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Monthly Archives: June 2016

Investors aren’t paying attention.

There is an important picture that is currently developing which, if it continues, will impact earnings and ultimately the stock market. Let’s take a look at some interesting economic numbers out this past week.

On Tuesday, we saw the release of the Producer Price Index (PPI) which ROSE 0.4% for the month following a similar rise of 0.4% last month. This surge in prices was NOT surprising given the recent devastation from 3-hurricanes and massive wildfires in California which led to a temporary surge in demand for products and services.

Then on Wednesday, the Consumer Price Index (CPI) was released which showed only a small 0.1% increase falling sharply from the 0.5% increase last month.

This deflationary pressure further showed up on Thursday with a -0.3 decline in Export prices. (Exports make up about 40% of corporate profits)

For all of you that continue to insist this is an “earnings-driven market,” you should pay very close attention to those three data points above.

When companies have higher input costs in their production they have two choices: 1) “pass along” those price increase to their customers; or 2) absorb those costs internally. If a company opts to “pass along” those costs then we should have seen CPI rise more strongly. Since that didn’t happen, it suggests companies are unable to “pass along” those costs which means a reduction in earnings.

The other BIG report released on Wednesday tells you WHY companies have been unable to “pass along” those increased costs. The “retail sales” report came in at just a 0.1% increase for the month. After a large jump in retail sales last month, as was expected following the hurricanes, there should have been some subsequent follow through last month. There simply wasn’t.

More importantly, despite annual hopes by the National Retail Federation of surging holiday spending which is consistently over-estimated, the recent surge in consumer debt without a subsequent increase in consumer spending shows the financial distress faced by a vast majority of consumers. The first chart below shows a record gap between the standard cost of living and the debt required to finance that cost of living. Prior to 2000, debt was able to support a rising standard of living, which is no longer the case currently.

With a current shortfall of $18,176 between the standard of living and real disposable incomes, debt is only able to cover about 2/3rds of the difference with a net shortfall of $6,605. This explains the reason why “control purchases” by individuals (those items individuals buy most often) is running at levels more normally consistent with recessions rather than economic expansions.

If companies are unable to pass along rising production costs to consumers, export prices are falling and consumer demand remains weak, be warned of continued weakness in earnings reports in the months ahead. As I stated earlier this year, the recovery in earnings this year was solely a function of the recovering energy sector due to higher oil prices. With that tailwind now firmly behind us, the risk to earnings in the year ahead is dangerous to a market basing its current “overvaluation” on the “strong earnings” story.

Don’t say you weren’t warned.

In the meantime, here is your weekend reading list.


Trump, Economy & Fed


VIDEO – It’s A Turkey Market


Markets


Research / Interesting Reads


“The only function of economic forecasting is to make astrology look respectable.” – Sir John Templeton

Questions, comments, suggestions – please email me.

“Or would you like to swing on a star
Carry moonbeams home in a jar
And be better off than you are
Or would you rather be a pig” 
Duffy’s Tavern, “Swinging on a Star” (1945)

I see downside market risk at about four times the upside reward.

I don’t believe stocks are a buy on a minor dip — a view adopted by most.

Given the outlook that there is outsize risk, I have been steadily expanding my large net short exposure.

The bearish tremors are multiplying. Let’s look at my long-term, intermediate-term, and short-term and everyday concerns.

Long-Term Concerns

Uncle Sam’s Unfunded Promises:  The Trump administration’s tax plan is not a plan. It is a melange of ideas put forth without precision or arithmetic. Any possible supply-side benefits of the tax proposal must be weighed against the dampening impact of future deficits on economic growth.

Pension Storm Warning

The Screwflation of the Middle Class:  A longstanding concern of mine, the continued income and wealth gap and the likely continued failure of trickle-down economics, holds important and adverse social, political and economic ramifications.

The Fed’s Role and Its Effect on the Markets The bullish cabal is taking an incredible leap of faith that the Fed’s tightening cycle is going to be without hiccup and essentially have been brainwashed by not just the Fed but by the actions of all central banks in believing that every slip-up will be fully rectified. The central banks believe they have cured the diseases called “bear market” and recession and convinced us that we are in a new paradigm. I would argue that this is likely a big mistake, as evidenced by the numerous policy boners by the Fed in the last one to two decades.

Washington, D.C., Is Broken and Is More Partisan Than Ever: Political polarization between the Republicans and Democrats is not rhetoric — it is reality. Like the income and wealth gap, it holds adverse and potentially grave social and economic ramifications.

Intermediate-Term Concerns

Excessive Liquidity Is Being Turned Off: Asset prices have been buoyed by massive central bank liquidity, but the shoe is being placed on the other foot in the time ahead as central bankers begin to reduce or eliminate the monetary spigot.

Stretched Multiples: Valuations, buoyed by liquidity, the popularity and proliferation of passive investing (ETFs) and dominance of quant strategies (e.g., risk parity and volatility trending) have stretched price-to-earnings multiples and other metrics (price to book and CAPE, among others) to at least the 95th decile. (See “The Active vs. Passive Conflict, and Why All Dips are Bought.”)

Stretched Multiples (Part Deux): Contrary to the consensus, we have been in a valuation-driven and not an earnings-driven market. (See “It’s an Earnings-Driven Market? Not So Fast, Kids.”)

Market Positioning and the Global Volatility Short Bubble: An extended period of low volatility absent any real market weakness that has characterized the market backdrop for several years has abetted the buy-the-dip conditioning, has made bears an endangered species by reducing the latent demand for stocks on any drop, and, importantly, has created a volatility short bubble that raises the chance of a dangerous “flash crash” and a deleveraging of risk-parity accounts. (See “More on the Global Volatility Short Bubble.”)

A Global Bond Market Bubble (see below): Many thoughtful investors I know (e.g., Lee Cooperman, Warren Buffett) express the notion that stocks are cheap relative to today’s interest rates, and as long as a rate rise is contained they can continue to prosper. Those same investors fully recognize and agree that bonds are frothy and that we are in the eighth or ninth inning of the bond bull market. To me, stocks are not cheap because the current level of rates is not likely to be a condition that lingers for very long. Bond yields likely will regress to the mean, possibly sooner than many expect. So, saying that stocks as an asset class are cheap relative to a possible Generational Low in yields — my view from June 2016 — makes little sense.

* Failing and Flailing White House Policy: Regardless of one’s political viewpoint, the administration’s fiscal initiatives have been fundamentally misshapen, delivered ineffectively and represent another trickle-down solution not likely to produce a timely economic-friendly outcome. Indeed, nearly a year after the election, not a single major piece of legislation has been passed by the Trump White House.

Short-Term Concerns

For those who have been patient and are attuned to reactionary responses, there are developing technical signposts that should concern investors:

Weakness Over There: The Euro STOXX bank index is down in eight of the last nine days. And the Euro STOXX 600 is down for the seventh straight day and is below its 500-, 200- and 100-day moving averages and at a two-month low. (Hat Tip Peter Boockvar)

The Global Bond Market Bubble (Part Deux) Is Now Deflating: The European high-yield credit index compiled by Credit Suisse yielded 1.91% last week — lower than the U.S. five-year Treasury note yield! During the last five trading days the European junk bond market has imploded. Today the European high-yield credit market yields 2.50%, up 59 basis points in a week. That is a monumental move and represents a monumental loss for those who own this asset class.

Junk Bonds Fall: The deterioration of the high-yield market relative to the climb in the broader indices has grown unusually and historically wide. The dreaded alligator formation has appeared. (See “Beware of That Gator Lurking Beneath the Surface.”)

Slowing Domestic Economic Growth Is the Message of the Bond Market and Yield Curve:  The universal view that domestic growth is on solid footing and may accelerate may be misplaced. This morning the yield on the 10-year U.S. note is down by another four basis points, yielding 2.34%. The 2s/10s curve is flattening further, by two basis points today.

Bad Breadth: Breadth is bad and worsening. As the Divine Ms. M, Helene Meisler, writes this morning, the number of new lows is expanding, the percentage of stocks trading above their 50- day moving average is decreasing and the McClellan Index indicates the majority of stocks are trending down, not up.

Sector Underperformance Accumulating: This week has witnessed a conspicuous rollover seen in biotech, transports, the Russell Index, industrials and materials; check out copper’s 2% drop yesterday and look at the charts of Freeport-McMoRan (FCX) and Glencore).

* Investor Sentiment Is at a Bullish Extreme: Investor surveys are one-sided and bullish. The spread between bulls and bears is at the highest level in over a year.

An Increasingly Speculative Overtone: The proliferation of SPAC (special-purpose acquisition company) share sales is historically another warning sign.  So is the general acceptance of covenant-lite debt offerings that have mushroomed over the last few months. And then there are the Rokuians (ROKU) — move over Iomegans.

Continuing and Everyday Concerns

Finally, my eight questions asked every morning argue in favor of lower, not higher, valuations:

  1. In a paperless and cloudy world, are investors and citizens as safe as the markets assume we are?
  2. In a flat, networked and interconnected world, is it even possible for America to be an “oasis of prosperity” and a driver or engine of global economic growth?
  3. With the G-8’s geopolitical coordination at an all-time low, how slow and inept will the reaction be if the wheels do come off?
  4. Remember when the big argument in favor of President Trump was that he was a dealmaker who knew how to get things done? That was when he was doing real estate deals. Now he has to deal with 535 other politically partisan legislators in Congress on their own real estate turf.
  5. Does the administration have the depth of experience, understand the extent of the legwork and organization required for passing legislation or have a coherent idea or shared vision of what it wants to achieve and what problems it means to solve?
  6. If President Trump can’t easily put through a health care package, what does that mean for more difficult regulatory reforms and his tax- and fiscal-policy agenda?
  7. President Trump took credit for the stock market’s advance since his election victory. Will he take responsibility for a correction? And is it a slippery slope for an administration to use the S&P 500 as a barometer of success? And is a pro-business and anti-domestic programs (in education, the arts, etc.) agenda going to benefit those in the lower and middle class (largely his base) who have suffered the most over the last decade?
  8. With the specialist system now extinct, when ETFs sell, who will buy?

Bottom Line

“You can be better than you are
You could be swingin’ on a star”

Or would you rather be a bear?

With recent new short additions of General Motors Co. (GM) , CSX Corp. (CSX) , Union Pacific Corp;. (UNP) , Caterpillar Inc. (CAT) and Deere & Co. (DE) , I am at my highest net short exposure in four years.

“Before long, we will all begin to find out the extent to which Brexit is a gentle stroll along a smooth path to a land of cake and consumption.” – Mark Carney, Bank of England Governor

In 1939, the British Government, through the Ministry of Information, produced a series of morale-boosting posters which were hung in public places throughout the British Isles. Faced with German air raids and the imminent threat of invasion, the slogans were aimed at helping the British public brave the testing times that lay ahead. The most enduring of these slogans simply read:

 “Keep Calm and Carry On.”

Ironically, it was the only one of the series that was never actually displayed in public as it was reserved for a German invasion that never transpired. Today, the British Government may wish to summon a fresh propaganda strategy to address a new threat on the horizon, that of the eventuality of Brexit.

The Kingdom Divided

The United Kingdom (UK) is in the process of negotiating out of all policies that, since 1972, formally tied it to the economic dynamics of the broader western European community. Since the unthinkable Brexit vote passage in June 2016, the unthinkable has now become the undoable. The negotiations, policy discussions, logistical considerations and legal wrangling are becoming increasingly problematic as they affect every industry in the UK from trade and finance to hazardous materials, produce, air travel and even Formula 1 racing.

The worst case scenario of a disorderly or “hard” Brexit, whereby no deal is reached by the March 2019 deadline, is the most extreme for investors along the spectrum of potential outcomes. A deadlock, which is unfortunately the most likely scenario, would result in tariffs on trade between the UK and the European Union (EU). Such an outcome would result in a rapid deterioration of British economic prospects, job losses and the migration of talent and businesses out of the country. Even before the path of Brexit is known, a number of large companies with UK operations, including Barclays Bank, Diageo, Goldman Sachs, and Microsoft, are discussing plans to move or are already actively moving personnel out of Britain. Although less pronounced, the impact of a “hard” Brexit on the EU would not be positive either.

The least damaging Brexit outcome minimizes costs and disruption to business and takes the form of agreement around many of the key issues, most notably the principle of the freedom of movement of labor. The current progression of events and negotiations suggests such an agreement is unlikely. The outcome of negotiations between the UK and the EU will be determined by politics, with the UK seeking to protect its interests while the EU and its 27 member states negotiate to protect their own.

To highlight the complexities involved, the challenges associated with reaching agreements, and why a hard Brexit seems most likely, consider the following:

  • Offering an early indication of the challenges ahead, German Prime Minister Angela Merkel stated that she wants the “divorce arrangement” to be agreed on before terms of the future relationship are negotiated. The UK has expressed a desire for these negotiations to run concurrently
  • A withdrawal agreement (once achieved) would need to be ratified by the UK
  • A withdrawal agreement would have to be approved by the European Parliament
  • A withdrawal agreement would have to be approved by 20 of the 27 member states
  • The 20 approving states must make up at least 65% of the population of the EU or an ex-UK population of 290 million people
  • If the deal on the future relationship impacts policy areas for which specific EU member states are primarily responsible, then the agreement would have to be approved by all the national parliaments of the 27 member states

The summary above shows that the unprecedented amount of coordination and negotiation required within the 27 member states and between the EU Commission, the EU Council and the EU Parliament, to say nothing of the UK.

The “do nothing and see what happens” stance taken by the British and the EU would likely deliver a unique brand of instability but one for which there is a precedent.

