Appears to me that stocks don’t always outperform bonds.

What do you see?

Silly myths, misused snippets of information, creative data mining.

They’re all not so silly when your wealth is on the line.

Are they?

Things get serious.

And so many myths and stories need to die away.

Never to return.

Real Investment Advice welcomes Ben Masters to our growing list of contributors. Benjamin Masters is the creator, designer, and writer for Third Wave Finance, With over ten years of experience working as a lead Portfolio Analyst, Ben brings additional insights into the discussion of economics, markets and portfolio management.

Part 1 Of The Series

Part 2 Of The Series

Currency Devaluation


After addressing the dire condition of economics and monetary policy in Part 1, and highlighting some of their more-damaging effects in Part 2, it’s now time to address one of the fundamental pillars of current policy — a hazard so deeply rooted yet one so easily accepted due to its illusory nature: namely, the process of currency devaluation and inflation targeting.

Yet another adjustment/manipulation scheme used to temporarily boost growth, currency devaluation (via currency creation) is not a new policy — it’s one that has been used throughout history by many countries and empires, including the Roman Empire.  And while the process of currency devaluation can evolve so slowly (potentially over a lifetime or more in a major economy/empire) that an unawareness develops and the instinct to question it subsides, its temporary benefits are often merely offset by a reduction in economic prosperity in the future; depending on the extent to which the policy is used, the economic strains may even lead to social disruption.

For an extreme example one need only look to the social disruptions and anger that developed in 1920s Weimar Germany; currency devaluations were so extreme that they yielded bizarre cases of zero stroke, and created an environment where it was cheaper to burn currency than use firewood. 

This example is not highlighted to imply that inflation or deflation should be the desired target, but merely to point out that economic policy can often be over-influenced by recent history — the economic and social strain of hyperinflation in the 1920s led to a German tendency to fear inflation, while the U.S. Great Depression of the 1930s has led to an American tendency to fear deflation.

The important point to make here is that deflationary and inflationary economic forces can often be occurring at the same time in different areas of the economy — they may simply be indicating a transition (cost and/or popularity of one time falls as the cost and/or popularity of another item rises).  The more-dangerous situation is when extremes in deflation or inflation develop throughout the economy indicating an imbalance, or when that imbalance is specifically targeted.

Inflation Targeting

As discussed, following the Great Depression, modern economic policies have reversed course so drastically that they have merely unbalanced the ship to the other side.  The fear of inflation has given rise to a tendency for central banks to “lean on inflation” (i.e. actively target inflation) via a process of currency-creation/currency-devaluation.

However, actively targeting positive inflation to avoid its counterpoint, deflation, may simply result in a storing of deflationary energy to be released later, as a misallocation of wealth builds.  Here again the wildfire suppression scenario highlighted in Part 2 is at play: just as fires are restricted (the kindling builds, the ecosystem changes storing potential energy for larger fires), so too does inflation-targeting work in the same way; it inhibits deflationary forces, allowing the potential energy of deflation to be stored and released later.  A further visualization of this concept — the storage-and-release of energy — can be seen in introductory physics…

A roller coaster that momentarily stops on the top of its very last large ramp has a high potential energy (energy that is not currently being used, as the coaster is motionless and high above the ground), but a low kinetic energy (energy of movement).  Then as the coaster begins to descend, the potential energy transitions to kinetic energy (motion).

“So inflation turns out to be merely one more example of our central lesson.  It may indeed bring benefits for a short time to favored groups, but only at the expense of others.  And in the long run it brings ruinous consequences to the whole community.  Even a relatively mild inflation distorts the structure of production.  It leads to the overexpansion of some industries at the expense of others.  This involves a misapplication and waste of capital.  When the inflation collapses, or is brought to a halt, the misdirected capital investment — whether in the form of machines, factories or office buildings — cannot yield an adequate return and loses the greater part of its value…

…Yet the ardor for inflation never dies.  It would almost seem as if no country is capable of profiting from the experience of another and no generation of learning from the sufferings of its forebears.  Each generation and country follows the same mirage.  Each grasps for the same Dead Sea fruit that turns to dust and ashes in its mouth.  For it is the nature of inflation to give birth to a thousand illusions.” 

– Henry Hazlitt (H.H.)

The difficulty in “leaning on inflation” (i.e. creating currency above the natural state) is that creating more currency to distribute does not increase real purchasing power — the country has more currency, but that currency buys less items than it could before (a currency is only a tool used to exchange real wealth items, it is not fundamental wealth).

Yet, regardless, inflation continues to be targeted — arguably due to ease, and its illusory nature — to “paper over” the restrictive reality of deflation; and in that respect, inflation can be considered a clandestine redistribution of wealth — one that is similar to an unpredictable, unbalanced, and spontaneous tax.  The redistribution of wealth occurs as the created currency disproportionately benefits those who receive it first; they have the first bid (vote) on assets, goods, and services.  As the newly created currency reaches other individuals, the more desirable assets, goods, and services will have already been bid up (higher prices) by those that received the currency first.  In effect, those that receive the currency last are punished at the expense of those that receive it first; and knowing who will be affected — and to what extent — will be difficult (What will the desirable assets be when the currency makes its way through the economy?).  By its very nature inflation indicates that some individuals benefited before others, yet it typically rests heavier on those least able to pay.

“…inflation does not and cannot affect everyone evenly.  Some suffer more than others.  The poor are usually more heavily taxed by inflation, in percentage terms, than the rich, for they do not have the same means of protecting themselves by speculative purchases of real equities.  Inflation is a kind of tax that is out of control of the tax authorities.  It strikes wantonly in all directions.” – H.H.

So although it’s possible that inflation targeting can be used to temporarily offset deflation, its risk is that it’s illusory and more easily abused.  In our current environment the tendency to question deflation is more commonplace than the inclination to challenge inflation (maybe merely due to a lack of education and awareness).  In deflation, the imbalance is visible; in inflation, the problems are for another day.

A more direct illustration, case 1:  If your income rises but inflation is greater than the change in your income, you’re actually poorer than you were before even though you have more money.  How can this be?  It’s because the total currency in circulation has increased, thus your currency — simply a medium of exchange — buys less real items; you’re poorer even though you have more dollars because each dollar now buys fewer real items.

In a countering example, case 2:  If your income goes down but deflation is more significant than the change in your income, you’re actually wealthier than you were before even though you have less money — each dollar can now buy more real items.

This is the illusory and deceptive nature of inflation: if the amount of currency has increased, your wealth is less — and although it is openly targeted, inflation is infrequently questioned, because, in our current environment, there is less of an inclination to question the state of things when you have more currency (even though your real wealth has gone down).  The inclination to question the state of things — even though it’s misplaced — seems more natural in case 2 because you have less money.  The education and awareness are not present to raise the flag of warning.  For these reasons, inflation is politically favorable, leading us to the questionable state — and abusive use — of economics.

“And this is precisely its political function.  It is because inflation confuses everything that it is so consistently resorted to by our modern ‘planned economy’ governments.” – H.H.

Get Part 1 Here

Get Part 2 Here

Since the U.S. economic recovery from the 2008 financial crisis, institutional economists began each subsequent year outlining their well-paid view of how things will transpire over the course of the coming 12-months. Like a broken record, they have continually over-estimated expectations for growth, inflation, consumer spending and capital expenditures. Their optimistic biases were based on the eventual success of the Federal Reserve’s (Fed) plan to restart the economy by encouraging the assumption of more debt by consumers and corporations alike.

But in 2017, something important changed. For the first time since the financial crisis, there will be a new administration in power directing public policy, and the new regime could not be more different from the one that just departed. This is important because of the ubiquitous influence of politics.

The anxiety and uncertainties of those first few years following the worst recession since the Great Depression gradually gave way to an uncomfortable stability.  The anxieties of losing jobs and homes subsided but yielded to the frustration of always remaining a step or two behind prosperity.  While job prospects slowly improved, wages did not. Business did not boom as is normally the case within a few quarters of a recovery, and the cost of education and health care stole what little ground most Americans thought they were making.  Politics was at work in ways with which many were pleased, but many more were not.  If that were not the case, then Donald Trump probably would not be the 45th President of the United States.

Within hours of Donald Trump’s victory, U.S. markets began to anticipate, for the first time since the financial crisis, an escape hatch out of financial repression and regulatory oppression.  As shown below, an element of economic and financial optimism that had been missing since at least 2008 began to re-emerge.

Data Courtesy: Bloomberg

What the Federal Reserve (Fed) struggled to manufacture in eight years of extraordinary monetary policy actions, the election of Donald Trump accomplished quite literally overnight. Expectations for a dramatic change in public policy under a new administration radically improved sentiment. Whether or not these changes are durable will depend upon the economy’s ability to match expectations.

Often Wrong, Never in Doubt

The institutional economists searching for a coherent outlook for 2017 are now faced with a fresh task. President Trump and his cabinet represent a significant departure from what has come to be known as “business-as-usual” Washington politics over the past 25 years.  Furthermore, it has been 89 years since Republicans held control of the White House as well as both the House of Representatives and the Senate. The confluence of these factors suggests that the outlook for 2017 – policy, the economy, markets, geopolitical risks – are highly uncertain.  Despite what appears to be an inflection point of radical change, most of which remains unknown, the consensus opinion of professional economists and markets, in general, are well-aligned, optimistic and seemingly convinced about how the economy and markets will evolve throughout the year.  The consensus forecast based upon an assessment of economic projections from major financial institutions appears to be the result of a Ph.D. echo chamber, not rigorous independent analysis.

Economic Outlook – Consensus Summary

After a thorough review of several major financial institutions’ economic outlooks for 2017 and market implied indicators for the year, below is an overview of what 720 Global deems to be the current consensus outlook for 2017.

