Monthly Archives: July 2016

September 20th, 2017 will likely be a day that goes down in market history.

It will either be remembered as one of the greatest achievements in the history of monetary policy experiments, or the beginning of the next bear market or worse.

Given the Fed’s inability to spark either inflation or economic growth, as witnessed by their dismal forecasting record shown below, I would lean towards the latter.

The media is very interesting. Despite the fact there is clear evidence that unbridled Central Bank interventions supported the market on the way up, there is now a consensus that believes the “unwinding” will have “no effect” on the market.

This would seem to be naive given that, as shown below, the biggest injections of liquidity from the Fed have come near market bottoms. Without the proverbial “punch bowl,” where does the “support” come from to stem declines?

I tend to agree with BofA who recently warned” the paint may be drying but the wall is about to crumble.”

This point can be summarized simply as follows: there is $1 trillion in excess TSY supply coming down the line, and either yields will have to jump for the net issuance to be absorbed, or equities will have to plunge 30% for the incremental demand to appear.”

“An unwind of the Fed’s balance sheet also increases UST supply to the public. Ultimately, the Treasury needs to borrow from the public to pay back principal to the Fed resulting in an increase in marketable issuance. We estimate the Treasury’s borrowing needs will increase roughly by $1tn over the next five years due to the Fed roll offs. However, not all increases in UST supply are made equal. This will be the first time UST supply is projected to increase when EM reserve growth likely remains benign.

Our analysis suggests this would necessitate a significant rise in yields or a notable correction in equity markets to trigger the two largest remaining sources (pensions or mutual funds) to step up to meet the demand shortfall. Again, this is a slower moving trigger that tightens financial conditions either by necessitating higher yields or lower equities.”

Of course, as I have discussed previously, a surge in interest rates would lead to a massive recession in the economy. Therefore, while it is possible you could experience a short-term pop in rates, the end result will be a substantial decline in equities as money flees to the safety of bonds driving rates toward zero.

“From many perspectives, the real risk of the heavy equity exposure in portfolios is outweighed by the potential for further reward. The realization of ‘risk,’ when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.”

My best guess is the Fed has made a critical error. But just as a “turnover” early in the first-quarter of the game may not seem to be an issue, it can very well wind up being the single defining moment when the game was already lost. 

In the meantime, here is what I am reading this weekend.


Politics/Fed/Economy


Markets


Research / Interesting Reads


“If you are playing the rigged game of investing, the house always wins.” ― Robert Rolih

Questions, comments, suggestions – please email me.

By Doug Kass

* In a paperless and cloudy world, are investors and citizens as safe as the markets assume we are? –Kass Diary

Another provocative missile launched by North Korea and another apparent terrorist attack in London, England, are, once again, overnight and early-morning features of our reality as investors and as citizens.

The S&P futures fell a meaningless four handles from the time of the events, indicating even the machines and algorithms couldn’t care less about much of anything impacting equities!

“Nothing succeeds like success.” –Alexandre Dumas

“Group stink” runs thick these days, as Dumas, a 19th century French writer, noted.

To this observer, our markets’ resilience is all too reminiscent of former Citigroup CEO Chuck Prince, who kept on dancing because the music was still playing.

To me, the indomitable market is more a function of lemming-like behavior in a market, economy and profit setting that is far less secure and strong than many subscribe to.

Group stink is a powerful force in the markets, especially when the machines and algorithms and the ever-constant inflows into popular passive funds and ETFs dominate the investment backdrop. These factors exacerbate short-term trends and may contribute to the perpetuation of an ill-conceived perception of a daunting and inexhaustible virtuous market cycle.

Golfer Tom Watson once wrote, “Sometimes thinking too much can destroy your momentum.” And most investors and traders, in a reactionary mode, seem to prefer to adopt such a strategy. But, I vividly remember the positive and incessant price momentum in early 2000 and late 2007 that appeared impossible to divert until, all at once, an important change in price trend occurred, seemingly overnight. The market consequences were ugly.

There is now a near-universality of view that stocks will move higher and that any dip is to be bought. Even the threat of a potential nuclear attack now brings on a market yawn.

The one-way action and lack of volatility have resulted in some of the greatest hedge-hoggers giving back tons of money (e.g., Seth Klarman’s Baupost) and/or closing down completely (as chronicled here and here.)

If some of the greatest minds can’t deliver alpha, we possibly should consider that things have gone awry and think about accepting something that Grandma Koufax used to say: “Dougie, something is rotten in Flatbush.”

As I recently wrote in “The Market Band Plays On, But You Won’t Catch Me Humming Its Mindless Tune”:

Throughout the last six months I have expressed the view that the S&P 500 Index was in the process of making an important top and that risk was being underpriced.

Throughout the last month I have grown more bearish than I have been in several years. That negative outlook is reflected in the extreme condition that, beyond indirect holdings in my hedge fund, I am in the unique position of owning no individual equities in my personal account.

That’s a statement of conviction in view.

In “Dark Conditions Totally Eclipse Anything We’ve Seen in Decades” I outlined my concerns:

* Markets: The dominance and popularity of passive investing — most notably ETFs and volatility-trending and risk-parity strategies — are relatively new to the market’s picture. I contend that the lack of price discovery from these influences may have spoiled stock charts and partially ruined the ability of some to rely on technical analysis.

* Valuations: Most valuation metrics are at least in the 95% decile, an occurrence that typically has coincided over history with the end of maturing bull markets or in the ninth inning of speculative eras.

* Corporate Profits: With the largest spread between GAAP and non-GAAP earnings in history, never has such liberal use of accounting standards been accepted by the masses of market participants.

* Central Banks: With $19 trillion ($1.5 trillion added in 2017 alone) in central bank assets, monetary authorities never have had such influence as they have in the past few years. Like quantitative strategies, the outsize role of central banks is new and its impact is great. It also has diminished price discovery. As I recently wrote, the “Debt Opioid Addiction Could Turn Ugly Fast.”

* Economic: As the years go by it is increasingly clear that, despite the unprecedented role of central bankers reducing interest rates, secular global growth prospects have been reduced relative to the last several decades. Moreover, The Screwflation of the Middle Class has resulted in an income and wealth gap that has not improved over the last three to five years.

* Politics: The Orange Swan is a new factor, as articulated here and here. Like him or hate him, President Trump is unlike any POTUS in history. Another aspect of politics that is different is the degree of animus in Washington, D.C. There has never been such partisanship. Ever.

* Geopolitical: Markets have never been as exposed to such geopolitical acts and risks. Specifically, it has been 53 years since we faced a nuclear risk.

Respectfully, unlike some others, I belief the cause of the recent market indigestion — and possible future market drawdowns — likely has very little to do with seasonality or the month of August, nor will it likely be a function of the historical weakness often seen in September and October.

The market’s issues run deeper and my concerns are based on both technical and fundamental grounds.

They have to do in part with the uncertainty surrounding various political, geopolitical, economic, market and monetary policy issues, many of them with potentially adverse outcomes. At least to me, the macroeconomic does impact Bristol-Myers Squibb (BMY) and Amazon (AMZN) and General Motors (GM) .

My concerns also have to do with the message of the bond market (this morning, the yield on the 10-year U.S. note is down by nearly five basis points to 2.11%), which indicates to me that the trajectory of domestic GDP growth and corporate profits is likely to disappoint for the fourth consecutive year.

Further adding to my concerns is the role of passive investing as the dominant influence on the markets. ETFs that rebalance daily and quantitative strategies such as volatility trending and risk parity exacerbate short-term moves and are, too often, the tail that wag the market dog. As I have asked, if the machines decide to sell, who is left to buy?

In part, these strategies have elevated valuation metrics above the 95% decile, alarming far too few market participants. Unfortunately, markets that are priced to perfection are vulnerable to exogenous shocks such as an Orange Swan, a missile aimed at Japan, a severe hurricane or a monetary policy mistake.

Meanwhile, there were technical breaks developing, starting with the outsize performance gains from the anointed FANG stocks. These conditions also were generally ignored by the bullish cabal.

Group Stink has ruled the day — a condition often seen historically at or near market tops.

As I have written, the thing to fear is the lack of fear itself.

Few commentators and talking heads in the business media, many of whom counseled the lemmings who stood strong in equities in both early 2000 and late 2007, have been willful participants in the Bull Market in Complacency and have contributed to the potential of a Minsky Moment.

My bearishness also reflects my view that the business cycle is mature and that there are Peaks Everywhere. Most notably, low interest rates have pulled forward sales in various sectors. Industries such as housing, where affordability again has been stretched, and autos, where the cycle has peaked, are samples of my concerns. Meanwhile, the retail industry has been eviscerated, with ugly consequences for real estate and employment, by a Dark Star named Amazon, a recent target of my disaffection.

Nearly three weeks ago on Aug. 10, I wrote “To Heck With the Crowd, I Remain Manifestly Bearish,” which underscored my multiple concerns (as they specifically relate to North Korea, see my boldfaced first question below that gnaws at me every morning).

It stated in part:

“I won’t tell you that the world matters nothing, or the world’s voice, or the voice of society. They matter a good deal. They matter far too much. But there are moments when one has to choose between living one’s own life, fully, entirely, completely – or dragging out some false, shallow, degrading existence that the world in its hypocrisy demands. You have that moment now. Choose!” –Oscar Wilde

Sometimes you need to sit alone on the floor in a quiet room in order to hear your own voice and not let it drown in the noise of others.

I am sitting on that floor now, and thinking — and shorting more.

Too many traders and investors think they know what will happen in the markets. They establish one, specific price target, usually clothed in certainty.

But the most successful traders and investors work with probabilities of outcomes.

I continue to maintain a historically high net short exposure because I believe we face numerous political, geopolitical, economic and market outcomes that could end badly — very badly.

After yesterday’s “fire and fury” (“TV-tough”) statement by President Trump regarding North Korea, I repeated five of my concerning questions:

* In a paperless and cloudy world, are investors and citizens as safe as the markets assume we are?

* 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?

* 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.

* 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?

* 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?

I then repeated my top 10 market concerns.

Bottom Line

“I wanted a perfect ending. Now I’ve learned, the hard way, that some poems don’t rhyme, and some stories don’t have a clear beginning, middle, and end. Life is about not knowing, having to change, taking the moment and making the best of it, without knowing what’s going to happen next. Delicious Ambiguity.” –Gilda Radner

Market views are like noses — everyone seems to have one!

To me, investors are complacent, numerous outcomes of all breeds (many of them adverse) seem possible, the business cycle is mature, machines and algorithms have undue market influence (and if the movie goes into reverse, selling rather than buying remains an existential market threat), valuations are at an historical extreme and thus make markets vulnerable to external shocks, and the market’s technical condition has been deteriorating for months.

And, in 2017, our interconnected, flat and networked world is unsafe on numerous fronts.

And, as I have expressed, after a lengthy period of quiet, volatility and uncertainty are likely to be great again.I plan to continue to err on the side of conservatism and I continue to maintain a skeptical view of the market’s reward compared to risk and the limited upside relative to downside.

But, as described in “Fearlessly Make Uncertainty and Volatility Your Friends!,” I also intend to capture alpha by being opportunistic, both from a trading and investing perspective.