The last time we observed an economic event unfold in this way, investment firm Lehman Brothers disappeared along with several trillion dollars of global net worth. Although the Lehman bankruptcy was much more abrupt and less predictable, a hard Brexit seems likely to similarly roil global markets. The “no deal” exit option, which is the path currently being followed, threatens to upend the intricate and endlessly interconnected system of global financial arbitrage. Markets are complacent and seem to have resigned themselves to the conclusion that since no consequences have yet emerged, then they are not likely.

Lehman Goes Down

In late 2007 and early 2008, as U.S. national housing prices were falling, it was becoming evident that the financial sector was in serious trouble. By March of 2008, Bear Stearns was sold to JP Morgan for $2 per share in a Fed-arranged transaction to stave off bankruptcy. Bear Stearns stock traded at $28/share two days before the transaction and as high as $172 per share in January 2007. Even as evidence of problems grew throughout the summer of 2008, investors remained complacent. After the Bear Stearns failure, the S&P 500 rallied by over 14% through mid-May and was still up over 3% by the end of August following the government seizure of Fannie Mae and Freddie Mac. While investors were paying little attention, the solvency of many large financial entities was becoming more questionable. Having been denied a Federal Reserve backstop, Lehman failed on September 15, 2008 and an important link in the global financial system suddenly disappeared. The consequences would ultimately prove to be severe.

On September 16, 2008, the first trading day after Lehman Brothers filed for bankruptcy, the S&P 500 index closed at 1192. On September 25, just 10-days later, it closed 1.43% higher at 1209. The market, in short time, would eventually collapse and bottom at 666 in six short months. Investors’ inability to see the bankruptcy coming followed by an inability to recognize the consequences of Lehman’s failure seems eerily familiar as it relates to the current status of Brexit negotiations.

If all efforts to navigate through Brexit requirements are as complicated and difficult as currently portrayed, then what are we to expect regarding adverse consequences when the day of reckoning arrives? Is it unfair to suspect that the disruptions are likely to be severe or potentially even historic? After all, we are not talking about the proper dissolution of an imprudently leveraged financial institution; this is a G10 country! The parallel we are trying to draw here is not one of bankruptcy, it is one of disruptions.

As it relates to Brexit, Dr. Andreas Dombret, member of the executive board of the Deutsche Bundesbank, said this in a February 2017 speech to the Bank of International Settlements –

“So while economic policy will of course be an important topic during negotiations, we should not count on economic sanity being the main guiding principle. And that means we also have to factor in the possibility that the UK will leave the bloc in 2019 without an exit package, let alone the sweeping trade accord it is seeking. The fact that this scenario would most probably hurt economic activity considerably on both sides of the Channel will not necessarily prevent it from happening.”

Rhyming

On June 23, 2016, the day before the Brexit vote, the FTSE 100 closed at 6338. After a few hours of turbulence following the surprising results, the FTSE recovered and by the end of that month was up 2.6%. Today, the index is up 17.5% from the pre-Brexit close. The escalating risks of a hard exit from the EU clearly are not priced into the risky equity markets of Great Britain.

Data Courtesy: Bloomberg

Conversely, what has not recovered is the currency of the United Kingdom (chart below). The British Pound Sterling (GBP) closed at 1.4877 per U.S. dollar on June 23, 2016, and dropped by 15 points (-10%) to 1.33 by the end of the month following the Brexit vote. Over the past several months the pound has fallen to as low as 1.20 but more recently it has recovered to 1.33 on higher inflation readings and hawkish monetary policy language from Bank of England (BoE) governor Mark Carney. Despite following through on his recent threats to hike interest rates, the pound has begun to again trend lower.

Data Courtesy: Bloomberg

Carney has voiced concern over Brexit-induced inflation by saying that if global integration in recent decades suppressed price growth then the reduced openness to foreign markets and workers due to Brexit should result in higher inflation. This creates a potential problem for the BoE as a disorderly exit from the EU hurts the economy while at the same time inducing inflation. Such a stagflation dynamic would impair the BoE’s ability to engage in meaningful monetary stimulus of the sort global financial markets have become accustomed since the financial crisis. If the central bankers lose control of inflation, QE becomes worthless.

Some astute observers of the currency markets and BoE pronouncements argue that Carney’s threat of rate hikes are aimed at halting the deterioration of value in the pound and preventing a total collapse of the currency. That theory is speculative but plausible when analyzing the chart. Either way, whether the pound’s general weakness is driven by inflation concerns or the rising risks associated with a hard Brexit, the implications are stark.

What is equally evident, as shown below, is the laissez-faire attitude of the FTSE as opposed to the caution and reality being priced in by the currency markets. In Lehman’s case, the stock market was similarly complacent while the ten year Treasury yield dropped by nearly 2.00% from June 2007 to March 2008 (from a yield of 5.25% to 3.25%) on growing economic concerns and a flight-to-quality bid.

Data Courtesy: Bloomberg

A Familiar Problem

As discussed above, the Bank of England may find itself in a predicament where it is constrained from undertaking extreme measures due to inflation concerns or even being forced to tighten monetary policy despite an economic slowdown. Those actions would normally serve to support the pound. Further, if the prospect of a hard Brexit continues to take shape, capital flight out of the UK may overwhelm traditional factors. In efforts to prevent the disorderly movement of capital out of the country, the BoE may be required to hike interest rates substantially. Unlike the resistance of equity markets to bad news, the currency markets are more inclined, due to their size and much higher trading volume, to fairly reflect the dynamics of the economy and the central bank in a reasonable time frame.

Our perspective is not to presume a worst case scenario but to at least entertain and strategize for the range of possibilities. Equity markets, both in the UK and throughout the world, transfixed by the shell game of global central bankers’ interventionism, are clearly not properly assessing the probabilities and implications of a hard Brexit.

All things considered, the pound has rallied back to the high end of its post-Brexit range which seems to suggest the best outcome has been incorporated. If forced to act against inflation, the Bank of England will be hiking rates against a stagnant economy and a poor economic outlook.  This may provide support for the pound in the short term but it will certainly hurt an already anemic economy in the midst of Brexit uncertainty.

Summary

Timing markets is a fool’s errand. Technical and fundamental analysis allows for an assessment of the asymmetry of risks and potential rewards, but the degree of central bank interventionism is not quantifiable. With that premise in mind, we can evaluate different asset classes and their adherence to fundamentals while allowing a margin of error for the possibility of monetary intervention. After all, if central banks print money to inflate asset prices to create a wealth effect, some other asset should reveal the negative effects of conjuring currency in a fiat regime – namely the currency itself. In the short term, it may appear as though rising asset prices create new wealth, but over time, the reality is that the currency adjustments off-set some or all of the asset inflation.

Investors should take the time, while it is available, to consider the gravity of the disruptions a hard Brexit portends and look beyond high flying UK stocks to the more telling movement of the British pound. Like with Lehman and the global financial system in 2008, stocks may initially be blind to the obvious. Although decidedly not under the threats present during World War II, the British Government and the EU lack the leadership of that day and will likely need more than central banker propaganda to weather the economic storm ahead.

Keep calm and carry on, indeed.

Earlier this week, I wrote about the “Turkey” market.

What’s a “Turkey” market?  Nassim Taleb summed it up well in his 2007 book “The Black Swan.”

“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say.

On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

Such is the market we live in currently.

The video below walks you through my thoughts of the risks to investors currently of the “Turkey” market we have likely transitioned into.


You’re the Astros, not the Dodgers, Yankees or Red Sox

The city of Houston is elated, tired and relieved today with the close of an epic World Series and our team coming out on top. This has been a long time coming, 56 years to be exact and it almost feels surreal. Houston is a tough city, not in the way of these streets are tough-though some are. More in a way that we’re resilient, diverse and have that never say never attitude. Yes, baseball is just a game, but this year it’s provided some much needed reprieve from daily life in a region devastated from Hurricane Harvey.

Look back a couple of years and this is a team that endured 3 consecutive 100 loss seasons. A starting over, if you will from being a once competitive staple in the National League Central Division. This organization has had to pick itself up from bouncing around on rock bottom. They could have easily tried to spend their way out of the hole or they could very strategically and patiently draft and develop talent little by little, year by year. This is a roster that until recently was void of any top earners and really the last bet Jeff Lunhow the Astros general manager made was one of risk/reward in Justin Verlander and boy did that pay off in ways only imaginable for the Astros fans. This team is now set up for years to come, by not taking the easy way out, by sticking to their plan and enduring the process knowing that these days will come. Is this a Dynasty? Only time will tell, but they are set up for the next several years with players under contract and a clubhouse that appears to love each other’s company.

The Dodgers, Yankee’s and Red Sox have the highest payrolls in baseball and have a collective 40 World Series Championships. In retrospect, they are your too big to fail banks. You and I we’re just mere mortals. Championships were bought and paid for long ago for times just like this week. They can afford to swing and miss because they’ll just step back up in the batter’s box with more money to offer and the promise of chasing a ring to superstar free agents. Most people, companies or teams don’t have that luxury.

In a lot of ways, we’re just like this Astros team, our financial wealth generally didn’t appear from thin air. Rather it was worked on, sacrifices and plans were made. There are times life throws us curve balls in the form of sickness, job loss, natural disaster, children, death or just unexpected expenses. This is when one must remember to stay the course, market returns help grow your money, but you and your good saving and spending habits will get you to your destination.  Risk management is now key, especially when you accumulate assets or when you reach your goal. For most, that goal is retirement. Find a Jeff Lunhow or in our case an advisor to help chart your course, you see you don’t have to be the Dodgers, Yankees or Red Sox to get the prize.

The road isn’t straight nor is it easy, but just like these Astros showed a little planning, nurturing, patience, sound defense and a double or home run every now and then can get you a long way.

Every day, the A-listers, those known around the world as household-name financial media royalty, are making public statements that if taken on the surface as actionable advice, are going to lead to unpleasant financial surprises.

Not for them. For you.

As authorities, no matter what they bloviate about on radio, television and in print, their words are taken as unadulterated truth. Perhaps it’s because they believe they’re bulletproof against criticism or a half-truth is just as helpful as the complete story.

So, is all the advice they provide, incorrect? No. Much is acceptable to follow. Where they run into trouble (or where you will experience long-term disappointment), is the mysterious math of stock market returns behind those media sound bites. What is communicated about investing and what is experienced by most investors are consistently disparate outcomes.

Recently, Suze Orman the superstar financial planner outlined for CNBC, her observations on the new reality of retirement. Let’s break down where she got it correct and the information you need to know to adjust your expectations.

Read: Suze Orman says this is the ‘New Retirement Age’ – And it Might Make you Cringe.

Let’s break it down:

“70 is the new retirement age.”

I’d say Ms. Orman is close. Very close.

Per market statistician Doug Short:

 “Since January 2000, the participation rate for all the elderly has soared by 55.9 percent and for elderly women by 74.3 percent.”

There are several valid reasons for people to work longer or return to the workforce. Obviously, the primary reason for working longer is the need for cash flow as a majority of Americans are inadequately prepared for retirement.

Research conducted this year from The National Institute on Retirement Security finds that 76% of Americans are concerned about their ability to achieve a secure retirement.

A 2016 survey by Transamerica Center for Retirement Studies finds that baby boomers or those born between 1946-1964 have median retirement savings of $147,000.

So yea, Suze Orman is on to something valid here.

Sure, there are retirees who return to the workforce to remain socially and mentally engaged. Primarily, it’s to pay the bills.

Healthcare costs add up, Ms. Orman notes.

Give that financial planner a prize. Another effective electronic bit of wisdom. Fidelity Investments estimates for a couple retiring today, $275,000 should cover healthcare costs in retirement. A 6% jump over 2016.

The Employee Benefit Research Institute at www.ebri.org, in their long-running Retirement Confidence Survey, outlines how retirees dramatically underestimate their healthcare expenses in retirement (47% found their healthcare expenses somewhat and much higher!).

“Having a comfortable retirement is all about using compound interest, Orman sad at Miami’s eMerge conference in June: “You invest money and your money makes money, and the money you made with the money that you had makes money, and everything compounds.”

Well, this commentary is a bit “iffy,” as 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 inflicted long-term damage on household wealth.

When it comes to compounding, investors should never suffer torturous time to breakeven. Compound interest works if the rate of interest is consistent, not variable. You wouldn’t know it from stocks, especially this year, but from what I know, stocks are indeed a variable, and occasionally, volatile asset class.

So sorry, Suze. This bit of knowledge? Strike out. Not everything compounds.

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

This statement perplexes me. While I wholeheartedly agree with a monthly investing or saving discipline spouted here, especially into a Roth IRA where earnings grow tax-deferred and withdrawn tax-free at retirement, I had a dilemma making her retirement numbers work.

As outlined in the chart above, on an inflation-adjusted basis, achieving a million-buck balance in 40 years by dollar-cost averaging $100 a month, requires a surreal 11.25% annual return. In the real world (not the superstar pundit realm), a blind follower of Suze’s advice would experience a whopping retirement funding gap of $695,254.68.

I don’t know about you, to me this is a Grand Canyon expectation vs. reality-sized unwelcomed surprise.

On a positive note, investing on a disciplined basis for 40 years still results in a retirement account balance most Americans nearing retirement would envy. However, it’s far from a million as touted so effervescently by Ms. Orman.

Overall, I give Suze Orman a C+ for her media-pundit ponderings this time around. She performed better than others whose words of wisdom I parse.

Financial star-power across the board fizzles out when it comes to sharing long-term stock performance reality and debunking the fictional warm and fuzzy story of compounding. It’s like they’re all afraid to share the truth about market cycles, the math of loss and how compounding does not apply adequately to variable assets.