  • The consensus is optimistic about economic growth for the coming year with expectations for real GDP growth in the 2.0-2.5% range
  • Recession risks will remain benign
  • The labor market is now at or near full employment
  • Wage growth is expected to increase to the 3.0-3.5% level as is customary for the economy at full employment
  • Inflation is expected to reach and exceed the Fed’s 2.0% target level
  • The Fed is expected to raise the Federal Funds rate in 25 basis point increments two or three times in 2017
  • The Fed will maintain the existing size of its balance sheet
  • Some form of fiscal stimulus will occur by the second half of the year
  • Fiscal stimulus is expected to be modest and unlikely to have a big impact on fiscal deficits
  • Tax reform will occur by the second half of the year and is viewed as highly supportive of corporate profits
  • Regulatory reform will begin to take shape in the first half of the year
  • Trade will be affected by some form of border tax adjustment, the economic impact of which is expected to be low
  • The combination of fiscal stimulus, tax reform, and regulatory reform in conjunction with an economy that is growing above trend and at full employment easily offsets Fed rate hikes supporting the optimistic outlook for economic growth

Despite the low probability of accuracy, the consensus outlook for 2017 is the starting point from which a discussion should begin because it is reflective of what markets and investors expect to transpire. Markets are pricing to this set of outcomes for the year.


Having established a consensus baseline, further attention is then paid to those areas where the consensus may indeed be wrong. Will inflation finally exceed the 2.0% level as expected? Will growth for the year end in the range of 2.0-2.5%? Can the new administration negotiate a fiscal stimulus package this year? These and many others are important questions that will dictate the strength of the U.S. dollar, the level of interest rates and the ability of equity markets to sustain current valuations.

If economic growth for the year is stronger than current projections and inflation is higher than forecast, then the Fed will appear to be behind the curve in hiking interest rates. In this circumstance, the Fed may begin to telegraph more than three rate hikes for the current year and a higher trajectory for rates in 2018. The interest rate markets will likely front run growth expectations and push interest rates higher. Given that investors have so little coupon income to protect them from price changes, such a move could occur in a disorderly manner, which will tighten financial conditions and choke off economic growth.

If, on the other hand, economic growth for the year falters and continues the recent string of disappointing, sub-2.0% readings, then fears of recession, and likely an abrupt change in confidence, will re-emerge.

This exercise undertaken each year by economists is akin to a meteorologist’s efforts to predict the weather several weeks in advance.  The convergence of high and low-pressure systems will produce a well-defined outcome, but there is no way to ascertain weeks or even days in advance that those air masses will converge at a precise time and location, or that they will converge at all.  It does in fact, as they say, very much depend on the “whether.”  Whether consumers borrow and spend more, whether companies hire and pay more or even whether or not confidence in a new administration promising a variety of pro-growth policies can fulfill those in some form.

The Lowest Common Denominator

Interest rates have already risen in anticipation of the consensus view coming to fruition.  Although higher interest rates today are reflective of an optimistic outlook for growth and inflation, the economy has become dependent upon low rates. Everything from housing and auto sales to corporate buybacks and equity valuations are highly dependent upon an environment of persistently low interest rates.  So, when the consensus overview expects higher interest rates as a result of higher wage growth and inflation, it is difficult to reconcile those expectations with the consensus path for economic growth.

Investors and markets continue to give the hoped-for outcome the benefit of the doubt, but that outcome seems quite inconsistent with economic reality. That outcome is that policy will promote growth, growth will advance inflation and interest rates must therefore rise.  The problem for the U.S. economy is that the large overhang of debt is the lowest common denominator.  The economy is a slave to the master of debt, which must be serviced and repaid. The debt problem is largely the result of 35 years of falling interest rates and the undisciplined habits and muscle memory that goes with such a dominating streak.  Marry that dynamic with the fact that this ultra-low interest rate regime itself has been in place for a full eight years, and the economy seems conditioned for an allergic reaction to rising rates.

Episodes of rising interest rates since the 1980’s, although short-lived, always brought about some form of financial distress. This time will likely be no different because the Fed’s zero-interest rate policy and quantitative easing have sealed the total dependency of the economy on consumption and debt growth.  Regaining the discipline of a healthy, organic economic system would mean both a rejection of policies used over the last 30 years and intense public sacrifice.


Given the altar at which current day politicians’ worship – that of power, influence, and self-promotion – it seems unlikely that this new Congress and President are inclined to make the difficult choices that might ultimately set the U.S. economy back on a path of healthy, self-sustaining growth.  Rather, debt and deficits will grow, and the enthusiasm around overly-optimistic economic forecasts and temporal improvements in economic output will fade as has been the case in so many years past.  Although a new political regime is in store and it brings hope for a new path forward, the echo chamber reinforcing bad policy, fiscal and monetary, seems likely to persist.






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

In last week’s post, I did a complete sector and major market review. Not much has changed in the past week given the very quiet activity that has persisted. This lack of volatility, while not unprecedented, is extremely long in duration as noted in past weekend’s newsletter, “An Unexpected Outcome:” 

“Speaking of low volatility, the market has now gone 108-trading days without a drop of 1% for both the Dow and the S&P 500. This is the longest stretch since September of 1993 for the Dow and December of 1995 for the S&P 500.”

The issue becomes, of course, which way the market breaks when volatility returns to the market. Over the course of the last three years, in particular, those breaks have been to the downside as shown below.

Given the particularly extreme overbought condition that currently exists, the strongest odds suggest the next pickup in volatility will be in the form of a corrective action to reverse some of that condition. As I detailed on Saturday:

“As noted in the chart below, the market is very close to a short-term ‘sell signal,’ lower part of the chart, from a very high level. Sell signals instigated from high levels tend to lead to more substantive corrective actions over the short-term. I have denoted the potential Fibonacci retracement levels which suggest a pullback levels of 2267, 2230, and 2193. To put this into ‘percent terms,’ such corrections would equate to a decline of -4.7%, -6.2% or -7.8% from Friday’s close.”

“To garner a 10% decline, stocks would currently have to fall 237.8 points on the S&P 500 to 2140.20.  Given there is little technical support at that level, the market would likely seek the next most viable support levels at the pre-election lows of 2075 or a decline of -12.7%.

Such a decline, of course, would not only wipe out the entirety of the ‘Trump Bump,’ but would also ‘feel’ much worse than it actually is given the exceedingly long period of an extremely low volatility environment.”

Of course, it could even be worse as noted on CNBC last week:

Are you ready for a 2,000 point drop in the Dow? That’s what a ‘normal’ correction would look like now. Normal corrections look kind of scary when markets are at these highs.

The Dow hit a new high on March 1 at 21,115. That means a 10 percent drop — what would be considered a ‘correction’ — would be a decline of 2,111 points. Sounds pretty steep, no?

Here’s an even bigger drop: 3,000 points. Dan Wiener, who runs the Independent Adviser for Vanguard Investors and runs money as president of Adviser Investments, pointed out to clients that over the past 30 years the stock market has declined an average of 14.3 percent from high to low on an intra-year basis.

That translates into a 3,019-point decline from the Dow’s March 1 top.”

As I noted previously in “The World’s Most Deceptive Chart” it is the “math” that is the problem. A 10% decline seems relatively minor. By comparison, a 2000-point decline is “psychologically” painful and leads investors to make emotionally driven investment decisions which typically have bad outcomes. 


These short-term declines are why investors are told to just “buy and hold,” and just “ride the markets out” because you can’t effectively “time” these events.

Usually, these comments are attached to the fictional idea that investors actually bought the lows. Like this one:

Finally, here’s an illustration of the power of staying in the market, not trying to time investing, and the beauty of compounding interest. March 9 was the eighth anniversary of the bottom of the market. It was widely noted that the S&P 500 was up over almost 250 percent since then.

Here’s an even more interesting tidbit: It’s up about 310 percent when dividends are accounted for.

That’s the power of compounded interest! That’s about a 19 percent annual compounded gain every year for eight years.

Think about that. Your money would be up an average of almost 20 percent a year when dividends are included and the money is reinvested over the last eight years. That is a remarkable run.”

It’s true…that is quite a remarkable run. In f

act, it is one of the longest-running bull markets in history.

They just never seem to remind you of what has happened next?

More importantly, following these regularly occurring “mean reverting” events, investors were not scrambling to buy the lows. Quite to the contrary, retail investors were often finally capitulating at the lows and liquidating their portfolios with the promise of “never buying stocks again.” 

Generally, they hold good to that promise until the markets rise to the next “bull market” peak and the pressure of “missing out” becomes too great. As shown in Ed Yardeni’s chart below, despite the commentary about how markets have compounded returns in recent years, a lot of investors were VERY late getting back into the investment game.

As I stated, the bull market remains intact currently and should not be dismissed lightly. Bull markets are extremely buoyant because of the underlying “psychology” that promotes it.

As John M. Keynes once quipped: “Markets can remain irrational longer than you can remain solvent.” 

However, there are some warning signs worth watching.

High yield bonds have started to exhibit weakness at a time when the stock/high yield bond ratio is at the highest level since the financial crisis. While, in and of itself, a high ratio is not indicative of a “crash,” it is the “fuel” for a “fire” if one occurs. 

As I have discussed before, the current deviation from the underlying bullish trend has historically been unsustainable over a longer-term period. Like “stretching a rubber band,” the extension must be relaxed either through consolidation or correction before the next advance can occur. 

The Coppock Curve has also recently peaked and has begun to turn lower. This is typical during short-term corrections.

One of the more concerning trends continues to be the deterioration in breadth as the number of stocks leading the market continues to decline despite indices sitting near all-time highs.

Jason Goepfert via Sentiment Trader recently noted that when the CBOE SKEW index climbs this far above the VIX, a downturn has tended to follow in the next 30 to 60 days.

“Historically, when we have seen an extreme in the relationship between the SKEW and VIX, the S&P moves in the opposite direction over the next 1-2 months.”

With the 50-dma of the SKEW/VIX ratio at the highest level of record, this is probably an indicator best not ignored.

Along with the ongoing weakness in the technical backdrop, the fundamental backdrop continues to weaken as shown in the P/E heat map below of the S&P 500.

The same goes for the PEG heat map as well.

The point here is simple.

Portfolios should be allocated to equities currently because the bull market trend is still firmly intact.

However, while I agree that you can not consistently and effectively “time” the market, which is being either “all in” or “all out,” I am suggesting that being prudent about the level of risk you are taking within your portfolio allocation can be curtailed. 

So, just invest and “fuhgettaboutit?”

Probably not the best idea. That approach has tended to yield very poor outcomes when the present conditions have existed previously. 