***

As it is said, we live in interesting (and challenging) times, influenced by a set of relatively new circumstances and actors that have led to a Bull Market in Complacency — and the risk of a Minksy Moment — in which numerous outcomes, many of them adverse, are possible.

Today, as I did in early 2000 and in the late summer of 2007, I pay heed to Woody Allen, who said:

“More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”

Be alert, consider the contrary and think about sitting out some of the market’s dances, perhaps before your legs are chopped off.

When I was growing up my father, probably much like yours, had pearls of wisdom that he would drop along the way. It wasn’t until much later in life that I learned that such knowledge did not come from books, but through experience. One of my favorite pieces of “wisdom” was:

“Exactly how many warnings do need before you figure out that something bad is about to happen?”

Of course, back then, he was mostly referring to warnings he issued for me “not” to do something I was determined to do. Generally, it involved something like jumping off the roof with a queen-sized bedsheet convinced it was a parachute.

After I had broken my wrist, I understood what he meant.

With that in mind, there are currently plenty of warning signs individuals might want to consider before taking that leap. Here are four to consider.

Warning 1: Investor Confidence

There are several different surveys of retail investors which all currently show the same thing. Individuals have never been as hopeful as they are currently that the stock market will continue to grind higher. Last week, I discussed the Gallup poll which showed investor optimism at the highest levels since 1999.

The latest survey comes from the University of Michigan survey courtesy of Business Insider.

The preliminary survey of consumer sentiment for September showed a record 65% expected probability that stocks would rise in the next year. The data goes back to 2002.

As BI noted:

“The report in February noted that people who were most bullish for the year ahead, and could invest more in stocks, were in the top third of income distribution and in the top tier of stock ownership. In other words, the respondents to this survey have reaped strong gains on a riskier asset class in a short period of time and are hoping this continues.”

As I have discussed many times previously, the stock market rise has NOT lifted all boats equally. More importantly, the surge in confidence is a coincident indicator and more suggestive, historically, of market peaks as opposed to further advances.

As David Rosenberg, the chief economist at Gluskin Sheff noted:

‘For an investment community that typically lives in the moment and extrapolates the most recent experience into the future, it would only fall on deaf ears to suggest that peak confidence like this and peak market pricing tend to coincide with each other.”

He is absolutely correct. As shown below in the consumer composite confidence index (an average of the Census Bureau and University Of Michigan surveys), previous peaks in confidence have been generally associated with peaks in the market.

Warning 2 – All Hat, No Cattle

For those of you unfamiliar with Texas sayings, “all hat, no cattle” means that someone is acting the part without having the “stuff” to back it up. Just wearing a “cowboy hat,” doesn’t make you a “cowboy.”

I agree with the premise that leverage alone is not a problem for stocks in the short-term. In fact, it is the increase in leverage which pushes stock prices higher. As shown in the chart below, there is a direct correlation between stock price and margin debt growth.

But, margin debt is NOT a benign contributor. As I discussed previously in “The Passive Indexing Trap:”

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.”

Not surprisingly, the expansion of leverage to record levels coincides with the drop in investor cash levels to record lows. As noted by Pater Tenebrarum via Acting-Man blog: (The following also reinforces Warning #1)

 “Sentiment has become even more lopsided lately, with the general public joining the party. It may not ‘feel’ like the mania of the late 1990s to early 2000, but in terms of actually measurable data, the overall bullish consensus seems to be even greater than it was back then.

Along similar lines, here is a recent chart that aggregates the relative cash reserves of several groups of market participants (including individual investors, mutual fund managers, fund timers, pension fund managers, institutional portfolio managers, retail mom-and-pop type investors). It shows that there is simply no fear of a downturn:”

So much for the “cash on the sidelines” theory.

When investors believe the market can’t possibly go down, it is generally time to start worrying. As Pater concludes:

“As a rule, such extremes in complacency precede crashes and major bear markets, but they cannot tell us when precisely the denouement will begin.”

Warning 3 – Valuations

In an extensive, must-read report at Zerohedge, Deutsche Bank’s Jim Reid, the credit strategist unveiled an extensive analysis of the Next Financial Crisis”and specifically what may cause it, when it may happen, and how the world could respond assuming it still has means to counteract the next economic and financial crash. The bottom line is simple:

“With the global levels of over-valuation of stocks and bonds, combined with excessive optimism and leverage as noted above, has set the stage for exceedingly low returns over the next decade or longer.”

As noted in the report:

“With that baseline in mind, what happens next should be obvious: unless one assumes that the laws of economics and finance are irreparably broken, a deep recession and a market crash are inevitable, especially after the third biggest and second longest central bank-sponsored bull market in history.”

Valuations, as discussed most recently here, are a very poor market timing device for short-term investors. However, from a long-term investment perspective, valuations mean a great deal as it relates to expected returns.

As I addressed in “Shiller’s CAPE – Is There A Better Measure:”

“The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor’s, periods of ‘valuation expansion’ are where the bulk of the gains in the financial markets have been made over the last 114 years. History shows, that during periods of ‘valuation compression’ returns are much more muted and volatile.

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

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

As I stated in yesterday’s missive, a key ‘warning’ for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market.”

Notice the downturn in the CAPE-5 ratio preceded the 2016 market swoon. However, thanks to rapid Central Bank interventions, that valuation slide was rapidly reversed is now approaching previous highs. With earnings estimates being revised lower, economic growth remaining weak, and monetary policy being reigned in, the danger to investors longer-term is mounting.

Warning 4 – Share Buy Backs

The use of “share buybacks” to win the “beat the estimate” game should not be readily dismissed by investors.

“One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buybacks. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.”

The problem with this, of course, is that stock buybacks create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding – reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created, no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders.

As noted by Business Insider that strategy deployed to boost share prices since the financial crisis is on the decline.

“Spending on buybacks, however, has slipped over the past six months. Investment-grade-rated corporations repurchased $64 billion worth of stock in the second quarter, down from $84 billion in the fourth quarter of 2016, according to data compiled by Bank of America Merrill Lynch.

The decline puts added pressure on the stock market, which has become accustomed to buybacks pushing shares higher during lean times when real fundamental catalysts aren’t present.”

Like margin debt, exuberance and valuations, investors have little need to worry about the decline in share buybacks in the short-term.

As BI concludes:

“The real test will come at the first sign of downward turbulence.”

If They Don’t “Buy & Hold” – Why Should You?

Of course, these are just “warning signs.” None them suggest that the markets, or the economy, are immediately plunging into the next recession-driven market reversion.

But they are warning signs nonetheless. Past experience suggests that future returns are likely to be far less than historical averages suggest. Furthermore, there is a dramatic difference between investing for 30 years, and whatever time you personally have left to your financial goals.

While much of the mainstream media suggests that you “invest for the long-term” and “buy and hold” regardless of what the market brings, that is not what professional investors are doing.

The point here is simple. No professional, or successful investor, every bought and held for the long-term without regard, or respect, for the risks that are undertaken. If the professionals are looking at “risk,” and planning on how to protect their capital from losses when things go wrong, then why aren’t you?

Exactly how many warnings do you need?

“There is no other agency of government which can overrule actions that we take.” 

– Alan Greenspan

The Federal Reserve (Fed) currently expects real economic growth for the foreseeable future to average below 2.00%. Japan, the United Kingdom, and the European region are forecasting an even more anemic pace. On numerous occasions, we have detailed the reasons the United States and many foreign nations are mired in economic stagnation. At the top of our list, is the over-reliance on debt and the burden that decades of debt-driven-consumption policies have inflicted upon economic activity. To not only accommodate existing debt, but promote more debt, Keynesian schooled central bankers have presided over extremely easy monetary policy for years. Policy has been administered through a combination of low-interest rates and more recently, as desperation escalates to keep the economic engine from sputtering, money printing.

In “How Much is too Much” we shared the following graph that plots the exponentially increasing amounts of stimulus supplied by the Fed to combat recessions and “sub-par” economic growth.

The graph above, and many others comparing the actions taken by central banks over the last 30-40 years provides sufficient scale to understand the use of the word “extraordinary” to describe policy resulting from the Great Financial Crisis of 2008.

We thought it was worthwhile to extend the study to help you fully grasp the sheer lunacy of what has taken place over the last nine years. The fascinating chart below plots the size of the Bank of England’s (BOE) balance sheet as a percentage of GDP since the year 1700.

Data Courtesy: St. Louis Federal Reserve (FRED) and Bank of England

The size of the BOE’s balance sheet is nearly equivalent to the amount of stimulus supplied by the BOE. Note the red circle highlighting the sharp increase from 1929 to 1947. This period covered three devastating events for the United Kingdom. In 1929, the Great Depression began and strangled growth worldwide. At the time, the British Pound was the reserve currency, so the stifling of global trade imposed inordinate demands on the British Pound. Approximately ten years later they were heavily involved in WWII. The UK declared war on Nazi Germany in 1939 and experienced extensive destruction to their cities and infrastructure. In 1944, as the war was nearing an end, the Bretton Woods agreement was signed which marked the beginning of the end for the pound as the world’s reserve currency.

During this tumultuous 18-year period, the BOE’s balance sheet increased 180%, marking a significant change in the trend of the prior 250 years. Now consider that, over the last eight years, the amount of stimulus supplied by the BOE has increased 251%. Given the contrast, this graph effectively conveys the seriousness of the current economic situation in the UK and is symptomatic of all developed economies. 

Given that the U.S. Federal Reserve was established in 1913, we do not have historical data comparable to what is shown in the BOE graph. That said, using various sources and the generous help of others (special thank you to Brett Freeze – Global Technical Analysis), we came up with the following chart going back to the Fed’s inception.

Data Courtesy: Global Technical Analysis and St. Louis Federal Reserve (FRED)

Like the BOE graph above, the contrast of recent growth of the Fed’s balance sheet (+428%) is nothing short of alarming. The fact that this posture has been sustained now for nearly a decade and is producing the weakest recovery on record is even more disconcerting.

The graph below shows the tremendous growth of Japan’s and Europe’s central bank balance sheets since the crisis.

Data Courtesy: Bloomberg

Summary

There is clearly something wrong when a central bank prints money in rapidly growing amounts.  Such a departure from prior trends enables other undesirable events to transpire. The Fed, Wall Street, and the media serve up complicated economic explanations for why this time is not different from the past. The evidence provided in these charts argue something is very different.

Our experiences during the Great Financial Crisis provided first-hand evidence of the instabilities caused by too much debt. The years since have been the denial of that evidence as the debt burden has only grown larger. There is little doubt that the years to come will eventually bear witness to the resolution.

The charts above illustrate that central bankers have been desperately trying to use liquidity to offset the prior excesses. However, this is not a liquidity problem it is an insolvency problem. Egregious improper use of their balance sheets has only made the prospects for resolution worse as zombie banks, companies, and consumer debt that should have been liquidated are imprudently allowed to survive.  It is just an eventuality that the Minsky moment will arrive – the time when extensive amounts of debt must be written off, losses taken and financial institutions re-capitalized. When that day arrives, the central bankers and their sledge hammers of monetary policy will not have the precision required to patch the problems yet again. At that point, they can either allow the economy to naturally deleverage in what would certainly be a painful economic event or they can print even more money in further attempts to reflate the economy. Experience has shown that the second option, while it delays the inevitable, is every bit as painful as the first. Our guess is they will select option two and desperately try to kick the can as long as possible and extend the charade of the past few years.