When it comes to shortfalls in reaching goals established in a financial plan, it’s not those smiling faces on the financial wall of fame that are accountable to you. If they’re wrong, it seems the public has short memories and willing to give them a pass. Must be nice.

“Hey, they must be right, they’re the pundits! The problem must be me!”

No, the problem isn’t you unless of course, you’re a blind follower of the taffy-truth pulling of financial media superstars.

If you’re a reader of Real Investment Advice, then I find comfort in knowing you’re never a blind follower; your perspectives are grounded in reality.

“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 or via Twitter.


With Thanksgiving week rapidly approaching, I thought it was an apropos time to discuss what I am now calling a “Turkey” market.

What’s a “Turkey” market?  Nassim Taleb summed it up well in his 2007 book “The Black Swan.”

“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say.

On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

Such is the market we live in currently.

In a market that is excessively bullish and overly complacent, investors are “willfully blind” to the relevant “risks” of excessive equity exposure. The level of bullishness, by many measures, is extremely optimistic, as this chart from Tiho Krkan (@Tihobrkan) shows.

Not surprisingly, that extreme level of bullishness has led to some of the lowest levels of volatility and cash allocations in market history.

Of course, you can’t have a “Turkey” market unless you are being lulled into it with a supporting story that fits the overall narrative. The story of “it’s an earnings-driven market” is one such narrative. As noted  by my friend Doug Kass:

“Earnings are there to support the market. If we didn’t have earnings to support the market, that would be worrying. But we have earnings.”
Mary Ann Bartels, Merrill Lynch Wealth Management

“Earnings are doing remarkably well.”
Ed Yardeni, Yardeni Research

“This is very much an earnings-driven market.”
Paul Springmeyer, U.S. Bancorp Private Wealth Management

This is very much earnings-driven.”
Michael Shaoul, Marketfield Asset Management

“Equities have largely been driven by global liquidity, but they are now being driven by earnings.”
Kevin Boscher, Brooks Macdonald International

“Most of the market action in 2017 has been earning-driven.”
Dan Chung, Alger Management

“The action is justified because of earnings.
James Liu, Clearnomics

In another case of “Group Stink” and contrary to the pablum we hear from many of the business media’s talking heads, the U.S. stock market has not been an earnings-driven story in 2017. (I have included seven “earnings-driven” quotes above from recent interviews on CNBC, but there are literally hundreds of these interviews, all saying the same thing)

Rather, it has been a valuation-driven story, just as it was in 2016 when S&P 500 profits were up 5% and the S&P Index rose by about 11%. And going back even further, since 2012 S&P earnings have risen by 30% compared to an 80% rise in the price of the S&P lndex!

He is absolutely right, of course, as I examined in the drivers of the market rally three weeks ago.

“The chart below expands that analysis to include four measures combined: Economic growth, Top-line Sales Growth, Reported Earnings, and Corporate Profits After Tax. While quarterly data is not yet available for the 3rd quarter, officially, what is shown is the market has grown substantially faster than all other measures. Since 2014, the economy has only grown by a little less than 9%, top-line revenues by just 3% along with corporate profits after tax, and reported earnings by just 2%. All of that while asset prices have grown by 29% through Q2.” 

The hallmark of a “Turkey” market really comes down to the detachment of price from valuation and the deviation of price from long-term norms. Both of these detachments are shown in the charts below.

CAPE-5 is a modified version of Dr. Robert Shiller’s smoothed 10-year average. By using a 5-year average of CAPE (Cyclically Adjusted Price Earnings) ratio, it becomes more sensitive to market movements. Historically, deviations above 40% have preceded secular bear markets, while deviations exceeding -40% preceded secular bull markets.

The next chart shows the deviation of the real, inflation-adjusted S&P 500 index from the 6-year (72-month) moving average.

Not surprisingly, when the price of the index has deviated significantly from the underlying long-term moving averages, corrections and bear markets have not been too distant.

Combining the above measures (volatility, valuation, and deviation) together shows this a bit more clearly. The chart shows both 2 and 3-standard deviations above the 6-year moving average. The red circles denote periods where valuations, complacency and 3-standard deviation moves have converged. 

Of course, with cash balances low, you can’t foster that kind of extension without sufficiently increasing leverage in the overall system. The expansion of margin debt is a good proxy for the “fuel” driving the bull market advance.

Naturally, as long as that “fuel” isn’t ignited, leverage can remain supportive of the market’s advance. However, when the reversion begins, the “fuel” that drove stocks higher will “explode” when selling forces liquidation through margin calls.

While the media continues to suggest the markets are free from risk, and investors should go ahead and “stick-their-necks-out,” history shows that periods of low volatility, high valuations and deviations from long-term means has resulted in very poor outcomes.

Lastly, there has been a lot of talk about how markets have entered into a new “secular bull market” period. As I have addressed previously, I am not sure such is the case. Given the debt, demographic and deflationary backdrop, combined with the massive monetary interventions of global Central Banks, it is entirely conceivable the current advance remains part of the secular bear market that began at the turn of the century.

Only time will tell.

Regardless, whether this is a bull market rally in an ongoing bear market, OR a bull rally in a new bull market, whenever the RSI (relative strength index) on a 3-year basis has risen above 70 it has usually marked the end of the current advance. Currently, at 84, there is little doubt the market has gotten ahead of itself.

No matter how you look at it, the risk to forward returns greatly outweighs the reward presently available.

Importantly, this doesn’t mean that you should “sell everything” and go hide in cash, but it does mean that being aggressively exposed to the financial markets is no longer opportune.

What is clear is that this is no longer a “bull market.”

It has clearly become a “Turkey” market. Unfortunately, like Turkeys, we really have no clue where we are on the current calendar. We only know that today is much like yesterday, and the “bliss” of calm and stable markets have lulled us into extreme complacency.

You can try and fool yourself that weak earnings growth, low interest rates and high-valuations are somehow are justified. The reality is, like Turkeys, we will ultimately be sadly mistaken and learn a costly lesson.

“Price is what you pay, Value is what you get.” – Warren Buffett

Turn on financial television or pick up a financially related magazine or newspaper and you will hear, or read, about what an analyst from some major Wall Street brokerage has to say about the markets or a particular company. For the average person, and for most financial advisors, this information as taken as “fact” and is used as a basis for portfolio investment decisions.

But why wouldn’t you?

After all, Carl Gugasian of Dewey, Cheatham & Howe just rated Bianchi Corp. a “Strong Buy.” That rating is surely something that you can “take to the bank”, right?

Maybe not.

For many years, I have been counseling individuals to disregard mainstream analysts, Wall Street recommendations, and even MorningStar ratings, due to the inherent conflict of interest between the firms and their particular clientèle. Here is the point:

  • YOU, are NOT Wall Street’s client.
  • YOU are the CONSUMER of the products sold FOR Wall Street’s clients.

Major brokerage firms are big business. I mean REALLY big business. As in $1.5 Trillion a year in revenue big. The table below shows the annual revenue of 32 of the largest financial firms in the S&P 500.

(The combined revenue of the 32 largest firms last year was in excess of $1 Trillion with the revenue of the 97 financial firms in the S&P 500 bringing in $1.5 Trillion.)

As such, like all businesses, these companies are driven by the needs of increasing corporate profitability on an annual basis regardless of market conditions.

This is where the conflict of interest arises.

When it comes to Wall Street profitability the most lucrative transactions are not coming from servicing “Mom and Pop” retail clients trying to work their way towards retirement. Wall Street is not “invested” along with you, but rather “use you” to make income.

This is why “buy and hold” investment strategies are so widely promoted. As long as your dollars are invested the mutual funds, stocks, ETF’s, etc, brokerage firms collect fees regardless of what happens in the market. These strategies are certainly in their best interest – they are not necessarily in yours.

But those retail management fees are simply a sideline to the really big money.

Wall Street’s real clients are multi-million, and billion, dollar investment banking transactions, such as public offerings, mergers, acquisitions and bond offerings which generate hundreds of millions to billions of dollars in fees for Wall Street each year.

In order for a firm to “win” that business, Wall Street firms must cater to those prospective clients. In this respect, it is extremely difficult for the firm to gain investment banking business from a company they have a “sell” rating on. This is why “hold” is so widely used rather than “sell” as it does not disparage the end client. To see how prevalent the use of the “hold” rating is I have compiled a chart of 4625 stocks ranked by the number of “Buy”, “Hold” or “Sell.”

See the problem here. There are just 2.8% of all stocks with a “sell” rating.

Do you actually believe that out of 4625 stocks only 124 should be “sold?”

You shouldn’t.  But for Wall Street, a “sell” rating is simply not good for business.

The conflict doesn’t end just at Wall Street’s pocketbook. Companies depend on their stock prices rising as it is a huge part of executive compensation packages.

Corporations apply pressure on Wall Street firms, and their analysts, to ensure positive research reports on their companies with the threat that they will take their business to another “friendlier” firm.  This is also why up to 40% of corporate earnings reports are “fudged” to produce better outcomes.

Earnings Magic Exposed, an article written by Michael Lebowitz last year, provides details on the games played on Wall Street when it comes to forecasting corporate earnings. He summarized the article as follows:

Consider the ploy that companies and Wall Street are using to fool the investing public.

  • First, they grossly overestimate earnings for the upcoming year. By overestimating earnings, they tout financial ratios based upon inaccurate expected earnings and sell investors on a bright future. How many times have analysts claimed that forward looking price to earnings ratios are constructive for price gains? How “constructive” would they be if the expectations were reconciled to reality and lowered by 75%?
  • Second, they progressively lower expectations prior to the earnings release so that financial results are effectively underestimated. The same analysts that peddled double digit earnings growth a year earlier somehow can now claim that earnings are better than they expected.

If actual earnings varied somewhat randomly from above expectations to below expectations, we would likely fault the analysts and corporations with being poor forecasters. But when such one-directional forecasting errors routinely and consistently occur, it is more than bad forecasting. At best one can accuse Wall Street analysts and the companies that feed them information of incompetence. At worst this is another pure and simple case of institutions gaming the system through a fraud designed to prop up stock prices.  Take your pick, but in either case it is advisable to ignore the spin that accompanies earnings releases and apply the rigor of doing your own analysis to get at the veracity of corporate earnings.

Wall Street Needs You To Sell Product To

When Wall Street wants to do a stock offering for a new company they have to sell that stock to someone in order to provide their client, a company, with the funds they need. The Wall Street firm also makes a very nice commission from the transaction.

Generally, these publicly offered shares are sold to the firm’s biggest clients such as hedge funds, mutual funds, and other institutional clients. But where do those firms get their money? From you.

Whether it is the money you invested in your mutual funds, 401k plan, pension fund or insurance annuity – at the bottom of the money grabbing frenzy is you. Much like a pyramid scheme – all the players above you are making their money…from you.

In a study by Lawrence Brown, Andrew Call, Michael Clement and Nathan Sharp it is clear that Wall Street analysts are clearly not that interested in you. The study surveyed analysts from the major Wall Street firms to try and understand what went on behind closed doors when research reports were being put together. In an interview with the researchers John Reeves and Llan Moscovitz wrote:

“Countless studies have shown that the forecasts and stock recommendations of sell-side analysts are of questionable value to investors. As it turns out, Wall Street sell-side analysts aren’t primarily interested in making accurate stock picks and earnings forecasts. Despite the attention lavished on their forecasts and recommendations, predictive accuracy just isn’t their main job.”

The chart below is from the survey conducted by the researchers which shows the main factors that play into analysts compensation.  It is quite clear that what analysts are “paid” to do is quite different than what retail investors “think” they do.

“Sharp and Call told us that ordinary investors, who may be relying on analysts’ stock recommendations to make decisions, need to know that accuracy in these areas is ‘not a priority.’ One analyst told the researchers:

‘The part to me that’s shocking about the industry is that I came into the industry thinking [success] would be based on how well my stock picks do. But a lot of it ends up being “What are your broker votes?”‘

A ‘broker vote’ is an internal process whereby clients of the sell-side analysts’ firms assess the value of their research and decide which firms’ services they wish to buy. This process is crucial to analysts because good broker votes result in revenue for their firm. One analyst noted that broker votes ‘directly impact my compensation and directly impact the compensation of my firm.'”

The question really becomes then “If the retail client is not the focus of the firm then who is?”  The survey table below clearly answers that question.

Not surprisingly you are at the bottom of the list. The incestuous relationship between companies, institutional clients, and Wall Street is the root cause of the ongoing problems within the financial system.  It is a closed loop that is portrayed to be a fair and functional system; however, in reality, it has become a “money grab” that has corrupted not only the system but the regulatory agencies that are supposed to oversee it.

Why You Need Independence

So, where can you go to get “real investment advice” and a true consideration of the value of YOUR money?

Thankfully, starting at the turn of the century, the rise of independent, fee-only, financial advisors, private investment analysts, research and rating firms began to infiltrate the system. 

Here is an example of the difference.

As an independent money manager, I use valuation analysis to determine what equities should be bought, sold or held in client’s portfolios. While there are many measures of valuation, two of my favorites are Price to Sales and the Piotroski f-score among others. I took the same 4625 stocks as above and ranked them by these two measures.

See the difference. Not surprisingly, there are far fewer “buy” rated, and far more “sell” rated, companies than what is suggested by Wall Street analysts.

Here is something even more alarming.

Just after the “dot.com” bust, I wrote a valuation article quoting Scott McNeely, who was the CEO of Sun Microsystems at the time. At its peak the stock was trading at 10x its sales. (Price-to-Sales ratio) In a Bloomberg interview Scott made the following point.