Importantly, in each period, it was always believed “this time is different.” Unfortunately, it never was.

Shiller’s Cape – Part 2

“Price Is What You Pay. Value Is What You Get.” – Warren Buffett

One of the hallmarks of very late stage bull market cycles is the inevitable bashing of long-term valuation metrics. In the late 90’s if you were buying shares of Berkshire Hathaway stock it was mocked as “driving Dad’s old Pontiac.” In 2007, valuation metrics were being dismissed because the markets were flush with liquidity, interest rates were low and “Subprime was contained.”

Today, we once again see repeated arguments as to why “this time is different” because of the “Central Bank put.” 

First, let me just say that I have tremendous respect for the guys at HedgEye. They are insightful and thoughtful in their analysis and well worth your time to read. However, a recent article by HedgEye made a very interesting point that bears discussion.

“Meanwhile, a number of stubborn bears out there continue to make the specious argument that the U.S. stock market is expensive. ‘At 22 times trailing twelve-month earnings,’ they ask, ‘how on earth could an investor possibly buy the S&P 500?’

The answer is simple, really. Valuation is not a catalyst.”

They are absolutely right.

Valuations are not a catalyst.

They are the fuel.

But the debate over the value, and current validity, of the Shiller’s CAPE ratio, is not new. Critics argue that the earnings component of CAPE is just too low, changes to accounting rules have suppressed earnings, and the financial crisis changed everything.  This was a point made by Wade Slome previously:

“If something sounds like BS, looks like BS, and smells like BS, there’s a good chance you’re probably eyeball-deep in BS. In the investment world, I encounter a lot of very intelligent analysis, but at the same time I also continually step into piles of investment BS. One of those piles of BS I repeatedly step into is the CAPE ratio (Cyclically Adjusted Price-to-Earnings) created by Robert Shiller.”

Let’s break down Wade’s arguments against Dr. Shiller’s CAPE P/E individually.

Shiller’s Ratio Is Useless?

Wade states:

“The short answer…not very. For example, if investors followed the implicit recommendation of the CAPE for the periods when Shiller’s model showed stocks as expensive they would have missed a more than quintupling (+469% ex-dividends) in the S&P 500 index. Over a shorter timeframe (2009 – 2014) the S&P 500 is up +114% ex-dividends (+190% since March 2009).”

Wade’s analysis is correct.  However, the problem is that valuation models are not, and were never meant to be, “market timing indicators.”  The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level it means that:

  1. The market is about to crash, and;
  2. Investors should be in 100% cash.

This is incorrect.

Valuation measures are simply just that – a measure of current valuation. More, importantly, it is a much better measure of “investor psychology” and a manifestation of the “greater fool theory.”

If you “overpay” for something today, the future net return will be lower than if you had paid a discount for it.

Think about housing prices for a moment as shown in the chart below.

There are two things to take away from the chart above in relation to valuation models.  The first is that if a home was purchased at any time (and not sold) when the average 12-month price was above the long-term linear trend, the forward annualized returns were significantly worse than if the home was purchased below that trend. Secondly, if a home was purchased near the peak in valuations, forward returns are likely to be extremely low, if not negative, for a very long time.

This is the same with the financial markets. When investors “pay” too much for an investment, future returns will suffer. “Buy cheap and sell dear” is not just some Wall Street slogan printed on a coffee mug, but a reality of virtually all of the great investors of our time in some form or another.

Cliff Asness discussed this issue in particular stating:

“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.

If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations.”

We can prove that by looking at forward 10-year total returns versus various levels of PE ratios historically.

Asness continues:

“It [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view, the critics have not provided a good reason this time around — I think you are making a mistake.”

While, Wade is correct that investors who got out of the market using Shiller’s P/E ratio would have missed the run in the markets from 2009 to present, those same individuals most likely sold at the bottom of the market in 2008 and only recently began to return as shown by net equity inflows below.

In other words, they missed the “run up” anyway. Investor psychology has more to do with long-term investment outcomes than just about anything else.

What valuations tell us, is that at current levels investors are strictly betting on there always being someone to pay more in the future for an asset than they paid today. 

Huckster Alert…

It is not surprising that due to the elevated level of P/E ratios since the turn of the century, which have been fostered by one financial bubble after the next due to Federal Reserve interventions, there has been a growing chorus of views suggesting that valuations are no longer as relevant. There is also the issue of the expanded use of forward operating earnings.

First, it is true that P/E’s have been higher over the last decade due to the aberration in prices versus earnings leading up to the 2000 peak. However, as shown in the chart below, the “reversion” process of that excessive overvaluation is still underway. It is likely the next mean reverting event will complete this process.

Cliff directly addressed the issue of the abuse of forward operating earnings.

“Some outright hucksters still use the trick of comparing current P/E’s based on ‘forecast’ ‘operating’ earnings with historical average P/E’s based on total trailing earnings. In addition, some critics say you can’t compare today to the past because accounting standards have changed, and the long-term past contains things like World Wars and Depressions. While I don’t buy it, this argument applies equally to the one-year P/E which many are still somehow willing to use. Also, it’s ironic that the chief argument of the critics, their big gun that I address exhaustively above [from the earlier post], is that the last 10 years are just too disastrous to be meaningful (recall they are actually mildly above average).”

Cliff is correct, of course, as it is important to remember that when discussing valuations, particularly regarding historic over/undervaluation, it is ALWAYS based on trailing REPORTED earnings. This is what is actually sitting on the bottom line of corporate income statements versus operating earnings, which is “what I would have earned if XYZ hadn’t happened.”

Beginning in the late 90’s, as the Wall Street casino opened its doors to the mass retail public, use of forward operating earning estimates to justify extremely overvalued markets came into vogue. However, the problem with forward operating earning estimates is they are historically wrong by an average of 33%. To wit:

“The biggest single problem with Wall Street, both today and in the past, is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.”

Ed Yardeni published the two following charts which shows analysts are always overly optimistic in their estimates.

“This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic roughly 33% on average. Furthermore, the reason that earnings only grew at 6% over the last 25 years is because the companies that make up the stock market are a reflection of real economic growth. Stocks cannot outgrow the economy in the long term…remember that.

The McKenzie study noted that on average ‘analysts’ forecasts have been almost 100% too high’ and this leads investors into making much more aggressive bets in the financial markets.”

The consistent error rate in forward earnings projections makes using such data dangerous when making long-term investments. This is why trailing reported earnings is the only “honest” way to approach valuing financial markets. Importantly, long-term investors should be abundantly aware of what the future expected returns will be when buying into overvalued markets. Bill Hester recently wrote a very good note in this regard in response to critics of Shiller’s CAPE ratio and future annualized returns:

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns.

As clearly stated throughout this missive, fundamental valuation metrics are not, and were never meant to be, market timing indicators. This was a point made by Dr. Robert Shiller himself in an interview with Henry Blodgett:

“John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price-earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent — wait until it goes all the way down to a P/E of 7, or something.”

Currently, there is clear evidence that future expectations should be significantly lower than the long-term historical averages.

Do current valuation levels suggest you should be all in cash? No.

However, it does suggest that a more cautious stance to equity allocations and increased risk management will likely offset much of the next “reversion” when it occurs.

My job is to protect investment capital from major market reversions and meet investment returns anchored to retirement planning projections. Not paying attention to rising investment risks, or adjusting for lower expected future returns, are detrimental to both of those objectives.

Next week, I will introduce a modified version of the Shiller CAPE ratio which is more constructive for shorter-term outlooks.

Shiller’s CAPE – Is There A Better Measure: Part 2

On Wednesday, as I discussed yesterday, the Fed hiked rates and despite the fact that hiking interest rates further tightens monetary policy, thereby reducing liquidity to the markets, the markets rallied anyway.

With the hopes of accelerated earnings recovery being muted by falling oil prices, higher borrowing costs, and a strong dollar, investors seem willing to forgo the basic fundamentals of investing to chase an already extended and aging bull market cycle.

This was noted yesterday in a note from Goldman’s Jan Hatzius, the chief economist warns that the market is over-interpreting the Fed’s statement, and Yellen’s presser, and cautions that it was not meant to be the “dovish surprise” the market took it to be.

“Surprisingly, financial markets took the meeting as a large dovish surprise—the third-largest at an FOMC meeting since 2000 outside the financial crisis, based on the co-movement of different asset prices.

The committee may have worried that a rate hike—especially a rate hike that was not priced in the markets or predicted by most forecasters as recently as three weeks ago—might lead to a large adverse reaction on the day, and wanted to avoid such an outcome by erring slightly on the dovish side. But we feel quite confident that they were not aiming for a large easing in financial conditions. After all, the primary point of hiking rates is to tighten financial conditions, perhaps not suddenly but at least gradually over time. And even before today’s meeting, at least our own FCI was already fairly close to the easiest levels of the past two years and this was likely one reason why the committee decided to go for another hike just three months after the last one.”

He’s right. The Fed, which is now tightening financial conditions (which should/will push asset prices lower), got the exact opposite result as everything rose Wednesday from stocks, to bonds, to gold.

In other words, market participates took the rate hike as another reason to “just buy everything.” 

Of course, with bullish trends still very much in place, it has been, and remains, very challenging to dispute that point.

Just realize, eventually the mantra of “just buy everything” from overly complacent bullish investors, will change to “just sell everything.” 

Of course, just understanding that particular point is just winning the battle.

Recognizing, and acting, on the change is what “Wins the war.”

Just some things I am thinking about this weekend as I catch up on my reading.



Financial Planning/Retirement

Research / Interesting Reads

“It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” – Henry Ford

Questions, comments, suggestions – please email me.

Future’s So Bright, We Gotta Hike Rates

“The simple message is the economy is doing well. We have confidence in the robustness of the economy and its resilience to shocks.” – Janet Yellen, March 15, 2017.


Because while you saying that the GDP NowCast from the Atlanta Fed just collapsed from nearly 3% at the beginning of the year, to just 0.9% currently.

The problem, as has been a continued issue with the Fed’s projections, is the expanse between the Fed’s “fantasy” and economic realities. This is shown in the table below which documents the median of the Fed’s economic projections versus what actually happens. In every single year, the March projections have consistently been revised lower.