Like a drug addict chasing the proverbial dragon, the world’s central bankers are faced with the painful choice of rehab to break the grip of easy money or an on-going downward spiral toward economic demise.

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Rising health care costs are a formidable challenge which requires ongoing vigilance. Preventative measures which include a regimen of regular exercise and smart eating habits can go a long way to improve the physical, mental and fiscal quality of decades in retirement.

There’s little bandwidth in retirement budgets to handle the growing burden of health care costs, so it’s surprising when Medicare’s open enrollment period rolls around and it’s not considered an annual opportunity to review coverage and costs for Medicare Advantage and Medicare Part D prescription drug plans. The window is from October 15 through December 7 for a change (or no change) in benefits beginning January 2018.

Before I delve into why it’s financially advantageous to undertake a yearly time-consuming exercise, a quick overview of health care inflation and costs is an important precursor. Comprehensive financial planning must include an estimate of annual health-related retirement expenses and an assessment of how much you or you and a spouse or partner will spend on health care throughout retirement.

According to the Kaiser Family Foundation through the Peterson-Kaiser Health System Tracker, U.S. health care spending per capita had risen at historically low rate, but began to accelerate in 2014 with the inception of ACA, also known as “Obamacare.” Health-care spending growth is projected to average 5% per year on a per capita basis.

When planning for retirement, make certain your financial partner is incorporating a realistic rate of health care inflation, no less than 4.5% and the program employed may be adjusted to reflect recent cost increases in Medicare premiums.

For example, Medicare Trustees, in their 2016 annual report, have determined that Medicare Part B and Part D costs have increased respectively by 5.6% and 7.7% over the past five years. Unfortunately, the Trustees have determined these costs will grow by 6.9% and 10.6% respectively, over the next five years.

During the retirement planning data-gathering phase, it’s also important to incorporate a realistic life expectancy target. Many planners default to age 100 “just to be safe,” without considering current health status, family history and habits like alcohol consumption and smoking.

Planning to 100 can be a frustrating, impractical, discouraging exercise for the majority of Americans who aren’t saving enough to reach retirement goals in the first place. Advising someone to save and invest sufficiently to make it age 100 may do nothing but create anxiety and feelings of hopelessness.

Practical retirement planning should employ a life expectancy calculator like www.livingto100.com. Astute advisors also utilize Whealthcare Planning’s Proactive Aging Plan module developed by financial advisor and physician Carolyn McClanahan. Either way, if your plan is designed to age 100, at least some form of analysis is backing it up.

With all that being outlined, the annual Medicare enrollment period is a time to assess current Medicare Advantage and Part D policies and make changes if warranted.

Here are several points to consider.

Medicare Advantage: What Is It? Should I Change?

Medicare Advantage is growing in popularity despite reductions in payments enacted by the Affordable Care Act. Per KFF.org, since 2010, Medicare Advantage enrollment has grown 71%.

The majority of Medicare Advantage Plans are inclusive which means they cover all services of Original Medicare, including prescription drugs. Most offer extra coverage like vision, hearing, dental and/or wellness plans. Two-thirds of the plans offered are through closed-physician network HMOs.

Advantage Plans usually have lower premiums than Medigap (also known as Medicare Supplemental Insurance), and are offered without evidence of insurability. However, out-of-pocket costs can be costly. Ostensibly, Medicare Advantage is most suitable for participants who are healthy and don’t visit the doctor often.

As a Medicare participant, you’ll soon be overwhelmed (if not already), by advertisements. Place them aside for now to focus on the Annual Notice of Change (ANOC) and Evidence of Coverage (EOC) documents that will outline the new terms of conditions of your Medicare Advantage plan.

Naturally, you’ll want to see if premiums have increased. Also important is to determine whether co-payments (the coverage costs you’re responsible for in addition to premiums,) are going higher.

Equally important is to see whether your pharmacy option has changed and your current prescription drugs are still covered. Remember, Advantage providers have the option to change their plan benefits every year; it’s best you don’t take the annual enrollment window, lightly and check that this is the same plan you signed up for.

Even if your plan is going to remain status quo, it’s now worth going through the advertisements. Perhaps attend a seminar or two (you’ll receive multiple invitations).

During the annual enrollment period, a participant may switch from one Medicare Advantage Plan to another, change from Original Medicare (A&B), to a Medicare Advantage Plan, or switch from a Medicare Advantage Plan that doesn’t offer drug coverage to one that does.

Last, find plans for comparison through www.medicare.gov’s impressive search engine.

What About Medicare Prescription Drug Plans?

If covered by standalone Part D or a drug plan through Medicare Advantage, now is the time to make sure it will still cover your prescriptions in 2018 (it may not), determine whether co-pays will change or additional restrictions will be initiated.

For example, various plans are switching to an exclusive mail order refill process for cost efficiencies which may mean higher out-of-pocket costs for brick & mortar pharmacy prescription drug orders.

Through Medicare’s find a plan you may input your current prescription drugs and compare your plan to other choices. Once you receive the Annual Notice of Change (you may have already), review it carefully. It will outline changes in cost, coverage or services if any.

What if your plan remains the same? It’s still worth doing some investigation to determine whether you can find a similar plan at lower out-of-pocket costs.

According to a report by EHealth, only 10% of those in Medicare prescription drug coverage plans were enrolled in the plans that covered their prescriptions at the lowest possible prices.

Medicare annual open enrollment should be perceived as an opportunity to fine-tune or at least, take close inventory of current coverage. Consider the objective assistance of a financial professional qualified to provide guidance.

If you would like a copy of Medicare’s “Yearly Medicare Plan Review,” checklist, feel free to  “email me” and we will e-mail this helpful guide to you.

The bulk of U.S. stock gains in this long-running bull market are due to one variable: the expansion of the price-to-earnings ratio.

Earnings for S&P 500 companies have stagnated since 2014. Stock prices have gone up because the Federal Reserve and other central banks have squeezed all investors to the same side of the risk curve. Stocks, especially high-quality ones that pay dividends, are regarded as bond substitutes. Investors now look at the dividends of those stocks and compare those yields to what they can earn in, say, 10-year Treasurys. This strategy will end in tears, as these bond-substitute stocks are significantly overvalued.

Investors globally are facing major obstacles nowadays. These include:

• The risk of lower or negative global economic growth.

• Inflation (high interest-rates), deflation (low interest rates) or a combination of the two (higher interest-rates and deflation).

We don’t know which of these extremes are going to show up, or in which order. Despite their eloquence and portrayed confidence, financial commentators arguing one or another extreme point of view don’t know either. In fact, the more confident they are, the more dangerous they are. Nobody knows.

What’s really called for is an “I don’t know” portfolio that can handle extremes.

As investors today we feel something like a traveler preparing to drive across an unknown continent. A look in the rear-view mirror tells us we should pick a sports car, and if the road continues to be as it has been, then our trip may be fast and uneventful. But what if the road that lies ahead is rocky, full of potholes, and maybe strewn with giant boulders?

A sports car will not get past the potholes. What we need is a four-wheel-drive, all-terrain vehicle. This monster will not have the speed or the sex appeal of the shiny red convertible, but it will complete the journey. Its position at the finish line will depend entirely on one unknown — the road ahead. If it is a smooth, unbroken route, then our Land Cruiser will be left in the dust by the Ferraris and Maseratis.

But if my prediction is correct, you’re going to be mighty glad to have four-wheel drive — you might even end up at the head of the pack.

On the surface, the U.S. and global economies appear to be growing, and though growth has been slow, it has been steady. My concern is that demand for goods has been highly inorganic, engendered by central bankers’ quantitative easing and government’s unsustainable budget deficits.

This is a time for investors to show humility and patience. Humility, because saying the words “I don’t know” is difficult for us money manager types.

Patience, because most assets today are priced for perfection. They are priced for a confluence of two outcomes:

  1. low (or negative) interest rates continuing at current levels or declining further, and;
  2. above-average global economic growth.

Both happening at once is extremely unlikely. Take one away, and stock market indexes are overvalued somewhere between a lot and humongously. (I won’t even try to quantify superlatives.)

So, how does one invest in this overvalued market? Our strategy is spelled out in this fairly in-depth article.

In this past weekend’s newsletter, I addressed three of my concerns for the markets going forward.

“Chart 2) One of the hallmarks of a late-stage bull market cycle is the acceleration in price as investors capitulate by “jumping in” as prices accelerate. While the long-term moving averages currently suggest the bull cycle is intact, we will watch for the crossover to give us an indication of when to leave.”

The acceleration in the increase of prices is a hallmark of “exuberance” in the markets. Not surprisingly, the sharp increase in asset prices, as the markets broke through successive barriers of 2200, 2300, 2400 and 2500, has spurred investor optimism to the highest levels in 17-years as noted last week:

“The latest boost in optimism pushes the index almost 100 points higher than the +40 score measured in February 2016. The 98-point hike over the past 18 months is the largest increase in the 20-year history of the index that is not a rebound immediately after a major drop in optimism.

After more than 8-years of a surging bull market, often declared the ‘most hated in history,’

  • Sixty-eight percent now say they are optimistic about the stock market’s performance during the next year, matching the record high for the question from December 1999 and January 2000.
  • At least 61% have expressed optimism about the stock market in each of the three surveys this year, a percentage matched or exceeded only four other times in the 132 times the question has been asked since April 2000.
  • Twenty-five percent say they are ‘very optimistic,’ topping the previous record high of 24% from the first quarter of this year. Only 11% were very optimistic a year ago.
  • Sixty-one percent of investors now say it is a good time to invest in the stock market, up from 53% two years ago. Among those saying it’s a good time to invest, the main reason is their belief that the market will continue to increase, mentioned by 47%.”

As Robert Shiller penned for the NYT, that surge in optimism is symptomatic of a bigger issue:

“Canny stock investors are like judges in a quirky beauty contest. They aren’t looking for real beauty but for qualities that other people believe still other people will find beautiful.

That was the observation of John Maynard Keynes, who suggested that investors do not actually make money by picking the best companies, but by picking stocks that waves of other traders will want to buy.

Investing, in other words, is an exercise in mass psychology.”

The belief that Central Banks have the markets under control is a dangerous one. While many believe that just a few Central Bankers have the foresight and capability to control a market driven by human emotion and frailties, such is unlikely to be the case. This was a point John Mauldin clearly made this past weekend:

“This time is different are the four most dangerous words any economist or money manager can utter. We learn new things and invent new technologies. Players come and go. But in the big picture, this time is usually not fundamentally different, because fallible humans are still in charge. (Ken Rogoff and Carmen Reinhart wrote an important book called This Time Is Different on the 260-odd times that governments have defaulted on their debts; and on each occasion, up until the moment of collapse, investors kept telling themselves ‘This time is different.’ It never was.)”