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees.That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

How many of the following “Buy” rated companies do you currently own that are currently carrying price-to-sales valuations in excess of 10x?

So, what are you thinking?

As more and more “baby boomers” head into retirement the need for firms that can do organic research, analysis and make investment decisions free from “conflict,” and in the client’s best interest, will continue to be in high demand in the years to come.

This is particularly the case when the next downturn occurs and the dangers of passive ETF indexing and robo-advisors are readily exposed.

Independent advice can help remove those emotional biases from the investing process that lead to poor investment outcomes over time. There are a raft of advisors with the the right team, tools and data, who can spend the time necessary to manage portfolios, monitor trends, adjust allocations and protect capital through risk management.

The next time someone tells you that you can’t “risk manage” your portfolio and just have to “ride things out,” just remember, you don’t.

You, and your money, deserve better. 

As I noted last Friday, the recently approved budget was an anathema to any fiscally conservative policy. As the Committee for a Responsible Federal Budget stated:

“Republicans in Congress laid out two visions in two budgets for our fiscal future, and today, they choose the path of gimmicks, debt, and absolutely zero fiscal restraint over the one of responsibility and balance.

Passing fiscally irresponsible budgets just for the sake of passing “tax cuts,” is, well, irresponsible. Once again, elected leaders have not listened to, or learned, what their constituents are asking for which is simply adherence to the Constitution and fiscal restraint.”

I then followed this up this past Monday with “3 Myths Of Tax Cuts” stating:

“Tax cuts do not pay for themselves; they can create growth, but in the amount of tenths of percentage points, not whole percentage points. And they certainly cannot fill in trillions in lost revenue. Relying on growth projections that no independent forecaster says will happen isn’t the way to do tax reform.

As the chart below shows there is ZERO evidence that tax cuts lead to stronger sustained rates of economic growth. The chart compares the highest tax rate levels to 5-year average GDP growth. Since Reagan passed tax reform, average economic growth rates have only gone in one direction.”

On Thursday, Fitch confirmed the same in their dismal report on the reality of what the effect of the “tax cut”

“Such reform would deliver a modest and temporary spur to growth, already reflected in growth forecasts of 2.5% for 2018. However, it will lead to wider fiscal deficits and add significantly to US government debt. As such, Fitch has revised up its medium-term debt forecast. US federal debt was 77% of GDP for this fiscal year. Fitch believes the tax package will be revenue negative, even under generous assumptions about its growth impact. Under a realistic scenario of tax cuts and macro conditions, the federal deficit will reach 4% of GDP by next year, and the US debt/GDP ratio would rise to 120% of GDP by 2027.

Tax cuts may lead to a short-lived boost to output, but Fitch believes that they will not pay for themselves or lead to a permanently higher growth rate. The cost of capital is already low and corporate profits are elevated. In addition, the effective tax rate paid by large corporations is well below the existing statutory rate.

Fitch expects US economic growth to peak at 2.5% in 2018 before falling back to 2.2% in 2019. The US will enter the next downturn with a general government “structural deficit” (subtracting the impact of the economic cycle) larger than any other ‘AAA’ sovereign, leaving the US more exposed to a downturn than other similarly rated sovereigns. The US is the most indebted ‘AAA’ country and it is running the loosest fiscal stance. Long-term debt dynamics are also more negative than those of peers, with health and social security spending commitments set to rise over the next decade. “

There is nothing “good” in any of the statements above,  and drive to the same conclusions I discussed last Monday.

You can’t solve a debt problem, by issuing more debt. 

While Congressional members continue campaigning that the “tax plan” would give an $1182 tax cut to most Americans, and boost wages by $4000, such has never been the case. A recent study by the Economic Policy Institute suggested the same in a recent study:

“Cutting corporate tax rate cuts would do very little to boost employment generation. In fact, cutting corporate tax rates ranks as the least effective form of fiscal support for employment generation, since corporate tax cuts primarily benefit rich households—who are less likely to increase their consumption than low- or middle-income households when they receive tax cuts.”

This is a point I have made previously. Corporate tax rate cuts will unambiguously redistribute post-tax income regressively. The corporate income tax is a progressive tax, with the top 1% of households accounting for 47% of the corporate income tax.

Don’t be bamboozled by the idea that tax cuts and reforms will lead to sustained economic growth. There is simply NO evidence that such is the case over the long-term.

However, there is plenty of evidence to suggest that further costly reforms and run-away budgets will lead to an increase of the current national debt and the ongoing low-growth economy that has plagued the U.S. since the turn of the century.

In other words….“it’s the debt, stupid.”

In the meantime, here is your weekend reading list.


Trump, Economy & Fed


VIDEO – Tax Cut/Reform Discussion (Real Investment News)


Markets


Research / Interesting Reads


“In investing, what is comfortable is rarely profitable.” – Rob Arnott

Questions, comments, suggestions – please email me.

Here we go again…

Since June of 2013, I have been writing about the reasons why rates can’t rise much and why calls for the end of the “bond bull market” remain wrong.

Regardless, about every 3-months or so, there is a tick up in rates and you can almost bet that soon thereafter will be a litany of articles explaining why THIS time the “bond bull market” is really dead. For example, just from this past week:

What is the argument from low rates will rise?

It basically boils down to simply this – rates are so low they MUST go up.

The problem, however, is that interest rates are vastly different than equities. When people go to make a purchase on credit, borrow money for a house, or get a loan for a new car, they don’t ask what the level of the stock market is but rather “how much will this cost me?” The differentiator between making a purchase, or not, is based on the simple outcome of the interest rate effect on the loan payment. If interest rates rise too much, consumption stalls, and along with it economic growth, causing rates to go lower. If economic demand is robust, rates rise to meet the demand for credit.

The trend and level of interests are the singular best indicator of economic activity. As Doug Kass recently noted:

“The spread between the two- and ten-year U.S. notes has fallen to 68 basis points — that’s the lowest print in ten years and if history is a guide it is signaling a potential domestic economic slowdown.”

“The flattening in the yield curve is happening despite a likely continued Federal Reserve tightening and a rise back to December levels for overnight index swaps (OIS). It was back in 2004 — as the Fed started its tightening cycle (that concluded in Summer, 2006) — that both the curve flattened and the five year OIS rose. At the conclusion of the tightening in the middle of 2006, a deep recession followed by about fifteen to eighteen months later.”

In other words, “It’s the economy, stupid.”

Economic Growth Drives Rates

The chart below is a history of long-term interest rates going back to 1857. The dashed black line is the median interest rate during the entire period. I have compared it to the 5-year nominal GDP growth rate during the same period.

(Note: As shown, interest rates can remain low for a VERY long time.)

Interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time.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 its 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.

Beginning in the late 50’s, America embarked upon its greatest quest in history as man took his first steps into space. The space race that lasted nearly twenty years led to leaps in innovation and technology that paved the wave for the future of America. Combined with the industrial and manufacturing backdrop, America experienced high levels of economic growth and increased savings rates which fostered the required backdrop for higher interest rates.

Currently, the U.S. is no longer the manufacturing powerhouse it once was and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. Today, the number of workers between the ages of 16 and 54 is at the lowest level relative to that age group since the late 70’s. This is a structural and demographic problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance.

This structural employment problem remains the primary driver as to why “everybody” is still wrong in expecting rates to rise.

As you can see there is a very high correlation, not surprisingly, between the three major components (inflation, economic and wage growth) and the level of interest rates. Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically, the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. (Currently, we do not have the type of inflation that leads to stronger economic growth, just inflation in the costs of living that saps consumer spending – Rent, Insurance, Health Care)

The chart above is a bit busy, but I wanted you to see the trends in the individual subcomponents of the composite index. The chart below shows only the composite index and the 10-year Treasury rate. Not surprisingly, the recent decline in the composite index also coincides with a decline in interest rates.

In the current economic environment, the need for capital remains low, outside of what is needed to absorb incremental demand increases caused by population growth, as demand remains weak. While employment has increased since the recessionary lows, much of that increase has been the absorption of increased population levels.

Many of those jobs remain centered in lower wage paying and temporary jobs which do not foster higher levels of consumption. To offset weaker organic consumption, artificially suppressed interest rates, though monetary policy, gives the appearance of economic growth by dragging forward future consumption which leaves a future “void” that has to be continually refilled.

Currently, there are few economic tailwinds prevalent that could sustain a move higher in interest rates. The reason is that higher interest reduces the flow of capital within the economy. For an economy that remains dependent on the generosity of Central Bankers, rising rates are not the outcome that “stock market bulls” should NOT be rooting for.

The Implications Of A Bond Bust

If there is indeed a bond bubble, a burst would mean bonds decline rapidly in price pushing interest rates markedly higher. This is the worst thing that could possibly happen. 

1) The Federal Reserve has been buying bonds for the last 9- years in an attempt to push interest rates lower to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.

2) The Federal Reserve currently runs the world’s largest hedge fund with over $4 Trillion in assets. Long Term Capital Mgmt. which managed only $100 billion at the time nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 45x that size.

3) Rising interest rates will immediately kill the housing market, not to mention the loss of the mortgage interest deduction if the GOP tax bill passes, taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

4) An increase in interest rates means higher borrowing costs which lead to lower profit margins for corporations. This will negatively impact the stock market given that a bulk of the “share buybacks” have been completed through the issuance of debt.

5) One of the main arguments of stock bulls over the last 9-years has been the stocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.

6) The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.

7) As rates increase so does the variable rate interest payments on credit cards.  With the consumer are being impacted by stagnant wages, higher credit card payments will lead to a rapid contraction in income and rising defaults. (Which are already happening as we speak)

8) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.

9) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.

10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.

I could go on but you get the idea.

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.

I won’t argue there is much room 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. This idea suggests is that there is one other possibility that the majority of analysts and economists ignore which I call the “Japan Syndrome.”

Japan is has been fighting many of the same issues for the past two decades. The “Japan Syndrome” suggests that while interest rates are near lows it is more likely a reflection of the real levels of economic growth, inflation, and wages.

If that is true, then rates are most likely “fairly valued” which implies that the U.S. could remain trapped within the current trading range for years as the economy continues to “muddle” along.

The irrationality of market participants, combined with globally accommodative central bankers, continue to push asset values higher and concentrate investors into the ongoing “chase for yield.” There isn’t much guessing on how this will end, history tells us that such things rarely end well.

Written By: Richard Rosso & Byron Kidder, Jr.

The human capital investment is a topic that very few on the front lines of finance wish to tackle.

Thankfully, there is a growing generation of financial professionals who on an hourly or monthly retainer fee basis act as holistic money coaches and are dedicated to partner with young professionals to help formulate and monitor fiscal steps that get them from soil (the basics of debt, saving & investment), to harvest (retirement).

So, what is human capital investment exactly?

The human capital investment is simply, YOU. Yes. YOU are an investment. The greatest investment. A lifetime money-making powerhouse. Earnings if directed wisely, result in long-term financial security and perhaps more important, a career passion that continues up to and far into retirement.

As adults, we have been counseled to invest financially through real estate, stocks, retirement, etc. but not always in ourselves…at least not to the same extent.  At Real Investment Advice, we believe that human capital investment is one of the biggest ROIs and should be treated with the same importance as traditional financial investment.  We call it “Return On You.”

The Census Bureau data shows the average American with a Bachelor degree earned $2.4 million over their lifetime in 2013.  It is hard to argue with these figures when AARP published the average seasoned American (e.g. at least 55-years-old) had $255,000 in their retirement account during the same year.

Formal education is important to earnings potential, but it’s merely the beginning of a lifelong learning process. The economy and career paths appear to be in constant flux; it’s easier than ever to lose the competitive edge.

Fortunately, unlike financial investments where many variables are out of our control, we do possess the ability to strategize and take ownership of human-capital gains whether personal or professional.

So, how do you begin to untap your peak human capital potential and eventually increase earnings power?

Here are 5 easy starter points.

Break it down to the basics.

Your ability to be a life-long learner in your field or passion of choice, share and then communicate that information in a simple manner, will allow deeper and memorable connection with others.

In my opinion, the absence of effective communication is one of the leading causes of career stagnation.  You must leave a positive impression, an impact in a world that is drowning in information. How will you stand out?

The spirit of communication begins with the role of active listener and using the technique to build on the basics of memorable verbal communication. Active listeners are masters of the quiet observation and ironically, the best communicators out there.

They are open and inviting in tone and mannerisms; they allow others to speak and share before responding. Active listeners become adept at the identification of key words, hot buttons, or motivations of others and follow up with open-ended questions using the same words or hot buttons, to gain clarification and foster bonding.

Active listeners care about those they encounter. They’re naturally inquisitive. Warm, direct eye contact and mental focus are important throughout the active listening process. You know you’ve met up with an active listener when you feel like you’re the most important person in the room during your time together.

There are no barriers or “airs” about them. There’s a genuine curiosity they wear on their sleeves and frankly, it makes them irresistible. It makes them leaders. It helps them gain promotions and earn more than their counterparts.

One of my favorite books on the topic is John C. Maxwell’s “Becoming a Person of Influence: How to Positively Impact the Lives of Others.”

Passion is the key that unlocks purpose.

Passion is a perpetual source of energy that allows an individual to plow through any challenge and discover the opportunities within them that most will overlook.

Over the coming weeks, I will share stories of how I found my passion and will introduce topics from my book “It’s All About Everything.” I’ll outline easy to implement strategies that will help you be the best you can be for yourself, clients, employers, family, and friends.

My goal is two-fold: to assist those who need the education, motivation and inspiration to elevate their careers and “nudge,” those who are stuck and seeking a way to forge an entrepreneurial path to success.