Yet, besides being the world’s worst economic forecasters, the market still believes every statement she makes.

Unfortunately, for market participants chasing asset prices on the back of “Make America Great Again” and Trump’s promise of 3-4% annualized GDP growth, the Fed is maintaining their expectations of the lowest long-term growth rates on record.

Someone is going to be wrong. Quite likely, it will be both of them.

Is Fed Late To The Game?

With the Federal Reserve lifting interest rates by another 0.25%, while also tilting hawkishly into the rest of year suggesting further rate hikes, she noted economic activity had expanded at “moderate pace,” and the U.S. labor market continued to strengthen with job gains remaining “solid”Of course, given the February employment report of 235,000 jobs, and improving manufacturing reports, the move would certainly seem logical

However, all may not be what it appears.

The last couple of months have marked some of the warmest winter temperatures that we have seen since 2011-2012. This is important, because of the “seasonal adjustments” applied to data collected during these typically cold months of the year. These “adjustments” boost the underlying data to normalize it and smooth the monthly volatility of the series into a more usable data set.

Here is the issue. When the winter is unseasonably warm, as it was this past year, workers are able to continue working in areas like manufacturing, construction, etc, where more normal inclement weather would have diminished those activities. So, when the “adjustments” are added to already abnormally high data levels, the data is skewed to the upside. This was something I noted back in 2013.

“I jest, of course, but what is relevant is that the effect of ‘Mother Nature’ has provided the short-term boosts to economic growth which kept a struggling economy above the water line.  How many more natural disasters and warm winters will come to offset the negative economic impact of a zero interest rate environment coupled with a wave of deflationary pressures is unknown. However, you do have to admit that the ‘Mother Nature’ effect is quite interesting nonetheless and wonder, if even for just a moment, if Bernanke has her on speed dial.”

Whether it was an earthquake, typhoon, the nuclear meltdown of Japan, warm winter cycles, Hurricane Sandy, tornado’s in Oklahoma, or just good old fashioned collapses in energy prices, each has had its impact on economic growth. Given the history of warm winter seasonal adjustment skewing, we are likely to see “repayment” coming towards the summer as the “adjustments” begin to run in reverse. 

This is important given the seasonal adjustment phenomenon has likely skewed employment data over the last couple of months giving a false sense of confidence about the Fed’s ability to safely raise interest rates. As shown in the chart below the Fed has NEVER hiked rates previous when employment had already peaked for its current cycle and was beginning to decline.

Furthermore, this same problem presents itself when looking at the Fed’s own Labor Market Conditions Index.

Another problem which is also likely skewing the inflation data has been the rise in oil prices. Since oil prices push through the commodity complex, inflationary pressures have risen in recent months. However, the recent drop in energy prices, and given the massive net long position discussed last weekend which could exacerbate the decline, will likely show up as a deflationary wave.

All of this suggests, the Fed may indeed be very late to the game and find themselves pushing the economy towards the next recession sooner than anticipated.

Something Is Amiss

Of course, at very low rates of economic growth, there is little wiggle room between slowing the economy and pushing it into a recession. However, it is hard to deny the rush of consumer and investor optimism since the election. But something appears to be amiss just beneath the surface.

Credit is the “lifeblood” of the economy, and the recent rate hikes will eventually increase borrowing costs for credit cards and other short-term loans. Unfortunately, bank loans and leases are already on the decline, and delinquencies are on the rise, as higher borrowing costs make fixed investment less profitable. Remember, the REASON the Fed hikes interest rates in the first place is to SLOW economic activity in order to QUELL inflationary pressures. 

Importantly, as noted by Zerohedge, it is not just on the business side of the equation. Consumption, which makes up roughly 70% of economic growth, is also feeling the pinch of a slowing economy and higher borrowing costs as consumers continue to reduce spending at restaurants. This is not a sign of improving “confidence” in their economic outlook.

Of course, the decline in the luxury of “eating out” is not surprising once you realize that debt expansion has come to offset weak wage growth which has failed to keep up with the spiraling costs of healthcare, rent and gasoline prices. 

While it is “hoped” that Trump’s policies will “Make America Great, Again,” there has been reality little change to actual underlying economic activity which is dependent on consumer spending from already “tapped out” consumers.

As noted the problem for both the Fed, and investors, is the detachment between market “expectations” and fundamental “realities.” 

In other words, if you are betting on a strong economic recovery to support excessive valuations and extremely stretched markets, you could be setting yourself up for disappointment.

Oh, and don’t think for a moment that rising interest rates, combined with a strongly rising dollar, is somehow “good for stocks.”

It isn’t.

It has never been.

Just some things I am thinking about.

Villanova versus Kansas

 Outcome versus Process Strategies

It is that time of year when the markets play second fiddle to debates about which twelve seed could be this year’s Cinderella in the NCAA basketball tournament. For college basketball fans, this particular time of year has been dubbed March Madness. The widespread popularity of the NCAA tournament is not just about the games, the schools, and the players, but just as importantly, it is about the brackets. Brackets refer to the office pools based upon correctly predicting the 67 tournament games. Having the most points in a pool garners office bragging rights and, in many cases, your colleague’s cash.

Interestingly the art, science, and guessing involved in filling out a tournament bracket provides insight into how investors select assets and structure portfolios. Before explaining, answer the following question:

When filling out a tournament bracket do you:

  1. A) Start by picking the expected national champion and then go back and fill out the individual games and rounds to meet that expectation?
  1. B) Analyze each opening round matchup, picking winners and advance round by round until you reach the championship game?

If you chose answer A, you fill out your pool based on a fixed notion for which team is the best in the country. In doing so, you disregard the potential path, no matter how hard, that team must take to become champions.

If you went with the second answer, B, you compare each potential matchup, analyze each team’s respective records, strengths of schedule, demonstrated strengths and weaknesses, record against common opponents and even how travel and geography might affect performance. While we may have exaggerated the amount of research you conduct a bit, such a methodical game by game evaluation is repeated over and over again until a conclusion is reached about which team can win six consecutive games and become the national champion.

Outcome Based Strategies

Outcome-based investment strategies start with an expected result, typically based on recent trends or historical averages. Investors following this strategy presume that such trends or averages, be they economic, earnings, prices or a host of other factors, will continue to occur as they have in the past. How many times have you heard Wall Street “gurus” preach that stocks historically return 7%, and therefore a well-diversified portfolio should expect the same thing this year? Rarely do they mention corporate and economic fundamentals or valuations. Many investors blindly take the bait and fail to question the assumptions that drive the investment selection process.

Pension funds have investment return assumptions which, if not realized, have negative consequences for their respective plans. Given this seemingly singular aim of the fund manager, most pension funds tend to buy assets whose expected returns in aggregate will achieve their return assumption. Accordingly, pension funds tend to be managed with outcome-based strategies.

For example, consider a pension fund manager with an 8% return target that largely allocates between stocks and bonds.

Given the current yields in the table above, and therefore expectations for returns on sovereign bonds of approximately 1%, the manager must instead invest in riskier fixed income products and equities to achieve the 8% return objective. Frequently, a pension fund manager has a mandate requiring that the fund hold a certain minimum amount of sovereign bonds.  The quandary then is, how much riskier “stuff” do they have to own in order to offset that return drag? In this instance, the manager is not allocating assets based on a value or risk/reward proposition but on a return goal.

To illustrate, the $308 billion California Public Employees Retirement System (CalPERS), the nation’s largest pension fund, has begun to shift more dramatically towards outcome-based management. In 2015, CalPERS announced that they would fire many of their active managers following repeatedly poor performance. Despite this adjustment, they still badly missed their 7.5% return target in 2015 and 2016. Desperate to right the ship, CalPERS maintains a plan to increase the amount of passive managers and index funds it uses to achieve its objectives.

In speaking about recent equity allocation changes, a CalPERS spokeswoman said “The goal is to eventually get the allocation to the right mix of assets, so that the portfolio will likely deliver a 10-year return of 6.2%.” That sounds like an intelligent, well-informed comment but it is similar to saying “I want to be in Poughkeepsie in April 2027 because the forecast is sunny and 72 degrees.” The precision of the 10-year return objective down to the tenth of a percent is the dead giveaway that the folks at CalPERS might not know what they’re doing.

Outcome-based strategies sound good in theory and they are easy to implement, but the vast amount of pension funds that are grossly underfunded tells us that investment policies based on this process struggle over the long term. “The past is no guarantee of future results” is a typical investment disclaimer. However, it is this same outcome-based methodology and logic that many investors rely upon to allocate their assets.

Process Based Strategies

Process-based investment strategies, on the other hand, have methods that establish expectations for the factors that drive asset prices in the future. Such analysis normally includes economic forecasts, technical analysis or a bottom-up assessment of an asset’s ability to generate cash flow. Process-based investors do not just assume that yesterday’s winners will be tomorrow’s winners, nor do they diversify just for the sake of diversification. These investors have a method that helps them forecast the assets that are likely to provide the best risk/reward prospects and they deploy capital opportunistically.

Well managed absolute return and value funds, at times, hold significant amounts of cash. This is not because they are enamored with cash yields per se, but because they have done significant research and cannot find assets that offer value in their opinion. These managers are not compelled to buy an asset because it “promises” a historical return. The low yield on cash clearly creates a “drag” on short-term returns, but when an opportunity develops, the cash on hand can be quickly deployed into cheap investments with a wider margin of safety and better probabilities of market-beating returns. This approach of subordinating the short-term demands of impatience to the long-term benefits of waiting for the fat pitch dramatically lowers the risk of a sizable loss.

A or B?

Most NCAA basketball pool participants fill out tournament brackets starting with the opening round games and progress towards the championship match. Sure, they have biases and opinions that favor teams throughout the bracket, but at the end of the day, they have done some analysis to consider each potential matchup.  So, why do many investors use a less rigorous process in investing than they do in filling out their NCAA tournament brackets?

Starting at the final game and selecting a national champion is similar to identifying a return goal of 10%, for example, and buying assets that are forecast to achieve that return. How that goal is achieved is subordinated to the pleasant but speculative idea that one will achieve it. In such an outcome-based approach, decision-making is predicated on an expected result.