As shown in the chart below, which is monthly price data, the market is trading 3-standard deviations and nearly 17% above its 3-YEAR moving average. Such extensions and deviations have generally not lasted long, but are evidence of the bullish psychology driving the market.

I agree with Dr. Shiller that such does NOT mean there is a crash coming tomorrow:

“But the result is that while valuations remain very high there just doesn’t seem to be much evidence that many investors in the United States stock market are actively worrying today that other investors are on the verge of selling. Mass opinions may well change, but for now, in the critical psychological dimension, the stock market does not closely resemble the market in the dangerous years of 1929 or 2000.

That doesn’t mean that there is no danger of a crash. But at the moment, the psychological preconditions for a spiraling downturn don’t appear to be in place.”

As is always the case in late-stage bull market advances, the need to chase performance overrides the logic of investing for the long-term. More importantly, mass opinions can change extremely quickly. Like a slow leak in the hull of a ship, it will begin slowly, but the eventual rupture will send participants scrambling for the lifeboats.

You can’t blame individuals really. They are inundated daily by media-driven commentary that pushes them to “jump in because they are missing out.” This sense of urgency to be invested leads to performance chasing of things that have already done well. As I have shown previously, there is substantial evidence that buying last year’s “winners,” more often than not, turn out to be this year’s “losers.”

Rob Arnott, Vitali Kalesnik and Lillian Wu of Research Affiliates made a brilliant point about the danger of performance chasing:

“Joe Kennedy famously said on the eve of the 1929 stock market crash: ‘When shoeshine boys have tips, the stock market is too popular for its own good.

The negative relationship between a manager’s past and future simple returns means that when your cab driver or bartender (shoeshine boys are less common these days) tells you about an investment with recent double- or triple-digit returns—beware! That may just be the signal to stay away from the market, and most particularly, from the winningest funds. Reciprocally (from repeated personal experience in 1974, 1982, 1987, 2002, and 2009), when you hear reasonably savvy people saying they’ll never invest in stocks again, chances are stocks are at extremely low valuations and are a bargain.

In other words, investing successfully is, in part, learning to do what is uncomfortable in the short-term.

As Research Affiliates concludes:

“Because it’s impossible to know where the top is, and we don’t want to sell too soon, ‘selling high’ is not easy. When we sell high, and the asset moves higher, we feel foolish. ‘Buying low’ is even harder. Anything that’s newly cheap has inflicted pain and losses in its path to low prices. It’s impossible to know where the bottom is, so buying low inevitably leaves us looking and feeling foolish until the turn. ‘Buy low, sell high’ is therefore a painful path to success.

Nevertheless, we hope our findings encourage investors to consider joining us in moving out of our respective comfort zones. The capital markets do not reward comfort. In investing, we generally find our best rewards in our discomfort zone.”

Holding higher levels of cash than normal, trimming back winning positions, and selling losing ones are all steps which “go against the grain” in the current market. As noted, it’s hard to think you are “missing out” as others may be getting ahead of you.

But, investing isn’t a competition. There are no winners, just losers when you get it wrong.

Just remember the one final chart below.

From the current levels of over valuation, excess extension and extreme bullishness which currently exists, the coming reversion “beyond” the mean will wipe out the majority of any gains made over the last several years. Such is the case with all reversions throughout history.

Worrying about “missing out” on the current bull market should probably not be at the top of your list.

Editor’s Note: All of us at Real Investment Advice are proud to welcome Daniel Nevins, CFA to our growing list of outstanding contributors. He has invested professionally for 30-years, including more than a decade at both J.P. Morgan and SEI Investments. He is perhaps best known for his behavioral economics research, which was included in the curriculum for the Chartered Financial Analyst® program and earned him recognition as one of the founders of goals-based investing. He has an economics degree from the Wharton School of Business and a degree from the University of Pennsylvania’s engineering school. 


Even as the Fed’s decision makers are beginning to worry less about recession and more about bubbly stock prices, we’re not yet moved by their attempts to curb the market’s enthusiasm. After all, the fed funds rate sits barely above 1%, which not too long ago qualified as a five-decade low. And other indicators, besides interest rates, aren’t exactly predicting the next bear, either. Inflation is subdued, credit spreads are tight, banks are mostly lending freely and the economy is growing, albeit slowly. It just doesn’t feel as though we’re close to a major market peak.

All that being said, we’re not so much about feelings as we are about delving into history (nerds that we are) and seeing if there’s anything we can learn. Let’s look at the last 90 years to see if any bear markets began under similar conditions to those today.

We’ll consider thirteen bears, as listed in the table below. (Our list may be different to yours, mainly because we use Robert Shiller’s monthly average S&P 500 prices, instead of daily prices, but also because we reset the cycle whenever the market falls 20% from a peak or rises 20% from a trough.)

Next we narrow the list by excluding bears that began during recessions, because we don’t think the economy is recessing as I write this (or recessing imminently—see here.) That removes the first three bears—those that began in 1929, 1930 and 1932. Every other bear began as the economy was expanding, which explains why market peaks are so difficult to predict.

We also exclude the bear that crossed the 20% threshold in June 1940 and can’t be separated from geopolitics. Hopefully, modern geopolitical risks won’t explode as they did then, but we can always return to the “WWII bear” if WWIII breaks out (presuming we’re alive and blogging).

After the exclusions, nine bears remain. We examine each one to determine how many were predicted by rising inflation, one of the strongest bear-market indicators. Rising inflation erodes purchasing power, invites monetary restraint and unsettles both lenders and investors. Judging by the next chart, it helped trigger at least seven of the nine bears:

The chart shows seven bears emerging from an inflation “shock” of 3% or more (referring to an increase from twelve months before a market peak to when stocks reached the bear market threshold of –20%). In each of those cases, it seems pointless to attempt to draw parallels to today. Inflation is currently below 2% and down almost a percent from January. Without an inflation shock in sight, we shouldn’t rely on the seven “inflation bears” to predict the future.

That leaves two bears we haven’t yet considered. In one of the two—the bear that began in August 2000—inflation contributed to the market’s reversal, but monetary policy and credit conditions were more telling. Policy rates rose, credit spreads widened and bank lending standards tightened—all before the market peak. Market conditions at that time were quite different to those today, as shown in the table below (which also includes the October 2007 peak for added context):

In other words, twelve of the original thirteen bears emerged from some combination of recession, inflation, world war, monetary tightening, and troubles in credit markets. In each case, market conditions were uglier than they appear now. The twelve bears tell us to be optimistic—they’ll continue to hibernate until conditions worsen. But we’ve yet to consider the 1962 bear, which finally supplies a potential match for today.

The lead-up to the 1962 bear looks eerily similar to 2017. Commentators called it the Kennedy Slide. Before the Slide, the market hadn’t fallen 20% on a month-average basis since 1946. And the bull gathered speed after JFK won the presidency. Sound familiar? Here’s a chart comparing the S&P 500 (SPY) in the three years after Kennedy’s election to the first ten months after Donald Trump’s election (there’s a joke somewhere in the respective trajectories, but we would like to keep our G rating):

Conclusions

The Kennedy Slide offers a reasonable guide to how a future bear could develop if key indicators remain benign. Consider that the Slide defied four fundamentals you wouldn’t normally associate with falling stock prices:

  • Inflation was subdued, peaking at 1.3%.
  • Monetary policy was close to neutral, with the discount rate at 3%.
  • Growth was strong, reaching 7.4% in Q1 1962 and 4.4% in Q2, after Q4/Q4 growth of 6.4% in 1961.
  • Credit spreads were testing 18-month lows of just above 1% (for the Moody’s Baa Corporate versus the 10-year Treasury).

Surely those cozy fundamentals explain the market’s rocket-fast recovery. Stocks reached a new all-time high in September 1963, just 21 months after the prior high. That’s the shortest period on record from one all-time high through a bear market to the next all-time high—faster even than the recovery from the 1987 crash.

And what might 1962 tell us about the future?

Well, as of now, inflation, monetary policy, growth and credit are only marginally less cozy than they were then. If that continues, we would bet on a rapid recovery from a Trump Slide, should one occur. But it’s important for inflation, monetary policy, growth and credit to remain nonthreatening. Any of those fundamentals could change rapidly, and they tend to correlate. (We expect monetary policy to be a particular risk within a couple of years, as discussed here.) Should the four fundamentals deteriorate, we would ignore the 1962 bear and turn to other bears for clues about what happens next. Considering the unprecedented period of monetary stimulus, we would then expect an ill-tempered bear, one that might resemble the bears that began in 1930, 2000 and 2007.

When we pass the next market peak, in other words, four key fundamentals should tell us whether we’ll “ride the slide” or experience something much worse.

Last week, I was discussing the rather “Pavlovian” response to Central Bank interventions which has led investors into a false sense of security with respect to the risk being undertaken within portfolios.

This got me to thinking about “risk” and reminded me of something Howard Marks once wrote:

“If I ask you what’s the risk in investing, you would answer the risk of losing money. But there actually are two risks in investing: One is to lose money, and the other is to miss an opportunity. You can eliminate either one, but you can’t eliminate both at the same time. So the question is how you’re going to position yourself versus these two risks: straight down the middle, more aggressive or more defensive.

I think of it like a comedy movie where a guy is considering some activity. On his right shoulder is sitting an angel in a white robe. He says: ‘No, don’t do it! It’s not prudent, it’s not a good idea, it’s not proper and you’ll get in trouble’.

On the other shoulder is the devil in a red robe with his pitchfork. He whispers: ‘Do it, you’ll get rich’. In the end, the devil usually wins.

Caution, maturity and doing the right thing are old-fashioned ideas. And when they do battle against the desire to get rich, other than in panic times the desire to get rich usually wins. That’s why bubbles are created and frauds like Bernie Madoff get money.

How do you avoid getting trapped by the devil?

I’ve been in this business for over forty-five years now, so I’ve had a lot of experience.  In addition, I am not a very emotional person. In fact, almost all the great investors I know are unemotional. If you’re emotional then you’ll buy at the top when everybody is euphoric and prices are high. Also, you’ll sell at the bottom when everybody is depressed and prices are low. You’ll be like everybody else and you will always do the wrong thing at the extremes.

Therefore, unemotionalism is one of the most important criteria for being a successful investor. And if you can’t be unemotional you should not invest your own money, period. Most great investors practice something called contrarianism. It consists of doing the right thing at the extremes which is the contrary of what everybody else is doing. So unemtionalism is one of the basic requirements for contrarianism.”

It is not surprising with markets hitting “all-time highs,” and the mainstream media trumpeting the news, that individuals are being swept up in the moment.

After all, it’s a “can’t lose proposition.” Right?

This is why being unemotional when it comes to your money is a very hard thing to do.

It is times, such as now, where logic states that we must participate in the current opportunity. However, emotions of “greed” and “fear” are kicking in either causing individual’s to take on too much exposure, or worrying that risk is too high and a crash could come at any time. Emotional based arguments are inherently wrong and lead individuals into making decisions that ultimately have a negative impact on their financial health.

As Howard Marks’ stated above, it is in times like these that individuals must remain unemotional and adhere to a strict investment discipline.