If you currently work a corporate job you dislike or feel stuck in an organization that conflicts with your passions and ethics, hanging around to collect a paycheck will ostensibly disconnect you from what makes you unique. The longer you stay, the unhealthier mentally and physically you’ll become.

Hey, breaking free from “The Matrix,” isn’t easy.

Studies show that people are less mobile today. In other words, they feel trapped and won’t transfer to where the opportunities are especially if it means packing up and leaving the security of a hometown or a bedroom at the parents’ house.  Learning to embrace change is not always an easy task and is often a barrier to the progression of one’s life goals.

That’s why living below your means financially and minimizing debt is so empowering to your future. If seeking to eventually break away from the cubicle coffin, you must manage the chains of personal liabilities. Without excess debt, you’ll have choices, be free to travel where the opportunities are.

At Real Investment Advice, we’ve created debt guidelines to empower you on the journey back to “YOU.” Check out Guardrail #4.

Begin a daily ritual.

To discover or re-ignite your passion, you must get to know who YOU are again. The YOU before the office politics, the YOU before the boss who made you feel inadequate, the YOU that commands a higher wage. But how?

Grit. It takes grit. The grit is comprised of small, measured steps taken to achieve the big goal. Hit the target. It’s the grind, albeit boring cadence of daily activities that nobody pats you on the back for; there are little social media accolades given. However, grit is the DNA that seeds the fire of who you want to be. Grit is fueled by your passion to win, and it begins with your daily rituals required to get to know yourself, again.

The daily ritual is comprised of those physical, emotional and mental activities undertaken to reunite you with your passions. Rich Rosso’s friend and mentor James Altucher calls this ritual a daily practice. The practice you personally craft is what makes your grit different from anybody else’s.

Change your mindset.

It’s never too late to take a new road. I was a late bloomer and returned to college at 22 and graduated at 26.  At the time, it felt like I was too old to change course, but my father provided some wisdom and emphasized “it is never too late.”

Who are the gatekeepers who deem us as too old? What does that mean?

Have you ever thought about who creates these mores and how they’re detrimental to your personal growth and earnings potential?

I’ve created my own set of rules. They arose through successes and most important, my failures. They are deliberately kept easy to understand, yet profoundly relevant to my journey.  If one person can be reached resulting in a better life leading to self-discovery, improved relationships, and increased business opportunities, I have succeeded.

I dropped out of college; it was my first impactful experience with failure.  It was demoralizing.  I could have stopped there but eventually realized that college was an investment. I went from drop out to a graduate with honors in Chemical Engineering.

Hey, everybody makes mistakes; however, failure is temporary and eventually realized as progress toward success. Learning to navigate one’s hills and valleys is an essential part of a person’s growth in both business and life. As a result of personal experiences, I developed simple self-improvement tools and happily share them.

For example, one strategy to improve or create a positive mindset (self-esteem, too), is to gain a reputation as a connector, the “go-to” person. Think of a connector as a human conduit, a matchmaker of sorts who is there to forge or facilitate a communication link between two people. Whether it’s for a service, or referral, be the reason for an engagement of others that eventually leads to overall positive outcomes. You’ll never be forgotten.  It’s all about creating good impactful memories.

Read, read again, then write.

Passionate readers and writers travel an indomitable path of self-discovery and analysis.

Rich has a reading goal of one new book a month. I know he’s re-reading “Never Eat Alone,” by Keith Ferrazzi & Tahl Raz. An excellent tome that outlines how to build lasting, life-changing relationships.

Reading leads to writing. Even if only 100 words a day, writing (not typing), will help you connect to what’s important and strengthen your ability to think and create.

Begin with a daily journal. Allot 30-45 minutes every day to write. I prefer mornings as it sets the tone for the day, but some are peak creative when the sun sinks low in the sky.

Rich’s journal of choice (which I endorse), is The Morning Sidekick Journal. Ten minutes will be all you’ll need to get focused for the rest of the day.

Finally, it’s an honor to join the “Money Avengers” radio team for the Real Investment Hour. I am excited to share my insights during each of the Human Capital Investment segments. The goal is to provide listeners with strategies as inspiration for success and earning more to save and invest even more.

Some rules will be easy to implement; others will require habitual application.  Like most habits, consistency and conscientious learning are keys to making them second nature.

Join me as we dive deeper into those tenets, through Real Investment Advice and the Real Investment Hour.


Byron Kidder is an engineer, author, business owner, and renowned sales and managerial professional within his fields of occupation.  He has honed the ability to not only understand his clients’ needs but deliver services beyond their expectations.  Mr. Kidder’s positive energy is contagious, and he hopes his best-in-class service will be too.

“I am a walking, talking enigma. We are a dying breed.” – Larry David, “Curb Your Enthusiasm” 

The Bear Cave has become a lonely place; like the dodo bird, bears are an endangered species.

And so has the contrary, non-consensus view become endangered.

Like Larry David, I am candid and can be neurotic, but I am generally disposed to pursuing what I perceive to be the right investment course!

At times like this, when the pendulum of investor optimism has moved to the right and some valuations have moved to the 95th percentile as every dip is being purchased, it is the best of times to consider the value of contrarian opinions, as I did in this early 2016 column:

“If past history was all there was to the game, the richest people would be librarians.” – Warren Buffett

There’s a broad market bias that’s geared toward both consensus and the bullish thinking often delivered by Wall Street, the business community and the financial media.

I understand that there’s a certain comfort in crowds, as well as a distrust of the remnants of individual opinion. I suppose that’s a function of the human condition, human spirit and human nature.

But in today’s interconnected world, all market, business and economic cycles arguably change with greater rapidity at any other time in human history. So, smart investors must be adaptive, anticipatory and stay on the alert.

Let’s look at some of the problems that we as investors face in doing so:

Business TV

“I never knew the game of baseball was so easy until I entered the broadcasting booth.” Mickey Mantle

Let me start by sharing that the following is not meant as an indictment of all of the business media.

But like most investors, business TV networks are often reactive. The media all too infrequently provide a platform for bearish views when stocks are robust, and all too infrequently provide a platform for bullish views when stocks have been battered.

Guests delivering “the contrary” are in the minority and often considered as investment pariahs. And when they do appear, they’re sometimes even bitterly criticized by commentators.

Of course, there are exceptions to this rule. I recently had an exchange with an old pal who hosts a popular CNBC show and who purposely tries to present guests with the “contrary.” He doesn’t suffer bullish fools lightly.

The reasons for the generally bullish bias are clear:

  • There’s a gravitational pull over history toward higher stock prices.
  • The long-investment community dominates the landscape. Like the dodo bird, shorts are scarce (and have gotten even more scarce in recent years).
  • Bullish sentiment sells better than bearishness.
  • Investors prefer a rising, profitable market to a declining, unprofitable one.
  • Who wants to hear that the market and individual stock outlooks stink?

All told, self-confidence of view and bullish commentary are nearly systemic on business TV despite growing possibilities of numerous outcomes (some of them adverse).

Check out Dr. Jeremy Siegel on CNBC yesterday. He and many other “talking heads” rarely seem as if they’ve met a market that they didn’t like.

“‘I was far too bullish last December,’ Siegel admitted, referring to a prediction then that valuations could stay on the high side. In November, he had even called the idea of the Dow hitting 20,000 during 2016 ‘a real possibility.'”

A Still-Conflicted Analyst Community

Analysts travel in crowds — their earnings estimates are typically grouped in close ranges. And many still face conflicts of interest despite former New York Attorney Gen. Elliot Spitzer’s 2003 efforts to separate Wall Street research from investment banking.

As Jim Grant has noted, Wall Street exists not to sell profitable and objective ideas, but to sell investment products.

Analysts who deliver “Sell” recommendations are often ostracized, and sometimes even barred from company conference calls (as has happened to banking analyst Mike Mayo).

Other analysts are destined to become part of the investor-relations or finance departments of companies they follow, so why jeopardize things with critical analysis?

Perennially Upbeat Managements

Too many company managements are “The Sunshine Boys,” parading in the media with their monotonous bullish melodies. And too often, these upbeat outlooks go unquestioned.

Business has cycles, but you wouldn’t know it listening to many company managers. When have you ever heard management express secular concerns going forward?

When people like CEO Doug Oberhelman of Caterpillar (CAT) finally see the carnage and the risks, it’s often too late. Hindsight is always 20/20 vision and helps few investors after the fact.

The Value of Contrary Analysis and Thought

“We can never know about the days to come
But we think about them anyway, yay.
And I wonder if I’m really with you now
Or just chasin’ after some finer day.”

– Carly Simon, Anticipation

As I wrote recently in the prelude to my 15 Surprises for 2016 column:

“I’ve never walked the same path in my investment career that others have found comfortable, and I’m not going to start now. You see, I find beauty in a variant view. It’s satisfying intellectually, analytically and financially (at least when you’re correct). There’s something special about adopting a non-consensus view and watching it become reality despite protests from many corners.”

None of us has a concession on the truth; we should all be open in weighing both bullish and bearish arguments.

I’m often wrong myself, but at least I guarantee you independent analysis and some original thinking that often contradicts the herd’s view. Given the wide array of possible outcomes in today’s uncertain world, I try to always use conditional words in my analysis, like “maybe,” “possibly” and “could.” And if I don’t have the answer for something, I readily reply “I don’t know.”

My variant viewpoints — coupled with the original technical and fundamental analysis delivered by other RealMoneyPro contributors — should give subscribers a range view of opinions, both bullish and bearish.

I recognize that the crowd typically outsmarts the remnants of independent thought, but there’s always value to contrarian opinions that test the prevailing market judgment and bias. My disdain applies to both “perma-bears” and “perma-bulls.” As I often write, neither group is a money maker — they’re just attention getters.

I spend a great deal of time in my diary on what I hope is hard-hitting, contrarian analysis. Indeed, I’m currently writing an outline for a book about some of the points I’ve touched upon here.

I suspect that will cause more outrage than many of the market concerns or shorting ideas that I’ve presented over the years in my diary.

My response: “Game on!”

If someone told you that the President of the United States in 2028 would be a Democrat and a woman from the state of New York, could you guess who it might be? We highly doubt it. In 1998, ten years before being elected president, Barack Obama had just been re-elected to the Illinois State Senate and was on no one’s radar as a Presidential candidate. In fact, had you been told at that time an African-American Democrat from Illinois would be president in 2008, it’s likely you would have assumed that two-time democratic presidential nominee Jesse Jackson would be the 44th President. In 1990, George W. Bush had just bought the Texas Rangers baseball club and was still four years from becoming Governor of Texas. In 1983, Bill Clinton was ten years out of law school and serving his second term as Governor of Arkansas. We could keep going down the line of presidents, and you would realize that even armed with some key details about the future, it would be extremely difficult to predict who a future president might be.

Stock investing is a little different. If you know the future level of three simple data points, you can calculate to the penny the price of any stock or index in the future and the exact holding period return. This precise prediction will hold up regardless of wars, economic activity, natural disasters, UFO landings or any other event you can dream up.

Unfortunately, those three data points are not readily available but can be inferred using historical trends, future expectations and logic to project them. With projections in hand, we can develop a range of price and return expectations for an index or an individual stock. In this paper, we provide an array of projections based on those factors and provide return expectations for the S&P 500 for the next ten years.

Factor 1: Dividends

Dividends are an important and often overlooked component of stock returns. To emphasize this point, an investor guaranteed a 3% dividend yield based on the current price, receives a 30% gain (non-compounded) in ten years. In other words, the investor has at least a 30% cushion to guard against price declines over a ten-year period.  That is what Warren Buffett refers to as a “moat,” and it is a wonderful benefit of investing in dividend-paying stocks.

The scatter plot graphed below compares the S&P 500 dividend yield to the Ten-year U.S. Treasury Note yield since 1980.  This historic backdrop helps project the S&P 500 dividend yield for the next ten years.

Data Courtesy: St. Louis Federal Reserve (FRED)

From 1980-1999, Treasury yields and dividend yields behaved alike. The trend line above, covering these years, has a statistically significant R-squared of 0.84 (84% of the move in dividend yields can be explained by moves in the 10-year yield). Since the year 2000, that relationship has all but disappeared. The R-squared for the post-financial crisis era is a meaningless .02.

Around the year 2000, dividend yields appear to have hit a floor ranging from 1-2%, despite a continued decline in Treasury yields. The reason for this is that many companies want to entice investors with higher dividend yields. As such, they raised dividends to keep the dividend yield relatively attractive. Had the regression of the 1980-1999 era held, dividend yields would be below 1% given current Treasury yields.

The graph above makes forecasting the future dividend yield relatively easy. As long as Ten-year U.S. Treasury yields stay below 5-6%, we expect dividend yields will range from 1-2%. Accordingly, we simplify this analysis and assume an optimistic 2% dividend yield for the next ten years.

Dividend Yield – Base/Optimistic/Pessimistic = 2%

Factor 2: Earnings

Over the long-term, earnings are well correlated to economic growth. Our ten-year analysis easily qualifies as long-term. Over shorter periods, there can be sharp variations due to a variety of influences such as regulatory policies and tax policies all of which influence profit margins. To arrive at reasonable expectations for earnings growth, we first consider economic growth. The following chart plots the declining trend in GDP growth since 1980.  Given the burden of debt, weak productivity growth and the obvious headwinds from demographics, we think it is likely the trend lower continues.