Considering each matchup in the NCAA tournament to ultimately determine the winner applies a process-oriented approach. Each of the 67 selections is based on the evaluation of comparative strengths and weaknesses of teams. The expected outcome is a result of the analysis of factors required to achieve the outcome.


It is very likely that many people filling out brackets this year will pick Villanova. They are a favorite not only because they are the #1 overall seed, but also because they won the tournament last year. Picking Villanova to win it all may or may not be a wise choice, but picking Villanova without consideration for the other teams they might play on the path to the championship neglects thoughtful analysis.

The following table (courtesy and Koch Capital) is a great reminder that building a portfolio based on yesterday’s performance is a surefire way to end up with sub-optimal returns.

Winning a basketball pool has its benefits while the costs, if any, are minimal. Managing wealth, however, can provide great rewards but is fraught with severe consequences. Accordingly, wealth management deserves considerably more thoughtfulness than filling out a bracket. Over the long run, those that follow a well-thought out, time-tested, process-oriented approach will raise the odds of success in compounding wealth by limiting damaging losses during major market set-backs and by being afforded opportunities when others fearfully sell.






Real Investment Advice welcomes Ben Masters to our growing list of contributors. Benjamin Masters is the creator, designer, and writer for Third Wave Finance, With over ten years of experience working as a lead Portfolio Analyst, Ben brings additional insights into the discussion of economics, markets and portfolio management.

Part 1 Of The Series

The Continuous and Immediate Democracy of the Price System

So often the devastating social and economic events of our past have occurred due to a misplaced desire to “fix” a problem.  For an illustration of the mechanism just look to the disastrous implications of forest fire suppression (also addressed by author and hedge fund manager Mark Spitznagel) — an attempt to prevent damage to ecosystems by only allowing small fires to occur has allowed more kindling to be built up to stoke even larger more disastrous fires.

In a similar fashion, current economic policies have — in an attempt to “fix” a problem — moved the economy away from the continuous and immediate democracy of the price system; a system that can be thought of as a constantly adjusting balance.  Every minute, of every hour, of every day individuals are voting on whether more or less of a product should be produced.  Every time they purchase an item they encourage its continued production at the expense of another item, and every time they decide not to buy they discourage its production, to the encouragement of another.

If more individuals want a particular item, it is difficult to keep it in stock, and the retailer is pushed to move the price up (if they don’t then they will underperform the competition who will move the price up).  But the price moves up because the majority of individuals agree that it should be higher; they desire the product more, which draws individuals into the industry (seeking profits) and increases production to meet demand.  By voting the price higher they are signaling desirability; when the price moves up, the profits of the company selling the product move up, more individuals enter the industry to follow profit potential, and the price then moves down when more have entered the industry than are necessary to meet demand.  It’s a cycle of adjustment based on the continuous and immediate voting of the individual — the voter decides whether the price is reasonable.

The shrinking or expansion of an industry depends on the desires of the majority.  If more people think that industry’s product or service is reasonable, the price transitions up, encouraging individuals to leave less desirable industries behind to pursue the industry with more profits — accommodating the desire of the majority.  If more people think the price is unreasonable, they refuse to buy, the price transitions down, and the industry shrinks as individuals move to pursue other industries that the majority does desire.

So, in this fashion, the decisions of individuals — on a moment-to-moment basis — cause the change in prices and production.  If more people desire computers rather than typewriters, the price of typewriters falls until it reaches the point where they are desirable again, and the typewriter industry is forced to lower prices based on the desire of the majority — the industry shrinks based on the majority’s preference for other items and services.

The continuous and immediate democracy of the price system is what calls into question the results of artificial adjustment schemes — those results being that any adjustment to this voting system would, in effect, benefit a small group of individuals at the expense of the larger group; yet this is the nature of the adjustment schemes championed by all sorts of different groups and governments.  The adjustments pursued include “parity” pricing, tariffs, “stabilizing” commodities, and price “fixing”, among many others; their commonality is that they disrupt the democratic price system, allow a smaller group to inhibit the desires of the larger group, and are still being used.

Leaving a much lengthier discussion to other sources, a few examples may be of use here.  Of the many examples of adjustment (or manipulation) previously listed, one would be the attempt to keep a price level artificially high.  In an attempt to save a dying industry the price for the product is held above the price voted on by the majority.  In this case the industry benefits (a minority of the population) at the expense of the majority who now have to pay more than they would otherwise deem reasonable.  The money above what they were willing to pay will now flow toward the “adjusted” industry and away from a different, more desirable one.

The effect of this attempt to manipulate the democratic price system is a temporary (short-term) benefit to the supported industry (the small group) at the expense of the larger group; yet since the majority is negatively affected, and the smaller group is not isolated (they are also dependent on others), the smaller group will eventually be negatively affected as well as the cycle continues.  This is, in essence, the wildfire suppression scenario — prevent fires (prevent the death of an undesirable industry) only to have to deal with larger fires (the majority is negatively affected and in turn negatively affects the smaller group).

The significance is that the manipulation of the equilibrium moves the majority to a lesser-desired state, encouraging a waste of raw materials and a squandering of time, both of which are used up on industries that are not as desirable as others — a misallocation of capital and an aggregate hindrance to the economy.

Technological Progress: Cessation of Industries = Progress for Others

Unfortunately, due to the custom of “specialization” (a person typically works in one industry), the individual effects of technological progress and invention can often be disastrous for some (those working in the industry with reduced demand), even though the change provides an aggregate benefit to the majority.  By its very nature that reduced demand for the failing industry is due to a demand for other more-desirable items.  This is not a new process.  It has occurred throughout history.  The mechanical revolution displaced so many that people that some thought work would become obsolete.

The same progress has continued to occur: the dwindling of the typewriter industry due to the boom of the computer industry and the loss of cashiers to automation, among many, many others.  But there are other jobs created that are not so easily recognized; the machines created to replace cashiers have also created jobs — designers, manufacturers, etc.  Labor moves to the desirable industries and creates new ones.  Technological advancement can even create demand in an industry if it reduces the price of the item to the point where individuals want more.

The cessation of undesirable industries results in progress for desirable ones; the outcome is a social benefit to the majority and an unfortunate, temporary, expense for a smaller group.  The best solution isn’t to prevent progress, but to allow for mobility between industries — to ease the transition, to encourage movement to existing in-demand industries and to those new industries yet to be created.

Unless everyone’s desires are completely satisfied there is still progress to be made.  It’s when individuals are freed from undesirable industries that their faculties are applied to the desires of the majority.  The worse outcome is for groups and governments to manipulate and encourage undesirable industries to use up finite raw materials and time when the actual demand of the majority lies elsewhere.

“If it were indeed true that the introduction of labor-saving machinery is a cause of constantly mounting unemployment and misery, the logical conclusions to be drawn would be revolutionary, not only in the technical field but for our whole concept of civilization.  Not only should we have to regard all further technical progress as a calamity; we should have to regard all past technical progress with equal horror…

…It follows that it is just as essential for the health of a dynamic economy that dying industries should be allowed to die as that growing industries should be allowed to grow.  For the dying industries absorb labor and capital that should be released for the growing industries.” 

– Henry Hazlitt (H.H.)

Returning to the topic of economic policy, one can see the wildfire suppression scenario occurring once again.  The attempt to pull growth forward by reducing interest rates (and using experimental policies, i.e. large-scale asset purchases) is effectively encouraging short-term benefits (fire suppression) at the expense of long-term benefits (a worse outcome, larger fires).  One could argue that the market crises and stock manias of the 21st century have been more severe because risk (kindling) has been allowed to build.

Since the 1980s the Fed has been encouraging debt-based spending to attempt to counter slowing economic growth — they influence interest rates lower (you get paid less interest in your bank account), and by doing so they’re attempting to make debt more attractive due to it being more “affordable” (individuals pay less in interest when they take on debt); individuals may then borrow more and spend more to boost economic growth.

However there is a “catch”: although more debt and more economic growth may occur temporarily due to the reduction of the interest rate target, the productiveness-of-the-debt determines the long-run outcome.  If the debt is productive — i.e. creates an income stream to repay the principal (original amount borrowed) and the interest on the debt — then long-run growth may not flag due to the debt; yet if the debt is unproductive and/or counter-productive then economic growth is constrained in the long run.  One of the most important measures of the productiveness-of-debt is the velocity of money.

The more serious implications of economic policy, however, are for the broad economy and country (the stock market is only a portion of the economy).  A misallocation of capital and investment, due to economic policy, slows growth and results in zombie industries kept alive by the continued attempt to manipulate the democratic price system; it creates an undesirable imbalance — a temporary benefit to a small group at the expense of a larger group, which in turn inhibits growth.

Get Part 1 Here

…Stay Tuned for Part III

What would you do with three-thousand bucks

And what if this small fortune was out of reach every year until you spent months gathering documents and wasting precious hours, patience or financial resources to prepare for its rightful return?

Consider it money held hostage.

Not just anybody’s money. Yours.

And that’s what most taxpayers, like you, do.

  • The average tax refund is $3,120 and an astounding 83% of tax returns are due a refund, according to the Internal Revenue Service.
  • Half of American households can’t raise 500 dollars in the face of an emergency yet a majority of taxpayers are due money back? Their money back, by the way.
  • An estimated $1 billion in refunds are unclaimed for taxpayers who haven’t filed a return. Ultimately, these funds are surrendered to the U.S. Treasury.

Why do we do exhibit these strange behaviors? Is it fear of owing money and not being able to cough it up? Perhaps a forced savings plan?

Downright Ignorance? 

Is it a mental accounting bias where we falsely believe the IRS refund is a bonus or windfall?

I’m consistently puzzled how happy many of us are to receive refunds and cheerfully share this new with anybody willing to listen.

I seek to help you change your mindset.

Think of it this way: We give a bloated, government bureaucracy the right to use our hard-earned dollars for over a year to have it returned to us, eventually. And that makes us happy!

Heck, this mission is too big for one person to take on. So, if you’ve surrendered to receiving a refund, not willing to check out the IRS Withholding Calculator and file a new W-4 with your employer, let me at least provide 5 money smart uses for the you know –  the return of your money.

Make a big dent in those ‘money-killing’ outstanding credit card balances.