RIA Portfolio Management Rules

It is from Marks’ view on risk management that I thought I would share with you the portfolio rules that drive own own investment discipline at Real Investment Advice. While I am often tagged as “bearish” due to my analysis of economic and fundamental data for “what it is” rather than “what I hope it to be,” I am actually neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy which focus on capital preservation and long-term “risk-adjusted” returns.

The fundamental, economic and price analysis forms the backdrop of overall risk exposure and asset allocation. However, the following rules are the “control boundaries” for all specific actions.

  1. Cut losers short and let winner’s run. (Be a scale-up buyer into strength.)
  2. Set goals and be actionable. (Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  3. Emotionally driven decisions void the investment process.  (Buy high/sell low)
  4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  5. Never let a “trading opportunity” turn into a long-term investment. (Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  6. An investment discipline does not work if it is not followed.
  7. “Losing money” is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)
  8. The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  9. Never, under any circumstances, add to a losing position. (As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  10. Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short. (Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  11. When markets are trading at, or near, extremes do the opposite of the “herd.”
  12. Do more of what works and less of what doesn’t. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  13. “Buy” and “Sell” signals are only useful if they are implemented. (Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  14. Strive to be a .700 “at bat” player. (No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  15. Manage risk and volatility. (Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Currently, the long-term bullish trend that began in 2009 remains intact. The correction that began in early 2016 was temporarily cut short by massive, and continuing, interventions of global Central Banks. There is a limit, of course, to the efficacy of those interventions.

A violation of the long-term bullish trend, and a failure to recover, will signal the beginning of the next “bear market” cycle. Such will then change portfolio allocations to be either “neutral or short.”  BUT, and most importantly, until that violation occurs, portfolios should be either long or neutral ONLY.  

The current market advance both looks, and feels, like the last leg of a market “melt up” as we previously witnessed at the end of 1999.  How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things do come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives.This is why focusing on “risk controls” in the short-term, and avoiding subsequent major draw-downs, the long-term returns tend to take care of themselves.

Everyone approaches money management differently.

This is just my approach and I am simply sharing my process.

I hope you find something useful in it.

I remember the first time I saw the movie “Poltergeist.” It scared the $*#@ out of me, and I slept with the lights on for a month.

Recently, I got a chance to catch a rerun. It certainly wasn’t the same experience. It was kind of like eating a “twinkie” as an adult, the sponge cake and creamy filling aren’t nearly as delicious as I remembered them. “Poltergeist” is now more of a “campy” flick with bad special effects.

But the run up in the markets over the last few days, on really no news at all, reminded me of the scene where “Carol Anne” is pointing to the static filled television screen proclaiming “they’re back.”

After a brief decline, market sentiment got bearish enough to provide the catalyst for a short-term rally. With Trump now caving in to “Chuck and Nancy,” the North Korean threat deflated, and hopes for tax cuts on the horizon, “the bulls are back.”

Since the election, there has been a concerted effort to push stocks higher on the hopes of tax reform, ACA repeal, and infrastructure building which would lead to strongly improving earnings for U.S. companies. Now, eleven months later, stocks have been breaching the psychologically important levels of 2200 in December, 2300 in February and finally 2400 in May. 2500 is the next target.

The problem is that NONE of the legislative agenda has been passed. Zero, Nada, Zip.

But such small details have not, as noted yesterday, deterred investors who have once again fully abandoned reason and have gone “all in.”

With cash levels at the lowest level since 1997, and equity allocations near the highest levels since 1999 and 2007, it also suggests investors are now functionally ‘all in.'”

“Here is the point, despite ongoing commentary about mountains of “cash on the sidelines,” this is far from the case. This leaves the current advance in the markets almost solely in the realm of Central Bank activity.”

Yes, the bulls are indeed back for now.

The ending of this version of “Poltergeist Market” will surely be just as scary as the last.

In the meantime, here is what I am reading this weekend.


Politics/Fed/Economy


Markets


Research / Interesting Reads


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

Questions, comments, suggestions – please email me.

With the market breaking out to all-time highs, the media has started to once again reach for their party hats as headlines suggest clear sailing for investors ahead.

After all, why not?  We have run one of the longest stretches in history without a 5%, much less a 10% decline. Threats of nuclear war, hurricanes, disaster, fires, earthquakes, and civil unrest have failed to unnerve investors. It seems all that has been missed was famine and pestilence.

Nonetheless, the breakout is indeed bullish, and signals the continuation of the bullish trend. However, such does not mean there are more than sufficient reasons to remain cautious. As noted on Tuesday, earnings growth remains weak outside of share buybacks, along with top line revenue. There is scant evidence of economic resurgence outside of a restocking cycle bounce, and inflationary pressures globally remain nascent. But such concerns, and I am not even sure the “4-horseman of the apocalypse” would make a difference, are “trumped,” by the ongoing global central bank interventions.

Not surprisingly, while it took individuals time to develop their “Pavlovian” response to the ringing of the “BTFD” bell, they have now fully complied as measured by the Investment Company Institute (ICI).

As shown in the chart above, as asset prices have escalated, so have individuals appetite to chase risk. The herding into equity ETF’s suggest that investors have simply thrown caution to the wind.

The same can be seen for the American Association of Individual Investors as shown below.

While the ICI chart above shows “net flows,” the AAII chart shows percentage allocated to stocks versus cash. With cash levels at the lowest level since 1997, and equity allocations near the highest levels since 1999 and 2007, it also suggests investors are now functionally “all in.” 

With net exposure to equity risk by individuals at historically high levels, it suggests two things:

  1. There is little buying left from individuals to push markets marginally higher, and;
  2. The stock/cash ratio, shown below, is at levels normally coincident with more important market peaks.

Here is the point, despite ongoing commentary about mountains of cash on the sidelines, this is far from the case. This leaves the current advance in the markets almost solely in the realm of Central Bank activity.

Of course, there is nothing wrong with that…until there is.

Which brings us to the ONE question everyone should be asking.

“If the markets are rising because of expectations of improving economic conditions and earnings, then why are Central Banks pumping liquidity like crazy?”

Despite the best of intentions, Central Bank interventions, while boosting asset prices may seem like a good idea in the short-term, in the long-term has had a negative impact on economic growth. As such, it leads to the repetitive cycle of monetary policy.

  1. Using monetary policy to drag forward future consumption leaves a larger void in the future that must be continually refilled.
  2. Monetary policy does not create self-sustaining economic growth and therefore requires ever larger amounts of monetary policy to maintain the same level of activity.
  3. The filling of the “gap” between fundamentals and reality leads to consumer contraction and ultimately a recession as economic activity recedes.
  4. Job losses rise, wealth effect diminishes and real wealth is destroyed. 
  5. Middle class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption. 
  7. Wash, Rinse, Repeat.

If you don’t believe me, here is the evidence.

The stock market has returned more than 60% since 2007 peak, which is more than three times the growth in corporate sales growth and 30% more than GDP. The all-time highs in the stock market have been driven by the $4.5 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, PE expansion, and ZIRP.

In turn, this has driven the average valuation of stocks to the highest ratio in history.

Which, as noted, has been driven by a debt-driven binge of share repurchases to boost bottom line earnings.

What could possibly go wrong?

However, whenever there is a discussion of valuations, it is invariably stated that “low rates justify higher valuations.” 

Maybe. But the argument suggests rates are low BECAUSE the economy is healthy and operating near full capacity. However, the reality is quite different as the always insightful Dr. John Hussman pointed out this past week:

“Make no mistake: the main contributors to the illusion of permanent prosperity have been decidedly cyclical factors.

Again, when interest rates are low because growth is also low, no valuation premium is ‘justified’ at all. In the present environment, investors are inviting disastrous losses by paying the highest S&P 500 price/revenue ratio in history (outside of the single week of the 2000 market high) and the highest median price/revenue ratio in history across S&P 500 component stocks (more than 50% beyond the 2000 peak, because extreme valuations in that episode were focused on much narrower subset of stocks than at present). Glorious past returns and record valuations are a Potemkin Village with a barren field behind it.”

There are virtually no measures of valuation which suggest making investments today, and holding them for the next 20-30 years, will work to any great degree.

That is just the math.

Which brings me to something Michael Sincere’s once penned:

“At market tops, it is common to see what I call the ‘high-five effect’ — that is, investors giving high-fives to each other because they are making so much paper money. It is happening now. I am also suspicious when amateurs come out of the woodwork to insult other investors.”

Michael’s point is very apropos, particularly today. It is interesting that prior to the election the majority of analysts, media and investors were “certain” the market would crash if Trump was elected. Since the election, it’s “high-fives and pats on the back.” 

While nothing has changed, the confidence of individuals and investors has surged. Of course, as the markets continue their relentless rise, investors begin to feel “bullet proof” as investment success breeds over-confidence.

The reality is that strongly rising asset prices, particularly when driven by emotional exuberance, “hides” investment mistakes in the short term. Poor, or deteriorating, fundamentals, excessive valuations and/or rising credit risk is often ignored as prices increase. Unfortunately, it is only after the damage is done that the realization of those “risks” occurs.

As Michael stated:

“Most investors believe the Fed will protect their investments from any and all harm, but that cannot go on forever. When the Fed attempts to extricate itself from the market one day, that is when the music stops, and the blame game begins.”

In the end, it is crucially important to understand that markets run in full cycles (up and down). While the bullish “up” cycle lasts twice as long as the bearish “down” cycle, the damage to investors is not a result of lagging markets as they rise, but in capturing the inevitable reversion. This is something I discussed in “Bulls And Bears Are Both Broken Clocks:”

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

The markets are indeed in a liquidity-driven up cycle currently. With margin debt near peaks, stock prices in a near vertical rise and “junk bond yields” near record lows, the bullish media continues to suggest there is no reason for concern.

The support of liquidity is being extracted by the Federal Reserve as they simultaneously tighten monetary policy by raising interest rates. Those combined actions, combined with excessive exuberance and risk taking, have NEVER been good for investors over the long term.

At market peaks – “everyone’s in the pool.”

Recently on our Twitter feed, @michaellebowitz, we introduced the hashtag #fedgibberish. The purpose was to tag Federal Reserve members’ comments that highlight desperate efforts to rationalize their inane monetary policy in the post-financial crisis era. This past week there were two quotes by Fed members and one by the head of the European Central Bank (ECB) which were highly deserving of the tag. We present them below, with commentary, to help you understand the predicament the Fed and other central banks face.

Lael Brainard

On September 5, 2017 Fed Governor Lael Brainard stated the following in a speech at the Economic Club of New York:

We should be cautious about tightening policy further until we are confident inflation is on track to achieve our target.” – “There is a high premium on guiding inflation back up to target so as to retain space to buffer adverse shocks with conventional policy.”

Let us rephrase: The Fed must be careful not to raise interest rates further until signs of inflation appear. When said inflation does pick up and it meets our target, we can then raise interest rates further. In doing so, we will then have the ability to lower interest rates when the economy hits a rough spot.