Data Courtesy: St. Louis Federal Reserve (FRED)

Next, we consider S&P 500 earnings growth rates. Earnings growth over the last three years, ten years and since 1980 are as follows: 3.18%, 4.38%, and 5.93% respectively. Given the economic and earnings trends, we believe a 3% future earnings growth rate for the next ten years is fair, 5% is optimistic, and 1% is pessimistic.

Earnings Growth – Base/Optimistic/Pessimistic = 3.00%/5.00%/1.00%

Factor 3: Valuations

Robert Shiller’s Cyclically Adjusted Price-to-Earnings ratio (CAPE) is our preferred method of valuation as it averages earnings over ten year periods. In doing so, it avoids short-term volatility of earnings and provides a more consistent baseline reflective of a company’s or indexes true earnings potential.  Currently, the CAPE of the S&P 500 sits in rare territory, as shown below. In fact, outside of the late 1990’s tech boom, there were only two months since 1881 when the Shiller CAPE was higher than today’s level – August and September of 1929.

CAPE has a history of extending well above and below its mean. Importantly, it also reverts to its mean after these long stretches of time. It does not seem unreasonable to expect that, over the next ten years, it will again revert to its mean since 1920 of 17.29. An optimistic scenario for 2028 is a CAPE reading of one standard deviation above the mean at 24.77. The pessimistic case is, likewise, one standard deviation below the mean at 9.70. Further, as shown below, we also present an outlook assuming CAPE stays at its current level of 31.21.

The graph below shows CAPE and the three forecasts along with the current level.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

CAPE – Base/Optimistic/Pessimistic = 17.29/24.80/9.70

What does 2028 hold in store?

The following graph and table explore the range of outcomes that are possible given the scenarios outlined above. To help put context around the wide range of expected returns, we calculated an equity-equivalent price of the 10-year U.S. Treasury Note and added it to the graph as a black dotted line. Investors can use the line to weigh the risk and rewards of the S&P 500 versus the option to purchase a relatively risk-free U.S. Treasury Note. The table below the graph serves as a legend and reveals more information about the forecasts. The color shading on the table affords a sense of whether the respective scenario will produce a positive or negative return as compared to the U.S. Treasury Note. The far right column on the table indicates the percentage of observations since 1881 that CAPE has been higher than the respective scenarios.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm and 720Global/Real Investment Advice

As shown in the graph and table above, only scenarios 8 through 12 have a higher return than the ten year U.S. Treasury Note. Of those, three of the five assume that CAPE stays at current levels. Scenario 8, shaded yellow, has a negligible positive return differential.

Summary

The bottom line is that, unless one has a very optimistic view on earnings growth and expects valuations to remain elevated beyond what historical precedent argues is reasonable, the upside is limited, and the downside is troubling. The odds favor that a risk-free investment in a 10-year Treasury note will provide a better return through 2028 with less volatility. With current 10-year note yields at roughly 2.25%, that should emphasize the use of the term “troubling.”

The lines in the graph above are smooth, giving the appearance of identical returns each period. Markets do not work that way. These projections do not consider the path taken to achieve the expected total return and they most certainly will not be smooth. The best case scenario, and the one least likely to occur is for volatility to remain low. This would generate the most orderly path. Given that the post-crisis VIX (equity market volatility index) has averaged 17.7, current single-digit levels are an aberration and it does not seem unreasonable to expect more volatility in the future.

Even if one of the scenarios plays out exactly as we describe, the path to that outcome would be very choppy. For instance, if the worst case scenario played out, an investor may lose 60-80% of value in a matter of one or two years. However they would most likely have better than expected annual returns in the years following.

In a follow up to this article we will take this thought a step further and discuss the so-called path of returns. We show you the expected and actual path of returns from 2005 to 2015 and argue that an investor armed with the three factors, and a little discipline, may have generated much better returns than those earned by investors using a buy and hold approach.

“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 or via Twitter.


This past weekend was riddled with shocking stories from the tragic shooting in Texas that left 26 dead and many more injured, to the arrest of Prince Alwaleed bin Talal who is one of Saudi Arabia’s most prominent businessmen. Prince Alwaleed, who appears fairly regularly on CNBC as his investment firm has holdings in Apple, Citigroup, and Twitter, was one eleven princes arrested along with four ministers and tens of former ministry officials detained on corruption, money laundering and bribery charges.

Then there was the helicopter crash in Saudi Arabia that killed eight more high-ranking government officials including Prince Mansour bin-Muqrin, the official collapse of the Sprint and T-Mobil merger, and the warning from the Chinese Central Bank (PBOC) of “latent risks accumulating, including some that are ‘hidden, complex, sudden, contagious and hazardous.'”

There were more than just those stories, but you get the idea. In normal times, such a negative news flow would surely set the stage for traders to reduce risk related assets by taking some “money off the table.”

But such was not the case Monday morning as bullish investors were blind to the news and continued to chase stocks higher. 

Currently, there seems to be nothing that can derail the markets from its bullish advance. After a brief 2-week correction this summer, stocks have reasserted their leadership over the last couple of months as economic and earnings data improved modestly.

Importantly, as I addressed last week, the “seasonally strong period” of the market was confirmed by both of the weekly MACD’s registering “buy signals” in October as shown in the chart above. The only concern is that those signals were triggered from extremely high levels which tend to be shorter in nature.

Nonetheless, the bullish trends do remain intact, keeping portfolios allocated towards equity risk currently, investors should not be overly complacent given the extreme overbought conditions that exist. The chart below shows the monthly RSI (Relative Strength Index) for the S&P 500 going back 35 years. Each time the market breached the 70% level, much less the 80% level (currently 81.72) the ensuing reversions have not been kind to investors. 

This divergence from long-term trends can also be seen in the chart below which is the deviation of the market from its 6-year (72-month) moving average. Historically, when the deviation has been greater than 20% from the mean, corrections and reversions have occurred. With the current deviation 26% above the long-term mean and pushing 2-standard deviations, investors are being “willfully blind” to the risks of a short-term correction.

Since I was unable to write the newsletter this past weekend, I am updating the sector analysis and portfolio management commentary. This commentary is updated weekly for our newsletter subscribers which is a free service. Simply click the subscription button on the website and enter your email address.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


ETF Model Relative Performance Analysis


Sector & Market Analysis:

Last week, the market continued its advance, although a bit more wobbly, but did finish the week at all-time highs. More importantly, the S&P 500 has now closed positive for 9-straight quarters which is a feat not seen since the run that begin in 1994.

Let’s look at the sector breakdown.

Technology, Discretionary, Financials – Have continued to push higher particularly as money is chasing technology in particular. While the overall trends are positive, these sectors are becoming quite extended suggesting some profit taking is warranted to rebalance risk.

Staples continue to remain under pressure particularly as earnings reports have been weak. However, the weakness in staples should not be summarily dismissed as this sector in particular is reflective of the broader trends economically speaking. Pay attention as the moving average crossover is close to triggering which will put downward pressure on the sector as a whole.

Basic Materials and Industrials stagnated last week but remain exceedingly overbought with valuations stretched. After big runs in both these sectors on hopes of “tax cuts and infrastructure” from the current administration, some rebalancing of holdings would be prudent.

Healthcare has slipped back to its 50-day moving average. The trend remains positive currently, but watch for a violation of previous lows and any failed rally attempt from the current oversold levels to signal a potential shift in portfolio weightings.

Energy – the underlying technicals have improved and the sector is close to registering a moving average crossover “buy signal.” The recent correction tested, and held, previous support at the 200-day moving average and, along with the breakout of the previous October highs, makes this sector much more appealing from an investment standpoint. The sector is currently grossly overbought so look to add energy exposure on dips to previous supports.

Utilities, we remain long the sector and have moved stops up to the 50-dma. Trends remain positive and interest rates have likely peaked for the current advance.

Small and Mid-Cap Stocks have stalled a bit after a torrid advance beginning last August. With both of the indexes very overbought, some rebalancing of portfolio risks is appropriate.

Emerging Markets and International Stocks have shown some weakness as of late but remain in a bullish trend overall. The recent successful test of the 50-day moving average continues to confirm the bullish trends in these markets. We remain long these markets for now but have moved up stops accordingly.

Gold – I noted previously the failure of precious metals to break back above the 50-dma. With the complete absence of FEAR of a potential crash, gold has temporarily “lost its luster” as a safe haven. We continue to watch the commodity currently, but remain on the sidelines for now.

S&P Dividend Stocks, after adding some additional exposure back in August, the index managed an extremely strong advance which ended two weeks ago as market participation narrowed sharply. We are holding our positions for now with stops moved up to $92. Take some profits and rebalance accordingly. Dividend stocks have gotten WAY ahead of themselves currently as the yield chase continues.

Bonds and REIT’s took a hit this week as “tax reform” moved forward and the expectations for higher inflation, wages, and economic growth pushed rates higher. While the economic benefit from tax reform is “WAY OVERSTATED,” we continue to hold our current exposure and continue to add to holdings on bounces in rates towards 2.4-2.5%.

Sector Recommendations:

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

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

Portfolio Positioning Update

We used the pop in interest rates to move cash management accounts, and larger cash holdings, into our cash allocation strategy providing for better yields. We also added some new bond exposure to accounts. Both of those actions have played out nicely as rates have run back down to 2.32% as of Monday.

As Dana Lyons recently penned:

“Critics of that notion, again, take exception to the argument on the basis of the structural downtrend in mutual fund assets. ‘Call us when bullish assets rise to an extremely high level’, they say. Well, you can start dialing because Rydex bullish fund assets just hit their highest level of the entire market cycle, going back at least 10 years.

“With a cycle high in bullish assets and bearish assets still plumbing record lows, there is certainly a good case to be made, on the surface, for overly bullish investor exuberance at the moment.”

While the risks clearly outweigh the potential for reward over the intermediate to long-term, the short-term frenzy to chase assets simply overwhelms logic. But such is always the case when markets enter the “melt-up” phase of the cycle.

We remain extremely vigilant of the risk that we are undertaking by continuing to ride markets at such extended levels, but our job is to make money as opportunities present themselves. Importantly, each week we raise trailing stop levels and continue to look for ways to “de-risk” portfolios to counter this late stage bull market advance.

As always, we remain invested but are becoming highly concerned about the underlying risk. Our main goal remains capital preservation. 

“A market that sees no danger is the most dangerous market of all.” 

On Friday, I touched on the proposed “tax cut/reform” bill introduced by the House Ways and Means committee which is chaired by Congressman Kevin Brady. Some of the key highlights of the “House plan”  are as follows (courtesy of Zacks Research):

  • No change to 401(k) contribution caps
  • Repeal the Alternative Minimum Tax (AMT)
  • Corporate tax rate at 20% (aims to be a permanent cut)
  • Top individual tax rate 39.6% threshold at $1 million
  • Cut the current 7 individual tax brackets down to 4:
    • 12% for $45,000 ($90,000 married) and lower
    • 25% for $45,001 – $200,000 ($90,000 – $260,000 married)  
    • 35% for $200,000 – $500,000 ($260,000 – $1,000,000 married)
    • 39.6% for $500,000+ ($1,000,000+)
  • Estate tax threshold doubles and gets repealed starting in 2024
  • Deductions  limited to $10,000 on property tax and 500,000 on “new mortgages”.
  • Pass-throughs
    • Passive owners of pass-through get 25% rate
    • Active owners have different standard
    • Presumes 70% of pass-through income is attributable to labor and would be taxable at higher individual income tax rates
    • For professional service firms default rate would be 100% of labor – no benefit from 25% rate
  • Repeals itemized deduction for medical expenses
  • Repeals credit for adoption
  • Child tax credit at $1600 and creates $300 credit for each parent – $300 credits expire after 2022
  • Repeals deduction for student loan interest
  • No expansion of charitable giving limits
  • For corporations, 10% tax on US companies’ high profit foreign subsidiaries calculated on global basis
  • Foreign companies operating in US face up to 20% tax on payments made abroad from US operations to prevent deduction load-up
  • Tax rate could be lowered by companies agreeing to increase US operations
  • Interest deductions capped at 30% of EBITDA – exemption for real estate firms and small businesses

While on the surface this tax proposal looks promising, when you dig into the details the outcome looks less robust.

Many of the proposed changes may sit wrong with the public as some of today’s more popular deductions will be reduced or repealed. Furthermore, when lumping individuals into fewer income brackets, combined with deduction eliminations, the result may actually create a “tax increase” on the bottom 40% of earners. As I noted on Friday the bottom 80% of tax payers currently pay only about 18% of the total individual tax liability with top 20% paying the rest. But the bottom 40% currently have a NEGATIVE tax liability and the elimination, or reduction, of many of the deductions could increase taxes for many. 

Importantly, notice the trend of those in the bottom 80% of taxpaying Americans. Ever since Reagan passed “tax reform,” the trend of Americans that do not pay taxes has trended steadily higher.

While Republican’s rush to promote the “tax bill” as the biggest tax cut for Americans ever, they also have to find ways to offset the initial reduction in tax collections so as to NOT expand the deficit by more than the estimated $1.5 Trillion dollars. By doing so Senate republicans can pass tax reform with only a 51-vote majority through the “reconciliation” process, otherwise it would require 60-votes which would be impossible for the current Senate to obtain.

Therefore, if order to “score” the bill to fit within that $1.5 trillion window, Republicans, are relying on several “myths” about how tax cuts will “pay for themselves” in the future as:

  1. Tax cuts will lead to stronger economic growth
  2. Tax cuts will increase wages for American workers
  3. Tax cuts will reduce Federal debt and deficit levels.

Let’s look at each one.