Per 2016 Federal Reserve Consumer Credit Report (the G.19), U.S. credit card debt reached $1 trillion. Yes, that’s trillion with a T. Approximately $650 billion was subject to finance charges with the national average credit card interest rate (APR) now at 15.07%.

A smart money strategy would be to direct the refund to outstanding credit card balances. Hit the card with the highest interest rate, first. You’ve earned a quick double-digit return on your money. Just like that.

Because going forward, you’re not going to earn those kind of dizzy-heights returns in the stock market. As a matter of fact, at RIA, we expect quite the contrary.

The Economic Policy Institute or EPI a non-partisan created in 1986 which focuses on low and middle-income workers produced a report recently that shared interesting facts, many of the same we’ve outlined at  –

Rising inequality means that although we are finally seeing broad-based wage growth, ordinary workers are just making up lost ground, rather than getting ahead. The way rising inequality has directly affected most Americans is through sluggish hourly wage growth in recent decades, despite an expanding and increasingly productive economy. For example, had all workers’ wages risen in line with productivity, as they did in the three decades following World War II, an American earning around $40,000 today would instead be making close to $61,000 (EPI 2017c). A hugely disproportionate share of economic gains from rising productivity is going to the top 1 percent and to corporate profits, instead of to ordinary workers.” 

Unfortunately, we are witnessing an increasing number of U.S. households employ credit cards to make up for a structural wage gap, which makes a tax refund mentality even more confusing to comprehend.

Invest in your greatest asset.

No, it’s not a house. Nor is it your 401(k). It’s you – your skills, and the ability to build upon human capital. Yes, YOU! You are the greatest creator of wealth. A big, lifetime earnings machine. A true investment is one that brings greater income into your household.

As we examine hundreds of company retirement plan accounts monthly, we seek to separate the ‘steak from the sizzle’ as I coin it. We look to gain an understanding of savings habits versus the rates of returns on investments within the plans.

Interestingly, once contributions are isolated, we discover that performance and healthy nest eggs are not the result of asset allocation strategies nor returns on investments. The bulk of returns are comprised of sweat equity, time and compromise undertaken to consistently make saving a priority.

So why not use a refund to fund education that can increase skills and ostensibly, earnings potential?

Last year, Money, along with, created a list of 21 of the most valuable career skills.

Local and online educational courses may range from $2,500-$6,000 and pay off handsomely when compared to the limited future growth potential in the stock market.

Can you fund a Roth IRA? Then, do it.

A Roth IRA allows you to save after-tax dollars and at retirement, withdraw money tax free. Unlike a traditional IRA that may be tax-deductible and is taxed as ordinary income upon distributions, a Roth is unlike your ordinary retirement savings vehicle.

So why is that important? You see, once you intend to re-create a paycheck and focus on portfolio distribution vs. accumulation, having the ability to draw from various buckets that are taxed at different rates or not at all, provides tax control.

As opposed to having every dollar taxed as ordinary income and then forced to take large required minimum distributions at 70 ½ from retirement accounts, what if you had a bucket of after-tax dollars and Roth IRA money to generate a retirement paycheck in the most tax-efficient manner?

For 2017, an individual may contribute $5,500 to a Roth IRA, $6,500 if 50 and older. Unfortunately, the Feds place income limits on Roth IRA contributions as they’re not big fans of tax-free income. For single tax filers, phase-out begins at $118,000 and complete ineligibility begins at $133,000.

All you ever wanted to know about Roth IRAs including information for joint filers, can be found at

 Bolster your emergency cash reserves.

A recent report by Bankrate outlined how six out of ten Americans don’t have enough in savings to cover a $500 to $1,000 unplanned expense.

Don’t be one of the six. Establish or bolster a cash stash to deal with future unexpected events.

Also, there’s (very) little motivation to consider the anemic rates on savings from your typical brick and mortar bank branch. They’re here to stay. It’ll take at least four Federal Reserve interest rate hikes for most national banks to consider increasing rates on savings, checking and money market accounts.

Open an online account with an FDIC-insured ‘virtual’ bank and transfer the rightful return of your money into it, electronically.

Popular choices include and Several virtual banks offer ATM cards, no minimum balances and free checking accounts if you would like to ditch (finally) your prehistoric bank, permanently.

Spend it. Go ahead. But choose with memories in mind.

Invest the funds in those you love and create a memorable family experience. There’s a return on life element that requires nurturing (and money).

To get the most of your travel budget, think “off season.” Per the popular website, the best packages from June through August are available for travel to Miami, Las Vegas and Colorado, respectively.

Taking the off-season path less traveled will result in the greatest emotional return on a refund in the form of less crowds equals less stress. Financial dollars will go further too for airfares, hotels, dining and entertainment.

If there’s a mental lift connected to the receipt of a tax refund, I won’t interfere.

Now’s the time to plan wisely for the lump sum headed your way.

After all, when it comes to making wise financial choices, my money is on you over the federal government – any day of the week.


On the night of the U.S. Presidential election, many investment assets went from a state of sheer panic at the prospect of Donald Trump winning the election, to manic euphoria as the glorious narrative of Reagan-esque economic revival was born with Trump’s victory. Euphoric markets are not generally built on durable substance, and they eventually reconcile with reality as investors come to their senses.

In today’s case, the enthusiasm of pro-growth fiscal initiatives are destined to collide with decades worth of ill-advised economic policies and political obstacles. As such, we created the Trump Range Chart to track the performance of various key indexes and tradeable instruments since Election Day. This tool serves as a gauge of market sentiment and the market’s faith in Donald Trump’s ability to effect real economic change.

We suspect that when economic proposals meet political and economic reality, some markets will begin to diverge from their post-election trends. As is typically the case, it is likely that this will occur in some markets before others. Markets showing early signs of divergence may provide tradable signals. We plan on releasing this data regularly to help our clients track these changes. Based on feedback, we may produce new range charts to include different markets, various time frames, and economic data.

On the following page you will find the range charts showing various market and index moves since the election. Below the chart is a user’s guide on how to read and process the information it offers.

How To Read The Charts

The data in the Trump range chart above is shown in a format that is quite different from what is commonly used to illustrate market changes. This format provides an easy way to view relative performance across a broad number of indexes and securities. It is intended to be a meaningful supplement and not a replacement to the traditional charts most investors review on a routine basis.

The base time frame captured by the graph reflects the market move for each index or security since Election Day, November 8, 2016. This change is represented by the 0% to 100% on the left hand axis. The 0% level reflects the intra-day low of the security since November 8 and the 100% level the intra-day high. For more clarity on the prices associated with the range, see the table below the chart for each respective index.

The (red/blue) bar reflects the price range of the past month relative to the base time frame.  The black “dash” within the 1-month bar reflects the previous week’s closing level (PWC) and the red dot highlights the closing level on the “as-of” date in the top left corner.

The diagram below isolates the chart and data for the Russell 2000 to further illustrate these concepts.





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

As I noted last week, the “Ides Of March” is upon us and there is a LOT of stuff going on that could send ripples through the market. Here is a brief listing of the key events to watch out for:

  • The most important, if mostly priced in, event is this FOMC announcement on Wednesday where Traders view a quarter-point Fed hike this week as a virtual certainty and will be watching the central bank’s policy decision for signals on what will come next.
  • The Dutch general election whose results should be known on Thursday morning. Focus will be on the performance of the anti-EU, anti-immigration party PVV, and party leader Geert Wilders’ pledge to hold a referendum on EU membership.
  • On Wednesday the US debt ceiling limit expires and is due to be reinstated on Thursday absent some last minute breakdown in communication.
  • UK Prime Minister May is expected to invoke Article 50 of the Treaty of Lisbon as soon as Tuesday. This begins the long goodbye from the EU.
  • President Trump may also reveal his first budget outline for fiscal year 2018 on Thursday.
  • The G-20 Meeting will convene in Baden-Baden on March 17-18th. This is the first meeting since Donald Trump’s U.S. election victory in November where his protectionist stance on international trade is likely to be a key issue.
  • The BoJ is expected to maintain the status quo for monetary policy, leaving its long rate and short rate targets unchanged at 0.0% and -0.1%, respectively. Watch for a potential reduction to QE programs.
  • The BOE is expected to keep rates on hold.
  • And there is a bunch of economic data out this week with a focus on inflation and sentiment data.

Since the November election of Donald Trump, the investing landscape has gone through a dramatic change of expectations with respect to economic growth, market valuations and particularly inflation. As I discussed previously, there is currently “extreme positioning” in many areas which have historically suggested unhappy endings in the markets. To wit:

“As we saw just prior to the beginning of the previous two recessions, such a bump is not uncommon as the impact of rising inflation and interest rates trip of the economy. Given the extreme speculative positioning in oil longs, short bonds, and short VIX, as discussed yesterday, it won’t take much to send market participants scrambling for the exits.

While I am NOT suggesting that we are about to have the next great market crash tomorrow, the current sensation of ‘Deja Vu’ might just be worth paying attention to.

Even though there was a mild correction last week, the still extreme extension of prices above the 200-dma remains. Such extensions, which are always combined with extreme overbought conditions, have typically not lasted long and have been a good indication to take profits in the short-term. This provides some opportunity to invest capital following a correction to some level of support.

Buy The Dip? Probably. 

Will any correction in the days/weeks ahead be a “buyable correction?”

My best guess is probably for the following reasons:

  • The bullish trend remains intact. (Currently at 2350 short-term, 2250 intermediate-term.)
  • We remain within the seasonally strong period of the year currently. 
  • Investor optimism remains unabashedly bullish.
  • There is little fear of a correction in the markets. 

However, it is important to denote the market is currently more overbought than at any point of over the previous couple of years AS the Fed moves to tighten monetary policy further. As I noted in last weekend’s newsletter:

“This recent pop in rates, when combined with a stronger dollar which drags on corporate exports (roughly 40% of earnings), has historically been an excellent opportunity to add to bond exposure. As shown below, the Federal Reserve, in their eagerness to hike rates, are once again likely walking into an ‘economic trap.’” 

Sector By Sector

With that bit of analysis in place, let’s review the market environment for risks and opportunities.


The OPEC oil cut will likely end over the next couple of months as the ramp up in production continues in the Permian Basin. The Saudi’s are only going to give up so much “market share” before returning back to full production.