Inflation has been benign since the 2008 financial crisis. Clearly, nine years of the lowest interest rates on record have not been inflationary for the prices of goods and services that make up most standard economic inflation gauges. In fact, it is difficult to find a better real world example of deflation than the incoherence of negative interest rates manufactured by some central bankers who are begging for inflation. That said, there is a strong positive correlation between the amount of Fed stimulus and the price of financial assets. What Lael Brainard and her colleagues fail to understand is that excessive Fed policy has diverted capital away from productive investments that would generate the inflation and economic growth she and her colleagues so desperately seek to conjure. The bottom line is they do not understand the effect that eight years of excessive stimulus have had on the economy and are clearly unaware of what must be done to solve the global economic malaise.

Neel Kashkari

On September 6, 2017 Neel Kashkari from the Minneapolis Fed stated the following:

“Fed rate hikes may have done real harm to the economy.”

Kashkari senses economic weakness, which he believes is occurring as a result of the Federal Funds rate increasing from zero to 1.25% over the past 21 months. While that statement might be legitimately arguable, he is woefully negligent in helping his listeners understand why the economy is struggling despite the lowest rates in recorded history. An economy that cannot handle such a rise in the cost of money is symptomatic of a society burdened by too much debt. We posit that the economic problems the Fed aims to fix are the result of abnormally low interest rates and other stimulus of years past. These have not had the desired economic effects and have also curtailed future growth. After all, the use of debt pulls forward future consumption leaving less consumption in the future. Mr. Kashkari should consider that encouraging more debt is not the way to solve a debt burden. Either that, or he should let us in on his plan to forestall the arrival of the future from which consumption has been borrowed and payback is required.

Mario Draghi

On September 7, 2017 ECB President Mario Draghi stated:

We do not see negative effects of QE”.

We are speechless. We simply ask Mr. Draghi – if there are no negative effects of QE then why are you contemplating tapering QE? In fact, why are the European people not rioting with pitchforks for a lot more QE?

There is no doubt in our mind Draghi’s statement flat out lie will become obvious over time. Until the media and the markets awaken from their central bank induced slumber, we leave you with the infamous words of prior ECB President Jean-Claude Junker:

When it becomes serious, you have to lie.

As we put the finishing touches on this commentary, New York Federal Reserve President Bill Dudley pointed out that the longer-run effects of disasters like the recent hurricanes actually lifts economic activity. Our reply to this absurd comment is simple: #fedgibberish

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I’m sure your financial partner is a well-meaning individual.

I’m also certain the professionals chosen to assist with growing and protecting your wealth are doing what is acceptable per what their compliance departments and branch managers dictate. They must never deviate. Or face the consequences.

That’s the mandate.

Something stinks.

Is this the best you deserve?

Information to consumers deemed suitable by financial industry regulatory agencies including a broker’s internal policing department is just more of what the financial marketing and branding machine requires to remain legally uninterrupted. Watered-down fiduciary standards are a first step to greater responsibility to clients however, there’s a very long way to go.

I mean, if it’s not broken, why hurry to fix or try to improve a system that’s benefited Wall Street for so long?

Candidly, most of what you’re sold as far as portfolio theory or regulatory-approved financial advice is a hodge-podge of half-truths wrapped in a highly polished, statistically-skewed heuristic narrative.

I know now, at the least, what the underbelly operation of a big-box financial retail operation looks like. I was on the dark side; I paid a tremendous price to scale the wall to escape. Let’s say it wasn’t pleasant.

However, I passionately believed that I had no choice five years ago but to make a break for it and let fate do what it needs to do. Good or bad.

Many readers and clients are familiar with my legal imbroglio with a former employer. It was a stressful process that lead to a purposely drawn-out arbitration that took a formidable toll on my physical, mental and fiscal health.

Three years after the verdict, a clear loss for corporate gunslingers in black hats, I have yet to fully recover. I also realized after numerous anxious nights of contemplation, regardless of outcome, I wouldn’t have changed my direction. I have gained a clear understanding of how big financial employers really feel about their tenured employees, especially when they depart.

Looking back, that fight for my career, and frankly my life, laid the groundwork for the vision that’s coming together at Real Investment Advice. The ability to communicate what I believe passionately is the truth about markets and financial planning, along with Lance Roberts and other smart-as-hell contributors, some being mentors, is one of the sweetest rewards. The best outcome I could have ever imagined. Now I answer to clients, not shareholders.

As I shared confidently with the enemy and makeshift judge and jury – “you’ll all be surprised what Lance Roberts and I are going to build together.”

Alas, I wouldn’t wish the arbitration process on anyone. Your fate rests with an assembly of tenured industry peers who do their best to even out the score, get the parties to settle (usually financially) and part ways nicely (highly unlikely).

I sort of knew as did my attorney. Right from day one. Who was willing to listen to both sides of the arguments and who sought the most harm against me, the defendant, even though alleged ‘objective parties’ had zero skin in the game. Or did they? I have my suspicions.

One of the most interesting (to me) and highlighted areas of contention from the plaintiff was my willingness to pay for out of my own pocket, subscriptions to financial publications and websites like The Wall Street Journal and Morningstar.

Research which contradicted the internal “think tank,” analysis and subsequently discussed with clients turned out to be an egregious act of insubordination. Naturally, I believed I was doing my job, fulfilling my responsibility. As a Certified Financial Planner bound to CFP Board Standards, I was encouraged to actively seek information which confirmed or contradicted what our internal research department was generating.

Obviously, my initiative was a huge mistake. Who would have imagined that gaining knowledge and sharing multiple perspectives with clients was so threatening? The act was considered “fiduciary,” and it was made very clear at the arbitration that I was not a fiduciary. As a matter of fact, I should be punished for even taking on the role.

It’s entirely feasible that your trusted financial professional suffers from an employer-induced strain of Stockholm Syndrome brought on by a prolonged fear of job loss. When sales goals aren’t met, intimidation is delivered straight out. Or the message is cleverly received through passive-aggressive tactics utilized under the guise of corporate policy distorted by an HR department whose sole purpose is to move your advisor legally closer to unemployment.

It’s really your call. After all, you’re the party ultimately responsible for the wealth. It’s up to you to uncover how far the employer allegiance goes.  How far apart is the employer and client loyalty dividing line. What separates it? How comfortable are you with it?  Can one serve two masters adequately? Can a professional walk the line?

I found it exceedingly impossible. So much so that I believed I had little choice but to flee from a long-term career I worked close to 14 years to build.

And just like that it was gone.

With that in mind, here are three thoughts that should motivate you to seriously ponder a broker’s allegiance.

Learned Belief System That Directly Conflicts With Wealth Preservation

From the day they’re hired, the financial front-line, the professionals you share your inner most concerns with, are trained (programmed) to believe that a market is a long-term continuous bull cycle.

Bear markets are mere speedbumps which do minimal damage, therefore they’re rarely discussed. If anything, the subject is passed over quick. Bear markets (secular or long-term bear losses average -65%,) and occur 40% of the time, per financial historian Doug Short. Not so shabby.

Has this important information been discussed with you? Is there a bear market game plan that your broker has identified? If not. Why?

Mainly, the market is positioned as a capital appreciation party with a perpetually filled punch bowl of positive, compounded returns. The only mantra that is taught is to remain fully invested regardless of conditions; just weather the storms that infrequently arise (yea right). After all, the industry does an impressive job making investors feel stupid to miss out on the best 10 days in the market.

The simplest of calculations and a semblance of sense are enough to comprehend how damaging the math of loss truly is.

So, let me ask, as you should too: Where’s your broker’s slick marketing material to showcase reality?

Let me save you the trouble. It doesn’t exist.

Brokerage marketing departments don’t go near material of such nature. I tried to find it when writing my book on investing and financial planning. Lance perfected what I required.

Pretty pictures are painted. Statistical models are proudly presented that validate how markets are supposed to behave. Then there’s all the scary stories about inflation. You know, your greatest enemy.  Or you’ll never successfully make it to retirement and if you do, it it’s only because most of your money was invested in risk assets, like stocks. Never forget that your nemesis is the long-term loss of precious capital. Inflation is a great consideration, but not the scariest boogieman in the room.

Growth in the market is allegedly the inevitable outcome of the statistically tight ebb and flow of calm, predictable seas your wealth navigates to happy outcomes. If you can stay afloat long enough. After all, the ship has a 4,000-year remote possibility of capsizing (which appears to occur more often). This fantasy is fully supported by an employer’s research data that is mined carefully, sliced, diced, and spoon-fed.

Listen, there’s no professional on earth who can predict when a market top is going to be reached or a bear market will occur. However, it’s crucial to the survival and growth of your wealth to understand the complete picture or as I call it – ‘full-circle’ analysis.

Once a market storm rolls in, your static asset allocation may not be enough to protect against bear market drawdowns and will require monitoring and then action to further minimize damage which requires precious time to recover from.

If your financial partner isn’t an objective student of markets and holistic financial planning or exclusively investigating and sharing their employer’s research department information on topics of this nature, then it’s best you find out before the next bear market begins showing teeth.

As my personal experience outlines, many so-called professionals are hired for their selling prowess, not financial or planning acumen. There’s nothing wrong with it as long as you understand where your broker’s strongest allegiance lies.

Understanding Of Diversification Is Based On Agenda, Not Fact.

The easiest way to convince investors to “stick with an asset allocation or investment plan” is to use the past as a pacifier, regardless of current market cycle. In other words, if it’s broken there’s no need to adjust the guidance.

The industry just needs to isolate and showcase a cycle when the old confines worked, push that specific timeframe into the present and extrapolate the positive, perpetually into the future.

An egregious stretch of the truth emboldens the heavily-protected sanctuary of diversification.

It’s a word that makes investors feel good.

It rolls sweet off the tongue. It represents warmth of a blanket fresh out of the dryer, the scent of fresh-baked cinnamon rolls.

However, don’t be duped. Today, diversification as pitched by your broker, is a wolf dressed as Red Riding Hood. Many financial professionals have fooled themselves regarding its effectiveness. At least the way it’s defined, currently.

You must understand what diversification is and most crucial, what it isn’t. Certainly, it’s not the panacea it’s communicated to be.

The outdated definition of diversification requires a tune up. There’s no ‘free lunch,’ here, although I continue to hear and read this dangerous adage in the media.

The word gets thrown around like a remedy for everything which ails a portfolio. It’s the industry’s ‘catch all’ that can lull investors into complacency, inaction.

So, who buys into this nonsense free lunch theory, again?

After all, what is free on Wall Street? Investors who let their guard down, buy in to the myth of free lunches on Wall Street, ostensibly find their money on the menu.

Due to unprecedented central bank intervention, there exists distortion in stock prices. Interest rates ‘lower for longer’ have created a frenzied reach for return in stocks.

A way to effectively manage risk has morphed into disparate perceptions. The investor’s definition of diversification and that of the industry has parted, leaving an asset allocation plan increasingly vulnerable.

Today, the practice of diversification is Pablum. Watered down. Reduced to a dangerous buzzword.

First, what is the staid, mainstream definition of diversification?