The Myths Of Tax Cuts

Myth #1: Tax Cuts Will Create An Economic Revival

As the Committee for a Responsible Federal Budget stated last week:

“Tax cuts do not pay for themselves; they can create growth, but in the amount of tenths of percentage points, not whole percentage points. And they certainly cannot fill in trillions in lost revenue. Relying on growth projections that no independent forecaster says will happen isn’t the way to do tax reform.”

That is absolutely correct and as I pointed out on Friday:

“As the chart below shows there is ZERO evidence that tax cuts lead to stronger sustained rates of economic growth. The chart compares the highest tax rate levels to 5-year average GDP growth. Since Reagan passed tax reform, average economic growth rates have only gone in one direction.”

Myth #2: Tax Cuts Will Lead To A Rise In Wages

The same is true for the myth that tax cuts lead to higher wages. Again, as with economic growth, there is no evidence that cutting taxes increases wage growth for average Americans.

In fact, as I discussed previously:

“An expansion that began, believe it or not, more than seven years ago has extended a longer-run trend of wage stagnation for the average US worker, despite a sharp drop in the official unemployment rate to 4.4% from an October 2009 peak of 10%.

After adjusting for inflation, wages are just 10% higher in 2017 than they were in 1973, amounting to real annual wage growth of just below 0.2% a year, the report says. That’s basically nothing, as the chart below indicates.”

Furthermore, the idea that companies will begin to increase employment is likely overestimated as well. With the long-run trend of employment growth declining, not to mention we are very late in the current economic cycle, tax cuts are unlikely to sharply increase employment rates.

This is particularly the case currently as companies are sourcing every accounting gimmick, share repurchase or productivity increasing enhancement possible to increase profit growth. While asset prices have surged higher, the underlying fundamental growth story remains weak. 

“The chart below expands that analysis to include four measures combined: Economic growth, Top-line Sales Growth, Reported Earnings, and Corporate Profits After Tax. While quarterly data is not yet available for the 3rd quarter, officially, what is shown is the market has grown substantially faster than all other measures. Since 2014, the economy has only grown by a little less than 9%, top-line revenues by just 3% along with corporate profits after tax, and reported earnings by just 2%. All of that while asset prices have grown by 29% through Q2.”

Myth #3: Tax Cuts Will Pay For Themselves

While the GOP has, for the last 8-years, continued to wield “fiscal conservatism” as a badge of honor, they have completely abandoned those principals in recent months in a full-blown effort to achieve “tax reforms.”

We are told, by these same Republican Congressman and Senators who just recently passed a fiscally irresponsible 2018 budget of more than $4.1 trillion, that tax cuts will “pay for themselves” over the next decade as higher rates of economic growth will lead to more tax collections.

However, once again, we see that over the “long-term” this is simply not the case as the deficit has continued to grow during every administration since Ronald Reagan. Furthermore, the widening deficit has led to a massive surge in Federal debt which is currently pushing $21 trillion and growing much faster than economic activity, or the nations ability to pay if off.

Effective Outcome

The effective outcome of tax cuts at this juncture will result in:

  • Only provide a minimal impact to economic growth, if any at all. 
  • An expansion of the debt of between $2-5 Trillion depending on the severity of  the next recessionary drag.
  • A ballooning of the budget deficit as entitlements rise with the expansion of child tax credits. 
  • A further divide in the “wealth gap” between those in the top 10% and the bottom 90%. 

The data suggests the myth that income tax cuts raise growth has been repeated so often it is now believed to be true. However, theory, evidence, and historical studies tell a different and more complicated story.

I am not stating that tax cuts don’t offer any potential to raise economic growth by improving incentives to work, save, and invest. However, tax cuts also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, Republicans are engaged in trying to use tax cuts as a stand-alone policy, rather than tying them to spending cuts, which will raise the federal budget deficit. It is important to consider that an increase in the deficit diverts income from productive investment as the underlying debt swells and must be serviced.

With the economic dynamics not supportive (debt, demographics, productivity and deflation) of further fiscal deficits, tax cuts, without spending cuts, are not self-supporting. Given today’s record-high and rapidly growing levels of national debt, the country cannot afford a deficit-financed tax cut. Tax reform that adds to the debt is likely to slow, rather than improve, long-term economic growth.

Real Investment Advice is pleased to introduce J. Brett Freeze, CFA, founder of Global Technical Analysis. Going forward on a monthly basis we will be providing you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. 

If you are interested in learning more about their services, please connect with them.

Introduction

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

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

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

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

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

Predicted Returns

Predicted Return: Sensitivity Analysis

Price to Peak Earnings

As of 10/31/2017:  Price/Peak Earnings 23.6

To get at the significance of the P/E, you have to start by understanding that stocks are not a claim to earnings anyway.  Stocks are a claim to a future stream of free cash flows – the cash that can actually be delivered to shareholders over time after all other obligations have been satisfied, including the provision for future growth.  Knowing this already tells us a lot.  For example, price/earnings ratios based on operating earnings are inherently misleading, since that “earnings” figure does not deduct interest owed to bondholders nor taxes owed to the government.   This isn’t to say that P/E ratios are useless, but it’s important for the “E” chosen by an investor to have a reasonably stable relationship to what matters, which is the long-term stream of free cash flows.  For that reason, our favored earnings measure for market valuation (though it can’t be used for individual stocks) is “peak earnings” – the highest level of net earnings achieved to date.  (Excerpted from Dr. John Hussman)

Duration

As of 10/31/2017:  Duration 53.5 years

In the case of equities, duration measures the percentage change in stock prices in response to a 1% change in the long-term return that stocks are priced to deliver. So we have a basic financial planning concept.  If a buy-and-hold investor with no particular view about market conditions or future returns wishes to have a fairly predictable amount of wealth at some future date, that investor should hold a portfolio with a duration that is roughly equal to the investment horizon.  (Excerpted from Dr. John Hussman)

Valuation

As of 10/31/2017:  Overvalued by 107.2%

Inflation Adjusted PE

As of 10/31/2017:  Real Price to 10-Year Real Earnings 31.1x

Dividend Yield

As of 10/31/2017: Dividend Yield 1.87%

Option Implied Volatility

VIX measures 30-day expected volatility of the S&P 500 Index.  The components of VIX are near- and next-term put and call options, usually in the first and second SPX contract months.   “Near-term” options must have at least one week to expiration; a requirement intended to minimize pricing anomalies that might occur close to expiration.

As of 10/31/2017:  10-Day EMA 10.44

Option Skew

The CBOE SKEW Index (“SKEW”) is an index derived from the price of S&P 500 tail risk.   The price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150.   A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible.   As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant.

As of 10/31/2017:  10-Day EMA 137.64

Realized Volatility

As of 10/31/2017:  6.34%

Inflation and PE Multiples

Lower levels of inflation are rewarded with higher earnings multiples.

Higher levels of inflation are punished with lower earnings multiples.

Inflation and PE Multiples

Lower levels of volatility are rewarded with higher earnings multiples.

Higher levels of volatility are punished with lower earnings multiples.

PE Multiples and Realized Returns

Lower valuations are rewarded with higher realized returns.

Higher valuations are punished with lower realized returns.

As of 10/31/2017:  Price to Peak Earnings 23.6x  Average: 12.6x

As I noted last Friday, the recently approved budget was an anathema to any fiscally conservative policy. As the Committee for a Responsible Federal Budget stated:

“Republicans in Congress laid out two visions in two budgets for our fiscal future, and today, they choose the path of gimmicks, debt, and absolutely zero fiscal restraint over the one of responsibility and balance.

While the original House budget balanced on paper and offered some real savings, the Senate’s version accepted today by the House fails to reach balance, enacts a pathetic $1 billion in spending cuts out of a possible $47 trillion, and allows for $1.5 trillion to be added to the national debt.

Make no mistake – this is a defining moment for the Republican party. After years of passing balanced budgets and calling for fiscal responsibility, the GOP is now on-the-record as supporting trillions in new debt for the sake of tax cuts over tax reform and failing to act on the pressing need to reform our largest entitlement programs.”

Passing fiscally irresponsible budgets just for the sake of passing “tax cuts,” is, well, irresponsible. Once again, elected leaders have not listened to, or learned, what their constituents are asking for which is simply adherence to the Constitution and fiscal restraint.

As the CFRB concludes:

“Tax cuts do not pay for themselves; they can create growth, but in the amount of tenths of percentage points, not whole percentage points. And they certainly cannot fill in trillions in lost revenue. Relying on growth projections that no independent forecaster says will happen isn’t the way to do tax reform.”

That is absolutely correct.

As the chart below shows there is ZERO evidence that tax cuts lead to stronger sustained rates of economic growth. The chart compares the highest tax rate levels to 5-year average GDP growth. Since Reagan passed tax reform, average economic growth rates have only gone in one direction.

However, the most likely unintended consequence of the proposed tax “cut” bill is that it will likely translate into a “hike” on middle class Americans. Take a look at the proposed tax bracket chart below.

Now, compare that with the actual breakdown of “who pays taxes.”

“The bottom 80% currently pay only about 18% of individual taxes with top 20% paying the rest. Furthermore, the bottom 40% currently have a NEGATIVE tax liability, and with the new tax plan cutting many of the deductions currently available for those in the bottom 40%, it could be the difference between a tax refund and actually paying taxes. “

“Of course, those in the top 20% of income earners are likely already consuming at a level with which they are satisfied. Therefore, a tax cut which delivers a few extra dollars to their bottom line, will likely have a negligible impact on their current levels of consumption.”

Given the newly designed tax brackets compresses individuals into fewer groups, it is quite likely a large chunk of the bottom 80% will likely experience either a hike or an inconsequential change. With the bottom 80% already consuming at max capacity, as discussed yesterday, a tax increase will hit the economy right where it hurts the most – in consumption expenditures. 

 “As the chart below shows, while savings spiked during the financial crisis, the rising cost of living for the bottom 80% has outpaced the median level of ‘disposable income’ for that same group. As a consequence, the inability to ‘save’ has continued.”

But while Congressional members were campaigning yesterday the “tax plan” would give an $1182 tax cut to most Americans, it should not be forgotten that since they failed to “repeal and replace” the Affordable Care Act, any tax cut will only be diverted to offset a substantial rise in health care premiums in 2018.

Regardless, the proposed tax bill is just the first step.

Let the “horse trading” begin.

In the meantime, while we await the actual tax reform bill, here is your weekend reading list.


Trump, Economy & Fed


Markets


Research / Interesting Reads


“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations which do not meet these requirements are speculative.” – Benjamin Graham

Questions, comments, suggestions – please email me.

The economy is booming.

Employment is at decade lows.

Unemployment claims are at the lowest levels in 40-years.

The stock market is at record highs and climbing.

Consumers are more confident than they have been in a decade.

Wages are finally showing signs of growth.

What’s not to love?

I just have one question. If things are so good, then why is America’s saving rate posting such a sharp decline?

The answer is not surprising. Despite the bullish economic optics, the reality for the majority of Americans is they simply have not yet recovered from the financial crisis. As the chart below shows, while savings spiked during the financial crisis, the rising cost of living for the bottom 80% has outpaced the median level of “disposable income” for that same group. As a consequence, the inability to “save” has continued.

I discussed previously the problem of rising debt. Beginning in 1990, the gap between the “standard of living” and real disposable incomes went negative with the resultant “gap” filled through the use of debt. However, since the financial crisis, this has no longer been the case. I modified the previous chart with the savings rate which tells the same story, as the cost of living began outpacing incomes the difference came from savings, and a continuous increase in debt. Again, despite the temporary uptick in the savings rate following the financial crisis, the real cost of living continues to erode the middle class.

You can see the erosion of the savings rate more clearly when you look at the rate of Personal Consumption Expenditure (PCE) growth as compared to debt growth. As spending and debt accelerated, the savings rate declined. More importantly, in 2000 the growth rate of debt sharply accelerated above PCE growth. This debt-fueled consumption, however, has not led to stronger rates of economic growth. 

Debt is a negative thing for the borrower. It has been known to be such a thing even in biblical times as quoted in Proverbs 22:7:

“The borrower is the slave to the lender.”

Debt acts as a “cancer” on an individual’s wealth as it siphons potential savings from income as those funds are diverted to debt service. Rising levels of debt means rising levels of debt service which reduces actual disposable personal incomes that could be saved or reinvested back into the economy.

The mirage of consumer wealth has been a function of surging debt levels. “Wealth” is not borrowed but “saved” and as shown in the chart below, this is a lesson that too few individuals have learned.

The reality is that since “savings” are the cornerstone of economic growth longer-term, as savings provide for productive investment and lending, it should be of NO surprise that, as shown in the next chart, there is a very high correlation between the savings rate, GDP, and PCE.

While many continue to suggest that “debt is not a problem,” the evidence is pretty clear that rising debt levels have impeded economic growth, savings, and consumption since slanting sharply upwards beginning in 1980.

Correlation or causation? You decide.

The chart above is extremely noisy so I have created a composite index below of inflation (CPI), GDP, Wages and the Savings Rate. I then compared that composite index to both interest rates and the S&P 500.

What you find, unsurprisingly, is that declines in the composite index also correspond with declines in both rates and equity prices. The most recent decline resulted in the near 20% sell-off in late 2015 and early 2016. The recent uptick in equities and the index follow on the heels of both the massive European and Swiss National Bank’s buying sprees and the “Trump bounce.”

The fall in the savings rate, combined with the subsequent rise in debt, is suggesting there is more weakness within the economy that headline data would suggest.

Currently, there are clear signs of stress emerging from credit. Commercial lending has taken a sharp dive as delinquencies have risen. These are both signs of a late stage economic expansion and a weakening environment. With savings rates weak, the real-world inflationary pressures of food, energy, medical and utilities have consumed more of discretionary incomes. This is why dependency on social support systems now comprise a record level of disposable incomes.