Furthermore, a break below $48/bbl is going to start putting pressure on the extreme “long” positioning currently remaining by speculators. There is an extremely high probability the supply increase that is currently happening will not only cap oil price temporarily, but will likely continue to push oil prices lower in the months ahead. 

Energy companies remain extremely overvalued, and disconnected, relative to the underlying commodity price. When the next economic recession hits, energy-related equities will likely once again recouple with its base commodity.


The health care sector moved from laggard to leader, as anticipated, over the last couple of months. With the raging debate over the repeal/replacement of the Affordable Care Act, there is volatility risk to the sector due to the very overbought condition that currently exists.

Current holdings should be reduced to market-weight for now as there is not a good stop-loss setup currently available. A correction to $70-72 would provide an entry point while maintaining a stop at $69.


Financials have weakened as of late in terms of relative performance. However, the sector is currently extremely overbought and very deviated from long-term moving averages. A correction back to support between $20 and $22 could provide for an entry point with a stop at $18.50.

There is a tremendous amount of exuberance in the sector at a time that loan delinquencies are rising and loan demand is falling. Caution is advised.


Industrial stock’s, like Financials, relative performance has begun to lag as of late. However, the “Make America Great Again” infrastructure trade is still on. Importantly, this sector is directly affected by the broader economic cycle which continues to remain weak so the risk of disappointment is very high if “hope” doesn’t become reality soon.

While the sector broke out to new highs, there is not a good risk/reward setup as there is a long way to a good stop level at $56. I would reduce holdings back to portfolio weight for now and take in some of the gains. 


As with Industrials, the same message holds for Basic Materials, which are also a beneficiary of the dividend / “Make America Great Again” chase. This sector should also be reduced back to portfolio weight for now with stops set at the lower support lines $49.00.


Back in January, I discussed the “rotation” trade into Utilities and Staples. That performance shift has played out nicely and the sector is now extremely overbought.

There is not a good stop currently available on a risk/reward basis as it resides all the way down at $45.00. However, a pullback to support between $48 and $49.50, could provide a reasonable entry to point to increase exposure. I would maintain a stop on all positions currently at $47.50.


Staples, have recovered as of late and are now back to extreme overbought, along with every other sector of the market. As with Utilities, there is not a good technical stop available. Set stops for now at $51 and look for a correction to $52 to $53 before increasing exposure to the sector.


Discretionary has been running up in hopes the pick-up in consumer confidence will translate into more sales. There is little evidence of that occurring currently, BUT with discretionary stocks at highs, profits should be harvested.

Trim portfolio weightings should back to portfolio weight with stops set at $80. With many signs the consumer is weakening, caution is advised and stops should be closely monitored and honored.


The Technology sector has been the “obfuscatory” sector over the past couple of months. Due to the large weightings of Apple, Google, Facebook, and Amazon, the sector kept the S&P index from turning in a worse performance than should have been expected prior to the election and are now elevating it post election.

The so-called FANG stocks (FB, AMZN/AAPL, NFLX, GOOG) continue to push higher, and due to their large weightings in the index, push the index up as well. 

The sector is extremely overbought and stops should be moved up to $45 where the bullish trend line currently intersects with the previous corrective bottom. Weighting should be revised back to portfolio weight.


Emerging markets have had a very strong performance and have now run into the top of a long-term downtrend live. The strengthening of the US Dollar will weigh on the sector and will only get worse the longer it lasts. With the sector overbought, the majority of the gains in the sector have likely been achieved. Profits should be harvested and the sector under-weighted in portfolios. Long-term underperformance of the sector relative to domestic stocks continues to keep emerging markets unfavored in allocation models for now.


As with Emerging Markets, International sectors also remain extremely overbought and unfavored in models due to the long-term underperformance. Underweight the sector, take profits, and focus more on domestic sectors for now. 


As stated above, the S&P 500 is extremely overbought, extended and exuberant. However, while a “buy signal” is currently in place, a sell signal registered from such a high level has previously coincided with bigger corrections.

Caution still advised for now.


Small cap stocks went from underperforming the broader market to exploding following the Trump election. However, as of late, that performance has stalled and the sector has now violated a bullish trend line. 

Importantly, small capitalization stocks are THE most susceptible to weakening economic underpinnings which are being reflected in the indices rapidly declining earnings outlook. This deterioration should not be dismissed as it tends to be a “canary in the coal mine.” 

Currently, small caps are back to an oversold condition which suggests the current corrective process is likely near completion. However, a failed rally attempt and a break below $820 would suggest a much deeper reversion is in process. Reduce exposure back to portfolio weight for now and carry a stop at $820.


As with small cap stocks above, mid-capitalization companies had a rush of exuberance following the election. However, Mid-caps currently remain overbought and is threatening to violate its bullish trend-line support. Reduce exposure back to portfolio weight for now and carry a stop at $1675.


REIT’s had been under pressure heading into the Fed’s expected rate hike this week. However, the sector is now oversold and maintained its bullish uptrend. Positions can be added with a stop set at $79.


Like REIT’s, and other interest rate sensitive sectors of the market, bonds are now oversold and sitting on support.  With the massive “short interest” position currently outstanding on bonds, a retracement of the previous decline to anywhere between $126 and $132 is very possible.  Furthermore, bonds are now back to extreme oversold conditions at more than 2-standard deviations below their moving averages.

Stops should currently be set at $115.


If you go back through all the charts and note the vertical RED-DASHED lines, you will discover that each time previously these lines denoted the peak of the current advance. Overall, in the majority of cases above, the risk/reward of the market is NOT favorable.

If, and when, the market corrects some of the short-term overbought conditions which currently exist, equity risk related exposure can be more aggressively added to portfolios.

Just be cautious for the moment.

It is much harder to make up losses than simply adding preserved cash back into portfolios.

Last week, I discussed the “World’s Most Deceptive Chartwhich explored the deception of “percentage” versus actual “point” losses which has a much greater effect on both the real, and psychological, damage which occurs during a bear market. To wit:

The problem is you DIED long before ever achieving that 5% annualized long-term return.

Outside of your personal longevity issue, it’s the ‘math’ that is the primary problem.

The chart uses percentage returns which is extremely deceptive if you don’t examine the issue beyond a cursory glance. However, when reconstructed on a point gain/loss basis, the ugly truth is revealed.”

Of course, there are those that still don’t get the basic realities of math, loss and time and resort to other flawed theses to support an errant view. As shown by a comment received by a reader:

“This is true only for price return, not for total return (dividends included). Since 1926, there has never been a negative 20-year period or 15-year period. There have been only four negative 10-year periods, 1928-1938, 1929-1939, 1998-2008, and 1999-2009.

The same fatal flaw afflicts that last graph. It shows inflation-adjusted price return (dividends not included). Including dividends increases that Mar 2009-Feb 2017 gain from 167% to 218%. Does Mr. Roberts throw away all his dividend cheques? Does anybody?” – Sam Baird

Sorry, Sam, the data WAS total, real returns, but the larger point you missed was the importance of understanding the devastating difference between POINT gain or loss, versus a PERCENTAGE gain or loss.

However, the point Sam made was nonetheless important as it showed another commonly held belief that is a fallacy.

Which bring us to….

The World’s Second Most Deceptive Chart

The following chart is the same real, inflation-adjusted, total return of the S&P 500 index from last week but converted to the compounded growth of a $1000 investment.

Note: The red lines denote the number of years required to get back to even following a bear market.

“See, other than those couple of periods, just buying, holding and collecting dividends is the way to go. Right?”

Again, not so fast.

First, as shown in the chart below, There have currently been four, going on five, periods of low returns over a 20-year period. Importantly, there also HAS been a NEGATIVE 20-year real, total return, holding period average of -0.22%

(Again, sorry Sam.)

I have added the P/E ratio which exposes the issue, once again, of the importance of valuation on future returns. In other words, your investment success depends more on WHEN you start, than IF you start investing.

“But Lance, yes, while there are some low periods, you made money provided you stayed invested. So what’s the issue?”

That brings me to my second point of that nagging problem of “time.” 

Until Death Do Us Part

In all of the analysis that is done by Wall Street, “life expectancy” is never factored into the equations used when presenting the bullish case for investing.

Therefore, in order to REALLY calculate REAL, TOTAL RETURN, we have to adjust the total return formula by adding in “life expectancy.” 

RTR =((1+(Ca + D)/ 1+I)-1)^(Si-Lfe)


  • Ca = Capital Appreciation
  • D = Dividends
  • I = Inflation
  • Si = Starting Investment Age
  • Lfe = Life Expectancy

For consistency from last week’s article, we will assume the average starting investment age is 35. We will also assume the holding period for stocks is equal to the life expectancy less the starting age. The chart below shows the calculation of total life expectancy (based on the average of males and females) from 1900-present, the average starting age of 35, and the resulting years until death. I have also overlaid the rolling average of the 20-year total, real returns and valuations.

If we use the stat and end dates, as shown in the first chart and table above, and calculate real total return based on the life expectancy for each period we find the following.

The horizontal red line is critically important.

One to the most egregious investing “myths” is when investors are told:

The power of compounding is the most powerful force in investing.” 

What the red line shows you is when, ON AVERAGE, you failed to achieve 6%-annualized average total returns (much less 10%.) from the starting age of 35 until DEATH.

Importantly, notice the level of VALUATIONS when you start investing has everything to do with the achievement of higher rates of return over the investable life expectancy of an individual. 

“Yes, but there are periods where my average return was higher than either 6% or 10%. So it’s not actually a fallacy. What am I missing?”


The stock market does not COMPOUND returns. 

There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.

As shown in the chart box below, I have taken a $1000 investment for each period and assumed a real, total return holding period until death. No withdrawals were ever made. (Note: the periods from 1983 forward are still running as the investable life expectancy span is 40-plus years.)

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

In every single case, at the point of death, the invested capital is short of the promised goal.

The difference between “close” to goal, and not, was the starting valuation level when investments were made.

This is why, as I discussed in “The Fatal Flaws In Your Retirement Plan,” that you must compensate for both starting period valuations and variability in returns when making future return assumptions. If you calculate your retirement plan using a 6% compounded growth rates (much less 8% or 10%) you WILL fall short of your goals. 