According to Investopedia – An internet reference guide on money and investments:

  • Diversification strives to smooth out unsystematic risk or events in a portfolio so the positive performance of some investments neutralizes the negative performance of others. Therefore, the benefits of diversification hold only if the securities in the portfolio are not perfectly correlated.
  • Diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan’s economy in the same way; therefore, having Japanese investments gives an investor a small cushion of protection against losses due to an American economic downturn.

Now let’s break down the lunch and examine how free it is.

Unsystematic risk – This is the risk the industry seeks to help you manage. It’s the risks related to failure of a specific business or underperformance of an industry.

To wit:

  • This is a company- or industry-specific hazard that is inherent in each investment. Unsystematic risk, also known as “nonsystematic risk,” “specific risk,” “diversifiable risk” or “residual risk,” can be reduced through diversification.
  • So, by owning stocks in different companies and in different industries, as well as by owning other types of securities such as Treasuries and municipal securities, investors will be less affected by an event or decision that has a strong impact on one company, industry or investment type.

So, think of it this way: A ‘diversified’ portfolio represents a blend of investments – stocks, bonds for example, that are designed to generate returns with less overall business risk.

While this information is valid, the financial industry encourages you to think of diversification as risk management, which it isn’t.

Here’s what you need to remember:

Ketchup (consumer staples) and oil (consumer cyclicals) all run down-hill, in the same direction in corrections or bear markets. 

Sure, ketchup may run behind, roll slower, but the direction is the one direction that destroys wealth – SOUTH.

Large, small, international stocks. Regardless of the risk within different industries, stocks move together (they connect in down markets).

Consider:

What are the odds of one or two companies in a balanced portfolio to go bust or face an industry-specific hazard at the same time?

What’s the greater risk to you? One company going out of business or underperforming or your entire stock portfolio suffers losses great enough to change your life, alter your financial plan.

You already know the answer.

Diversification is not risk management, it’s risk reduction.

  • When your broker preaches diversification as a risk management technique, what does he or she mean?
  • It’s not risk management the pros believe in, but risk dilution.
  • There’s a difference. The misunderstanding can be painful.

To you, as an investor, diversification is believed to be risk management where portfolio losses are controlled or minimized. Think of risk management as a technique to reduce portfolio losses through down or bear cycles and the establishment of price-sell or rebalancing targets to maintain portfolio allocations. Consider risk dilution as method to spread or combine different investments of various risk to minimize volatility.

Even the best financial professionals only consider half the equation.

Beware the lamb (risk management) in wolf’s clothing (risk dilution).

The goal of risk dilution is to “cover all bases.” It employs vehicles, usually mutual funds, to cover every asset class so business risk can be managed. The root of the process is to spread your dollars and risk widely across and within asset classes like stocks and bonds to reduce company-specific risk.

There’s a false sense of comfort in covering your bases. Diversification in its present form is not effective reduce the risk you care about as an individual investor – risk of loss.

Today, risk dilution has become a substitute for risk management, but it should be a compliment to it.

Risk dilution is a reduction of volatility or how a portfolio moves up or down in relation to the overall market.

Risk dilution works best during rising, or up markets as since most investments move together, especially stocksThink about betting on every horse in a race.

  • In other words, a rising tide, raises all boats.

Diversification can be stronger than it is right now. Unfortunately, the financial industry as a whole, has watered it down and widened it so much, it’s become absolutely ineffective as a safeguard against losses. One reason is the sales targets that forces financial representatives to spend less time with client portfolios.

Also, a financial big-box compliance department which is designed to protect the firm, not you as a client, will not allow anything but the washed-down outdated definition of diversification.

Think about it: A targeted diversification strategy places accountability on the advisor and poses risk to the firm. A wider approach makes it easier to vector responsibility to broad market ‘random walks’ so if a global crisis or bear market occurs and most assets move down together, an advisor and the compliance department, can “blame” everything outside their control.

  • “Hey, it’s not our fault, it’s the market!”

Convenient excuse, isn’t it?

You’ll find out, eventually.

Your Opinion Doesn’t Count For Much.

I engage frequently with individual investors who share a common, disturbing concern.  Their financial partners are minimizing their requests to manage risk.

Conversations are growing frustrating for those investors who have lived through two devastating market derails in 17 years. Some have yet to recover from the tech bubble. In the face of an 8-year cyclical bull market, financial professionals, especially those who have never experienced a bear mauling, are falling for their own stories. Investors aren’t as quick to go along as losses are not the brokers to suffer.

Recently, I met with a retired woman who holds a concentration of liquid assets in a junk bond fund. Her financial professional explained that it’s a “good fund,” and paying a “good income,” ending with the ever credible “I own it, too.” In other words, lots of positive words; yet her uncomfortableness was not addressed.

Regardless of his stamp of approval, I needed to empower her with the knowledge that indeed the concerns were valid. We needed to put a stop to her sleepless nights over this ongoing issue.

We reviewed together, step-by-step, the risk she was taking being overweight in this investment, the overall pros and cons and finally, a concrete, actionable game plan to reduce the risk she felt uncomfortable with along with detailed instructions for her advisor.

I’m anxiously awaiting to hear how the meeting went.

What appears to be an endless march higher for markets is encouraging financial professionals to perhaps grow overconfident in their abilities to generate returns. In some cases, they’re willing to outsource portfolio management and focus on ‘more important issues’ like financial planning which on the surface, is not a bad thing.

I’m an advocate for financial planning; I don’t underestimate its importance. However, I believe it may becoming employed as a ruse, an excuse to become distant about how stock markets behave, change and the damage that may result from putting our guard down. In other words, the ongoing bull market is making front-line advisors lazy and salespeople more emboldened than ever to pitch their wares.

It’s part of an advisor’s overall responsibilities to help investors participate in markets, minimize emotional and cognitive biases and importantly, manage market risk.

If they’ve forgotten how to, then you need to now take matters into your own hands and not look back.

Editor’s Note: All of us at Real Investment Advice are proud to welcome Vitaliy Katsenelson, CFA to our growing list of outstanding contributors. Vitaliy is the CIO at Investment Management Associates, which is anything but your average investment firm. He has also written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Forbes magazine called him “the new Benjamin Graham.” 

It is hard to find a bigger Apple stock cheerleader than me. I’ve been writing Apple stock love poems for years. For a long time, it was easy to love the shares because they were unloved by others and it was cheap.

Until recently, when Apple stock was still trading in the low $100s and at single-digit multiples, we were buying current product categories at a discount and were not paying for future product categories.

At today’s price that is not the case anymore. That is true with any company – the more expensive the stock gets, the more clairvoyance investors need to discern the company’s future growth.

At Apple’s size it is very hard for the company to increase its earnings significantly. Macs, iPads, and even iPhones are mature products.

The iPhone may have a few growth spurts left, but not many. It is facing an unavoidable headwind: the elongation of its replacement cycle. The iPhone improved substantially over the years, but as the i-marvels piled up, the incremental improvements that motivated people to buy a new phone every two years or so became less and less significant.

At some point the iPhone will face the fate of the iPad – its replacement cycle long in the tooth and sales stagnant and declining.

Will the iPhone’s sales stop growing in 2018, or 2020? I don’t know, but from a long-term perspective of the company’s valuation, a few years don’t make that much difference.

(A new iPhone is expected to be unveiled next week. The stock fell slightly Wednesday on concern supply disruptions could cause shipping delays with the new phone.)

Services is the only segment that can grow at a double-digit rate for a considerable period of time, but it only represents 13 percent of revenue. Even the Apple Watch doesn’t really move the needle.

They need another genius

But can Apple come up with new product categories? Let’s ponder on this question in the context of the following quote:

“Talent hits a target no one else can hit; Genius hits a target no one else can see.” – Arthur Schopenhauer

Apple has a lot of talented people designing and redesigning products in the categories that Apple already dominates. They are hitting a lot of targets no else can hit. Apple’s brand is as healthy as ever, and so is product satisfaction.

However, to create a new category of products Apple needs to “hit targets no one else can see,” and this requires a genius. But in an organization of this size with a lot of bright and talented people, it also requires a benevolent dictator – someone able to make bold, unconventional decisions (and own them), someone who in addition to everything else is able to inspire others to create what they may think is impossible. Yes, I am referring to the one and only Steve Jobs, he of the “reality distortion field.”

Here is an instance that comes to mind: Jobs asked his engineers to come up with a touchscreen computer – a tablet. They did. It looked like a bulky version of today’s iPad. Steve looked at and said “Let’s put the tablet on ice,” then refocused the company on miniaturizing that tablet and making a phone instead.

It is important to remember that at the time, though Apple was financially healthy, it was not swimming in cash the way it does today. Jobs made a benevolent dictator-like decision: He diverted engineers who were working on the MacOS to work on what would become the iPhone OS, causing the late release of some Mac products. And only years later, after the iPhone was a raging success, Apple brought the iPad back to life. That was Jobs’ Apple.

Now let’s visit Tim Cook’s Apple. The New York Times ran an in-depth article unearthing why Apple has (so far) failed to come up with an electric self-driving car. These few sentences jumped out at me:

“But the car project ran into trouble, said the five people familiar with it, dogged by its size and by the lack of a clearly defined vision of what Apple wanted in a vehicle. Team members complained of shifting priorities and arbitrary or unrealistic deadlines.”

Nokia spent a lot on R&D too

Even Jobs admitted that Cook is not a “product man.” Cook doesn’t have “the vision,” and thus he doesn’t have the authority to be a benevolent dictator. Nor does he have the charisma to project and maintain a reality distortion field.

Today Apple spends almost $12 billion on R&D – double what it spent just a few years ago. But as outside observers, we really don’t know where this money is going. Or more importantly, how productively it is being spent. I vividly remember how Nokia was increasing its R&D spend every year during the last years of its dumb-phone dominance, but all that R&D did not bring forth new products that would have saved the company from its eventual demise. Apple is not facing Nokia-like collapse, but the R&D argument still stands: R&D spend doesn’t always equal great new products.

The NY Times article said that Apple curtailed its ambition to make a car and is now focusing solely on self-driving technology. In other words, Apple is basically pulling out of the electric car space (at least for now).

If Apple develops and licenses its self-driving technology, it will recover some of its losses on investments made to date. But it will not be able to take advantage of the significant competitive advantage that comes with its incredible brand, its distribution network – hundreds of stores (potential car dealerships) sprinkled all over the world – its know-how in battery management, its design prowess, and its i-ecosystem.

We still own a little bit of Apple stock but have sold most of what we owned at current prices. Maybe Apple’s augmented reality products will become a huge success, or maybe the company is working on a brand new category of products that we have not even imagined. It is all possible.

In making investment decisions you never have perfect information. Apple is no exception. At today’s valuation we are paying for genius – Apple’s ability to successfully create and dominate a new, large product category. While the company is run by very talented people who will do a great job getting us excited about the categories of products they are already in, the company’s genius died with Steve Jobs.

In this past weekend’s newsletter. I discussed the potential for the market to hit new highs. To wit:

“The good news this week is that the market maintained last week’s advance despite the one-day tantrum earlier. Interestingly, since the election, the market has ratcheted higher in slightly more than 3% increments with each move higher followed by a drawn-out consolidation process that runs primarily along the 50-75 dma. The last sell-off tested, and held, the 100-dma but stayed within the confines of the consolidation process. The 2400 level on the S&P 500 remains the clear ‘warning level’ for investors currently.”