“Without government largesse, many individuals would literally be living on the street. The chart above shows all the government ‘welfare’ programs and current levels to date. The black line represents the sum of the underlying sub-components.  While unemployment insurance has tapered off after its sharp rise post the financial crisis, social security, Medicaid, Veterans’ benefits and other social benefits have continued to rise.

Importantly, for the average person, these social benefits are critical to their survival as they make up more than 22% of real disposable personal incomes. With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.”

It is hard to make the claim the economy is on the verge of acceleration with the underlying dynamics of savings and debt suggesting a more dire backdrop.

With the average American still living well beyond their means, the reality is that economic growth will remain mired at lower levels as savings continue to diverted from productive investment into debt service. Furthermore, with the Federal Reserve and the Administration actively engaged in creating an artificial housing recovery, and wealth effect from increasing asset prices, it is likely that another bubble is being created.

This has never ended well.

The concern is that without a reversion of debt to more sustainable levels the attainment of stronger, and more importantly, self-sustaining economic growth could be far more elusive than currently imagined.

This isn’t just about the “baby boomers,” either. Millennials are haunted by the same problems, with 40%-ish unemployed, or underemployed, and living back home with parents. In turn, parents are now part of the “sandwich generation” that are caught between taking care of kids and elderly parents. The rise in medical costs and health care goes unabated consuming more of their incomes.

As I stated previously:

“Hopefully, the recent upticks in the economic data are more than just the temporary “restocking cycles” we have seen repeatedly over the last 8-years. Hopefully, the current Administration will achieve some part of their legislative agenda to help boost economic growth. Hopefully, international economies can continue their growth trends as they account for 40% of corporate profits. Hopefully, an economic cycle that is already the 3rd longest in history with the lowest annual growth rate, can continue indefinitely into the future.”

But that is still an awful lot of hoping.

We’ve produced some research over the years that we’d love to see the powers-that-be react to, but none more so than our look at financial flows during the QE programs.

By netting all lending by banks and brokers-dealers and then comparing it to the Fed’s lending, we stumbled upon a chart that seemed to show exactly what QE does or doesn’t do. But “doesn’t,” not “does,” was the story, and it couldn’t have been clearer. Or shown a more stimulating pattern. To geeks like us, our Excel click on “Insert, Line” was like stepping from a shady trail to a sunny vista.

Here’s the updated chart, which we dubbed the “argyle effect” and looks even sharper than it did when we first produced it in 2014:

We like the chart because we’re just as confirmation-biased as the average human—anything that confirms our QE skepticism is cognitively satisfying. And the chart appears to show that QE was largely irrelevant. It merely replaced growth in privately financed credit with growth financed by the Fed. The Fed grabbed the credit-growth baton for QE laps and returned it to the private sector for QE pauses, and whoever didn’t have the baton more or less stood still. As we concluded in 2014, QE is a substitution story, not an addition story.

Many pundits told the addition story as QE was underway. They expected banks to “multiply up” reserves by aggressively expanding their loan books. But reserves never significantly multiplied. We think there are five reasons why the “money multiplier theory” failed:

  1. High-quality borrowers don’t emerge mysteriously from cracks in the Eccles Building and parade zombie-like to bank loan desks. In other words, credit demand was probably about the same with or without QE.
  2. QE’s effects on bank balance sheets aren’t quite as distorting as they’re often depicted. Consider that new reserves are typically matched by new deposits, because dealers offering bonds to the Fed get paid for those bonds through their accounts at commercial banks. In other words, QE adds a similar item to both sides of bank balance sheets, which you might not appreciate if your information comes from those who call for banks to “lend out” reserves. That’s impossible—reserves can’t be “lent out”—and it often leads to exaggerated statements about the implications of excess reserves.
  3. To a significant degree, banks can neutralize excess reserves (and the corresponding “excess” deposits) with financial derivatives and other balance sheet adjustments. They can rearrange exposures to mimic a balance sheet of equal risk that’s not stuffed with reserves.
  4. Just as importantly, excess reserves flow naturally from banks that don’t want them to banks that don’t mind them nearly as much. Consider that Fed data shows a disproportionate amount of QE’s extra reserves landing at U.S. branches of foreign banks. Those foreign banks might have sound reasons for holding excess reserves.
  5. The money multiplier theory is inconsistent with real-world reserve management practices. The Bank of England has called it “reverse” to how bank lending and reserve management work in the real world. And the gap between theory and reality is so large that you don’t even need the four reasons above to reject the money multiplier—you just need a healthy skepticism about mainstream theory.

According to our chart, even QE’s wealth effects appear to be poorly understood. If credit growth is the same with or without QE, any effects on bond and stock prices might be more psychological than commonly believed. Or, those effects might transmit mainly through financial derivatives (see #3 above). Or, I hear at least a few readers asking, “What wealth effects?” We’ll never know for certain if QE boosted asset prices at all. Maybe the bull market only needed low interest rates, a slowly growing economy, the knowledge that our policy honchos wanted asset prices higher, and a soothing narrative that they have the tools to make that happen?

Getting to the Bottom of the Burberry Backlash

To be sure, the argyle effect might not be surprising to the Fed’s policy makers. They might have already looked at the data in the same way we did. They might also believe that QE increased the overall lending trend (referring to the entire period’s lending growth), irrespective of the pattern from one QE to the next. All that said, we’d like to know their reaction.

We’d like to know: Would the Fed’s heads explain the chart pattern differently to our interpretation above? If our interpretation is on the central-bank-printed money, how do they justify their policies? How do they expect the pattern to change as QE unwinds? Or, do they not know what to expect—are they as confused as anyone else about what QE really does? The last possibility matches public statements by both current and former FOMC members.

(See, for example, Bill Dudley here, Kevin Warsh here, or just about anything from Richard Fisher.)

So, we’re asking Fed correspondents to lend a hand. Nearly nine years after QE began, you’re tired of having the same discussions, right? Here’s a chance to make the discussions more interesting—a chance to drop a Burberry bombshell on your most insightful Fed contact. Inquiring minds would like to see the bomb’s impact, or at least to know how policy makers would go about defusing it. More bluntly, inquiring minds deserve to know. It’s our economy, too, and public officials should be held accountable for the results of their actions.

And if the public interest isn’t enough to persuade Fed correspondents to investigate the argyle effect, we’ll offer other incentives. In return for a report that includes the insights of any FOMC member or senior Fed researcher, we’ll send a complimentary copy of Economics for Independent Thinkers, which is filled with similar research. Or, if our book isn’t mainstream enough for you, we’ll send a thank you with a big smiley face on it. Either way, we look forward to your report on our simple—yet oddly revealing—chart.

Author’s note: We separated QE and non-QE periods according to the credit the Fed added to the financial system through all of its activities, not just open market operations. Because we included loans, repos, and various emergency facilities enacted during the financial crisis, our time periods are slightly different than the announced start and end dates for QE alone. (For more details, see this note from 2014, although replicators should be aware that the Fed recently replaced its “credit market instruments” category with a few subcategories.) In other words, the line showing the Fed’s net lending is jagged by design. By separating periods of high versus low Fed-sourced credit, we can test whether the private sector’s net lending would show a reverse correlation to the Fed’s activities. As you can see, it did.

“The opening crawl is the signature device of every numbered film of the Star Wars series, an American epic space opera franchise created by George Lucas. It opens with the static blue text, ‘A long time ago in a galaxy far, far away….’, followed by the Star Wars logo and the crawl text, which describes the backstory and context of the film. The visuals are accompanied by the “Main Title Theme“, composed and conducted by John Williams.

The sequence has been featured in every live-action Star Wars film produced by Lucasfilm with the exception of Rogue One. Although it retains the basic elements, it has significantly evolved throughout the series. It is one of the most immediately recognizable elements of the franchise and has been frequently parodied.

Each film opens with the static blue text, “A long time ago in a galaxy far, far away….”, followed by the Star Wars logo shrinking in front of a field of stars. Initially the logo’s extremities are beyond the edge of the frame. While the logo is retreating, the “crawl” text begins, starting with the film’s episode number and subtitle (with the exception of the original release of Star Wars – see below), and followed by a three-paragraph prologue to the film. The text scrolls up and away from the bottom of the screen towards a vanishing point above the top of the frame in a perspective projection. Each version of the opening crawl ends with a four-dot ellipsis, except for Return of the Jedi which has a three-dot ellipsis. When the text has nearly reached the vanishing point, it fades out, the camera tiltsdown (or, in the case of Episode II: Attack of the Clones, up), and the film begins.” –Star Wars Opening Crawl, Wikipedia

As Mel Brooks wrote in the opening crawl of his parody “Spaceballs“:

Once upon a valuation warp. . . .

In a market very, very, very, very far away, there lived a ruthless race of beings known as … Momentum Investors.

Chapter Eleven

The evil leaders of momentum investing, having foolishly overestimated economic and profit growth and taken valuations to an extreme, have revised a secret plan to take every breath of reason from their reason- loving neighbor, Value Investing.

Today is Halloween. Unbeknownest to the consensus, but knownest to us, danger lurks in the stars above..

If you can read this, you don’t need glasses.

But I am getting ahead of myself, so let me start from the beginning:

Episode I: THE PHANTOM MENACE

“Turmoil has engulfed Planet Investors, upending rational investing. The statutory corporate tax rates to outlying star systems are in dispute.

Hoping to resolve the matter with a tax-free repatriation of overseas cash, the White House has stopped all shipping to the small planet of Maine.

While the Congress of the Republic endlessly debates this alarming chain of events, the Supreme Tweeter has secretly dispatched two of his warriors (Mnuchin and Cohn), his guardians of low taxes for the nobles in the galaxy, to settle the conflict….”

Episode II: ATTACK OF THE CLONES

“There is unrest in the Galactic Senate. As several establishment Republicans have declared their intentions to leave the Republic.

This separatist movement, under the leadership of the mysterious Count Flake, has made it difficult for the limited number of warriors to maintain peace and order in the galaxy.

Senator Collins, the former Queen of Maine, is returning to the Galactic Senate to vote on the critical issue of creating an ARMY OF THE REPUBLIC to assist the overwhelmed Jedi….”

Episode III: REVENGE OF THE SITH

“Twitter War! The Republic is crumbling under attacks by the ruthless Sith Lord, Robert Mueller. There are heroes on both sides. Evil is everywhere.

In a stunning move, the fiendish aging droid leader, General Bernie Sanders (not to be confused with the Evil Colonel Sandurz), has swept into the Republic capital and kidnapped Chancellor McConnell, leader of the Galactic Senate.

As the Separatist Droid Army attempts to flee the besieged capital with their valuable hostage, two other Jedi Knights lead a desperate mission to rescue the captive Chancellor….”

Episode IV: A NEW HOPE

“It is a period of investor strife. Rebel spaceships, striking from a hidden base, (with price-earnings ratios ever expanding and dips ever bought) have won their first victory against the evil Galactic Empire (despite the robotic and fake impressions coming out of Facebook and Twitter) .

During the battle, Rebel spies managed to steal secret plans to the Empire’s ultimate weapon, the Death Star AMAZON, an armored space station with enough power to destroy an entire planet (and/or markets).

Pursued by the Empire’s sinister agents, Princess Kamala races home aboard her starship (on the Left Coast), custodian of the stolen plans that can save the markets and instill value and common sense to the galaxy….”

Episode V: THE EMPIRE STRIKES BACK

“It is a dark time for the Rebellion. The Death Star Amazon has not yet been destroyed and Imperial troops have driven the Rebel forces from their hidden base and pursued them across the galaxy.

Evading the dreaded Imperial Starfleet (of Generals Kelly, H.R. McMaster and Mattis) , a group of freedom fighters led by Luke Booker has established a new secret base on the remote ice world of California.

The evil lord Paul Ryan, obsessed with finding young Booker, has dispatched thousands of remote probes (and quant strategies) into the far reaches of space, continuing to boost investor confidence and buoy the S&P Index….”

Episode VI: RETURN OF THE JEDI

“Luke Booker has returned to his home planet of Newark in an attempt to rescue his party from the clutches of the vile gangster Bannon the Hutt and from (unregulated and growing power/value) of the sinister FANGS.

Little does Luke know that the Galactic Empire has secretly begun construction on a new armored space station even more powerful than the first dreaded Death Star, AMAZON.

When completed, this ultimate weapon will spell certain doom for the small band of rebels and short sellers struggling to restore freedom and common sense to investors…”

Episode VII: THE FORCE AWAKENS 

“Luke Booker has vanished. In his absence, the sinister DARTH PUTIN has risen from the ashes of the Empire (and Facebook/Twitter) and will not rest until Booker, the last Jedi (and market complacency), have been destroyed.

With the support of the REPUBLIC, Princess Kamala Harris leads a brave RESISTANCE. She is desperate to find her brother Luke Booker and gain his help in restoring peace and justice and reasonable valuations to the galaxy.

Princess Kamala has sent her most daring pilot on a secret mission to PLANET DNC, where an old ally (Princess Elizabeth) has discovered a clue to Luke’s whereabouts….”

Hopefully, to find out the market outcome, we may only have to wait for next month’s (Dec. 15) release of Episode VIII, “The Last Jedi.”

But the wait could be as long as Dec. 20, 2019, with the release of the still-untitled Episode IX.

“Your eyes can deceive you. Don’t trust them.” – Obi-Wan Kenobi

It’s scary out there — after all, it’s Halloween.

Trick or treat?

Regardless of market outcomes, May the Schwartz be with (all of) you.”

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