But wait….

It’s Actually Even Worse

The analysis above does NOT INCLUDE the effect of taxes, fees, expenses or a withdrawal rate once individuals hit retirement age.

This was the point I discussed in “Retirees May Have A Spend Down Problem.”

“The chart below takes the average return of all periods where the starting P/E was above 20x earnings (black line) and uses those returns to calculate the spend down of retiree’s in retirement assuming similar outcomes for the markets over the next 30-years. As opposed to the analysis above, I have added a 4% annual withdrawal rate at retirement and included the impact of inflation and taxation.”

“On the surface, it would appear a retiree would not have run out of money over the subsequent 30-year period. However, once the impact of inflation and taxes are included, the outcome becomes substantially worse.”

Time To Get Real

The analysis above reveals the important points that individuals should OF ANY AGE should consider:

  • Expectations for future returns and withdrawal rates should be downwardly adjusted due to current valuation levels.
  • The potential for front-loaded returns going forward is unlikely.
  • Your personal life expectancy plays a huge role in future outcomes. 
  • The impact of taxation must be considered.
  • Future inflation expectations must be carefully considered.
  • 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.
  • The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for investors. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of variable rates of return based on current valuation levels.

You cannot INVEST your way to your retirement goal. As the last decade should have taught you by now, the stock market is not a “get wealthy for retirement” scheme. You cannot continue under-saving for your retirement hoping the stock market will make up the difference. This is the same trap that pension funds all across this country have fallen into and are now paying the price for.

Importantly, chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely realize. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined.

As shown above, our life expectancy rates are finite and the later we get started saving for goals, the less time we have to waste trying to “get back to even” following a “mean reverting event.”

Investing for retirement, should be done conservatively, and cautiously, with the goal of outpacing inflation over time. Trying to beat some random, arbitrary index that has nothing in common with your financial goals, objectives, and most importantly, your life span, has tended to end badly for individuals.

You can do better.

Next week the Janet Yellen and her minions are expected, with 100% certainty, to lift the Fed funds rate by another 0.25% to 1.00%.

This certainty has been building as of late given the rise in inflation pressures from higher commodity, particularly oil prices, and still rising health care costs as well as a strong market, dollar, and employment data. Speaking of employment data, ADP reported on Wednesday a 298,000 person increase in employment. What is interesting is this was the highest monthly employment rate seen since 2014, 2011, and 2006. In all three previous cases, it was the peak of employment before weakness begin to set in. 

Of course, given the “exuberance” following the election of “the guy that was supposed to crash everything,” it is not surprising that we have seen a pick up in some activity more closely aligned with a boost in sentiment.

The chart below is a composite index of the average of the UofM and CB survey readings for consumer confidence, consumer expectations, and current conditions. The horizontal dashed lines show the current readings of each composite back to 1957.

Importantly, as noted above, high readings of the index are not unusual. It is also worth noting that high readings are historically more coincident with a late stage expansion, and a leading indicator of an upcoming recession, rather than a start of an economic expansion.

The next chart shows the same analysis as compared to the S&P 500 index. The dashed vertical lines denote peaks in the consumer composite index.

Again, not surprisingly, when consumer confidence has previously reached such lofty levels, it was towards the end of an expansion and preceded either a notable correction or a bear market.

But therein lies the other issue. The strength in the recent employment reports will most assuredly push Yellen to hike rates next week. It is worth noting that historically there was a significant gap between the Labor Market Condition Index and the ZERO line when the Fed started a rate hiking campaign (vertical black lines) which provided a buffer until the next recession. That is not the case currently. 

Just some things I am thinking about this weekend as I catch up on my reading.



Research / Interesting Reads

“As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” – Chuck Prince, CEO of Citi in July, 2007.

Questions, comments, suggestions – please email me.

With the Federal Reserve now indicating they are “really serious” about “normalizing” interest rates, read “tightening” monetary policy, there have come numerous articles, and analysis, discussing the impact on asset prices. The general thesis is based on averages of historical tendencies suggesting equity bull markets never die simply of old age. They do, however, die of excessive Fed monetary restraint. As previously noted by David Rosenberg:

“In the past six decades, the average length of time from the first tightening to the end of the business cycle is 44 months; the median is 35 months; and the lag from the initial rate hike to the end of the bull equity market is 38 months for the average, 40 months for the media.”

So, that analysis would suggest that since the Fed hiked in December of 2015, there is still at least two years left to the current business cycle. Right?

Maybe not.

First, averages and medians are great for general analysis but obfuscate the variables of individual cycles. To be sure the last three business cycles (80’s, 90’s and 2000) were extremely long and supported by a massive shift in financial engineering and credit leveraging cycle. The post-Depression recovery and WWII drove the long economic expansion in the 40’s, and the “space race” supported the 60’s.  You can see the length of the economic recoveries in the chart below. I have also shown you the subsequent percentage market decline when they ended.

Currently, employment and wage growth is extremely weak, 1-in-4 Americans are on Government subsidies, and the majority of American’s living paycheck-to-paycheck. This is why Central Banks, globally, are aggressively monetizing debt in order to keep growth from stalling out.

If the Fed continues to hike rates, and the next recession doesn’t occur for another two years as David suggests, this would be the single longest economic expansion in history based on the weakest economic fundamentals.

Secondly, the above analysis misses the level of economic growth at the beginning of interest rate hiking campaign. The Federal Reserve uses monetary policy tools to slow economic growth and ease inflationary pressures by tightening monetary supply. For the last six years, the Federal Reserve has flooded the financial system to boost asset prices in hopes of spurring economic growth and inflation. Outside of inflated asset prices, there is little evidence of real economic growth as witnessed by an average annual GDP growth rate of just 1.3% since 2008, which by the way is the lowest in history since…well, ever.

The chart and table below compare real, inflation-adjusted, GDP to Federal Reserve interest rate levels. The vertical red bars denote the quarter of the first rate hike to the beginning of the next rate decrease or onset of a recession.

If I look at the underlying data, which dates back to 1943, and calculate both the average and median for the entire span, I find:

  • The average number of quarters from the first rate hike to the next recession is 11, or 33 months.
  • The average 5-year real economic growth rate was 3.08%
  • The median number of quarters from the first rate hike to the next recession is 10, or 30 months.
  • The median 5-year real economic growth rate was 3.10%

However, note the GREEN arrows. There have only been TWO previous points in history where real economic growth was near 2% at the time of the first quarterly rate hike – 1948 and 1980. In 1948, the recession occurred ONE-quarter later and THREE-quarters following the first hike in 1980.

The importance of this reflects the point made previously, the Federal Reserve lifts interest rates to slow economic growth and quell inflationary pressures. There is currently little evidence of “good” inflationary pressures outside of financial asset prices, and economic growth is weak, to say the least.

Therefore, rather than lifting rates when average real economic growth was at 3%, the Fed is doing this with rates closer to 2% over the last 5-years.

Think about it this way.

If it has historically taken 11 quarters to go fall from an economic growth rate of 3% into recession, then it will take just 2/3rds of that time at a rate of 2%, or 6 to 8 quarters at best. This is historically consistent with previous economic cycles, as shown in the table to the left, that suggests there is much less wiggle room between the first rate hike and the next recession than currently believed.

Recessions & Bear Markets

If historical averages hold, and since major bear markets in equities coincide with recessions, the current bull market in equities has about 12-18 months left to run. But this also may be a bit overly optimistic.

Given the combination of excessive bullishness, high valuations, weak economic data it is very likely the Fed will trip up the economy, and subsequently the markets, sooner than expected.

While the markets, due to momentum, may ignore the effect of “monetary tightening” in the short-term, the longer-term has been a different story. As shown in the table below, the bulk of losses in markets are tied to economic recessions. However, there are also other events such as the Crash of 1987, the Asian Contagion, Long-Term Capital Management, and others that led to sharp corrections in the market as well.

The point is that in the short-term the economy and the markets (due to momentum) can SEEM TO DEFY the laws of gravity as interest rates begin to rise. However, as rates continue to rise they ultimately act as a “brake” on economic activity. Think about the all of the areas that are NEGATIVELY impacted by rising interest rates:

1) Debt servicing requirements increase which reduces future productive investment.

2) The housing market. People buy payments, not houses, and rising rates mean higher payments. (Read “Economists Stunned By Housing Fade” for more discussion)

3) Higher borrowing costs which lead to lower profit margins for corporations.

4) Stocks are cheap based on low-interest rates. When rates rise, markets become overvalued very quickly.

5) The economic recovery to date has been based on suppressing interest rates to spur growth.

6) Variable rate interest payments for consumers

8) Corporate share buyback plans, a major driver of asset prices, and dividend issuances have been done through the use of cheap debt.

9) Corporate capital expenditures are dependent on borrowing costs.

Well, you get the idea. If real economic growth was near historical norms of 3%, this would be a different conversation. However, at current levels, the window between a rate hike and recession has likely closed rather markedly.

Lastly, it isn’t just recessions that have impacted stocks prices in the past. It is often suggested that stocks can withstand rising interest rates.

This claim falls into the category of “timing is everything.”

The chart below has been circulated quite a bit to support the “don’t fear rising interest rates” meme. I have annotated the chart to point out the missing pieces.


While rising interest rates may not “initially” impact asset prices, it is a far different story to suggest that they won’t.

In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest rate hiking campaign that has not eventually led to a negative outcome.

What the majority of analysts fail to address is the “full-cycle” effect from rate hikes. While equities may initially provide a haven from rising interest rates during the first half of the rate cycle, they have been a destructive place to be during the last half.

It is clear from the analysis is that bad things have tended to follow the Federal Reserve’s first interest rate increase. While the markets, and economy, may seem to perform okay during the initial phase of the rate hiking campaign, the eventual negative impact will push most individuals to “panic sell” near the next lows. Emotional mistakes are 50% of the cause as to why investors consistently underperform the markets over a 20-year cycle.

For now, the bullish trend is still in place and should be “consciously” honored. However, while it may seem that nothing can stop the markets current rise, it is crucial to remember that it is “only like this, until it is like that.” For those “asleep at the wheel,”there will be a heavy price to pay when the taillights turn red.

Just something to think about.