Chart updated through Monday’s open.

“But this short-term bullish backdrop is offset by intermediate-term bearish underpinnings as shown by the next two charts. With an intermediate-term momentum sell-signal in place, combined with overbought conditions, continues to suggest further gains from this point will likely remain limited and more volatile to obtain. That statement DOES NOT preclude the markets reaching new highs, it just suggests that downside corrective risks outweigh the potential currently for further gains.”

That “gap up” opening occurred Monday morning as “relief” spread through global markets due to the reduction of geopolitical stress as the U.S. once again “caved” to the threats of North Korea.

Over a month ago on the “Lance Roberts Show,” I discussed North Korea’s real positioning behind their nuclear tests and ICBM launches.

“While Kim Jung Un may ‘appear’ to be ‘crazy,’ and he is, he does understand the consequences of starting an actual war with the U.S. However, as a dictator, he can not afford to show weakness. Therefore, he needs the U.S. to acquiesce to some degree to allow him to claim victory over the ‘evil empire’ of the west.”

Over the weekend, as per Reuters, that is exactly what happened.

“A U.S.-drafted resolution originally calling for an oil embargo on the North, a halt to its key exports of textiles and subjecting leader Kim Jong Un to a financial and travel ban have been weakened, apparently to placate Russia and China which both have veto powers, diplomats said.”

And, as I stated would be the case, the spokesman for the Democratic People Republic of Korea quickly claimed:

“The world will witness how the DPRK tames the U.S. gangsters by taking a series of actions tougher than they have ever envisaged.”

With that, the world breathed a sigh of relief and the previous “risk off” trade rushed to pile back into “risk.”

“How do you spell relief?

“C-E-N-T-R-A-L B-A-N-K-S” 

According to BofA’s Michael Hartnett, in 2017 Central Banks have increased purchases of financial assets by roughly $2 Trillion. In turn, this has now pushed global balance sheets from $4.34 Trillion in 2008 (pre-Lehman,) to $15.6 Trillion currently.

At the same time, this has pushed yields to record lows, and equities to record highs. The problem is that markets have now been “priced to perfection” for future earnings growth and economic expectations. Yet, at the same time stock prices are rising, earnings estimates continue to decline. Via Factset:

“During the first two months of the quarter, analysts lowered earnings estimates for companies in the S&P 500 for the third quarter. The Q3 bottom-up EPS estimate (which is an aggregation of the EPS estimates for all the companies in the index) dropped by 1.7% (to $33.26 from $33.84) during this period.”

But while FactSet puts a positive spin on the decline, the decline in earnings estimates can be more clearly seen in the chart below. It compares REPORTED EPS from January, July and September 2017, to where estimates were in 2016 for the end of this year.

Here is the problem. While the financial markets have risen to “all-time” highs, estimates for 2017 are more than $10 lower than they were in 2016. Furthermore, Q4-2018 estimates are being consistently ratcheted lower and are now only $1.22 higher than where the Q4-2017 originally stood.

The bigger issue is that the largest driver of earnings per share growth has NOT come from the increase of sales and revenue, but rather through the reduction of shares outstanding. It is worth noting the previous collapse in EPS came not as share buybacks were falling, but when they stopped.

But that is a story yet to play out.

For now, stocks are pricing in forward estimates, and as stated above, have likely “priced in” all of the expected growth going forward.

Of course, as it has always been, it will be when expectations fail to become a reality the real problems will begin. It is the same problem that has triggered every “repricing” of assets throughout history.

But this too will be a story for another day.

For now, it remains a market driven by a simple belief that Central Banks can control outcomes. The flood of liquidity into the financial systems are finding their way either indirectly, or directly, into assets driving prices higher. That in turn has fueled investor optimism which has now hit the highest level in 17-years according to the latest Wells Fargo/Gallup poll.

“The latest boost in optimism pushes the index almost 100 points higher than the +40 score measured in February 2016. The 98-point hike over the past 18 months is the largest increase in the 20-year history of the index that is not a rebound immediately after a major drop in optimism.”

After more than 8-years of a surging bull market, often declared the “most hated in history,”

  • Sixty-eight percent now say they are optimistic about the stock market’s performance during the next year, matching the record high for the question from December 1999 and January 2000.
  • At least 61% have expressed optimism about the stock market in each of the three surveys this year, a percentage matched or exceeded only four other times in the 132 times the question has been asked since April 2000.
  • Twenty-five percent say they are “very optimistic,” topping the previous record high of 24% from the first quarter of this year. Only 11% were very optimistic a year ago.
  • Sixty-one percent of investors now say it is a good time to invest in the stock market, up from 53% two years ago. Among those saying it’s a good time to invest, the main reason is their belief that the market will continue to increase, mentioned by 47%.

See, what is there to worry about?

Everyone agrees this is the greatest “bull market” in history.

Of course, that brings me to this little note from Social Capital recently defining a bubble:

“But in a bubble, everyone stops worrying about that. Fear of losing capital becomes superseded by a different kind of fear: FOMO. Bubbles give everybody involved a credible reason to believe that follow-on financing will continue to be available, and at more and more attractive rates to boot. Which means, if you’re an investor, hey, we’ve gotta get started now! Hurry, before the price goes up! And if you’re an entrepreneur, Hey, we’ve gotta get started now, before the competition does! That’s what we need to break the coordination failure. Under bubble conditions, we willingly and enthusiastically embark on speculative projects that have no line of sight to positive free cash flow and must continue raising more and more money.”

Are we in a bubble? Probably. There are plenty of signs which suggest that is the case.

The next chart shows every major bubble and bust in the U.S. financial markets since 1871 (Source: Robert Shiller)

At the peak of each one of these markets, there was no one claiming that a crash was imminent. It was always the contrary with market pundits waging war against those nagging naysayers of the bullish mantra that “stocks have reached a permanently high plateau” or “this is a new secular bull market.”  (Here is why it isn’t.)

Yet, in the end, it was something that was unexpected, unknown or simply dismissed that yanked the proverbial rug from beneath investors.

What will spark the next mean reverting event? No one knows for sure, but the catalysts are present from:

  • Excess leverage (Margin debt at new record levels)
  • IPO’s of negligible companies (Blue Apron, Snap Chat)
  • Companies using cheap debt to complete stock buybacks and pay dividends, and;
  • High levels of investor complacency.

Either individually, or in combination, these issues are all inert. Much like pouring gasoline on a pile of wood, the fire will not start without a proper catalyst. What we do know is that an event WILL occur, it is only a function of “when.” 

The discussion of why “this time is not like the last time” is largely irrelevant. Whatever gains that investors garner in the between now and the next correction by chasing the “bullish thesis” will be wiped away in a swift and brutal downdraft. Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy” but never “when to sell.”

For now, the “bullish case” remains alive and well. The media will go on berating those heretics who dare to point out the risks that prevail. However, the one simple truth is “this time is indeed different.”  When the crash ultimately comes the reasons will be different than they were in the past – only the outcome will remain same.

Recently, Ryan Vlastelica penned a column suggesting investors should simply be “apathetic” when it comes to their money.

“Apathy doesn’t sound like a sensible investment philosophy, but it may be one of the most successful approaches a person can employ to grow wealth.”

Listen. I get it.

You can’t beat the market, so just “buy and hold.”

Over a long enough period, I agree, you will make money.

But, simply making money is not the point of investing.

We invest to ensure our current “hard earned savings” adjust over time to provide the same purchasing power parity in the future. If we “lose” capital along the way, we extend the time horizon required to reach our goals.

Crashes Matter A Lot

Ryan makes his case for “apathy” by quoting Barry Ritholtz who stated:

“If you don’t want to invest in equities because you fear a market crash, then you should never be in equities, because equities always crash.”

While Barry is absolutely correct in his statement, investing is never an “all or none” proposition. Being an investor is about understanding the “risk to reward” relationship of placing capital into the financial markets.

There is no “great investor” in history, not even Warren Buffett, who is apathetic about investing. It is also why every great investor has one simple rule in common:

“Buy low, Sell high.” 

Why? Because it is the ONLY manner in which you truly create wealth.  As Ryan notes:

“Ritholtz stressed that investors should diversify, in part to mitigate their concerns about portfolio volatility, but added that the best buying opportunities were when things looked the worst.”

The problem with being “apathetic” should be obvious. If you never sold high, then where will the capital come from to “buy low?”

Think about your personal situation.

  • If you have a big cash pile at the moment, then you aren’t investing and are “missing out,” according to Ryan. 
  • If you don’t have a big cash pile, then where would you come up with the cash to buy “when things looked their worst?”

Yes, that’s the problem with “buy and hold” and “dollar cost averaging” which will become much more apparent momentarily.

Crashes matter, and they matter a lot.

Let’s set up a quick example to prove the point.

Bob is 35-years old, earns $75,000 a year, saves 10% of his gross salary each year and wants to have the same income in retirement that he currently has today. In our forecast, we will assume the market returns 7% each year and we will use 2.1% for inflation (long-term median) for planning purposes.

In 30 years, Bob’s equivalent income requirement will roughly be $137,000 annually.

So, starting with a $100,000 investment, he gets committed to saving $7500 each year into his index fund and sits back to watch it grow into a whopping $1.46 million nest egg at retirement.

See, absolutely nothing to worry about. Right?

Not so fast.

This is where problem number one arises for the vast majority of Americans. Given the economic drag of the 3-D’s (Debt, Demographics & Deflation) currently in progress, which will span the next 30-years, long-term interest rates will remain low. Therefore, if we assume that a portfolio can deliver an income of 3% annually, the assets required by Bob to fulfill his retirement needs will be roughly $4.6 Million.

(Yes, I have excluded social security, pensions, etc. – this is for illustrative purposes only.)

The roughly $3-million shortfall will force Bob to reconsider his income requirements for retirement.

The second problem is that “crashes” matter and they matter a lot. The chart below is a $100,000 investment plus $7500 per year compounding at 7% annually versus actual market returns. I have taken historical returns from 2009 to present (giving Bob the benefit of front-loaded returns at the start of his journey) and then projected forward using a normal standard deviation for market returns.

The important point is to denote the shortfall between what is “promised to happen” versus what “really happens” to your money when crashes occur. The “sequence of returns” is critical to the long-term success of your investment outcomes.

Bob’s $1.5 million projected retirement goal comes up short by $500k. This only compounds the shortfall between what is actually required to create an inflation adjusted income stream at retirement.

This is specifically why there are more “baby boomers” in the workforce today than ever before in history.

“So, stop blaming “baby boomers” for not retiring – they simply can’t afford to.” 

Yes, Valuations Matter Also

As I noted last week in “The Rule Of 20”

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

There are two halves of every market cycle. 

While valuations should NEVER be used as a means to manage a portfolio in the “short-term,” valuations have everything to do with how you invest long-term. 

As I have shown many times previously (most recently here), the level of valuations at the start of the investing period are determinant of future returns. The chart below makes this extremely simple to understand. The chart shows the composite of total real compound returns over the subsequent 30-year period when valuations were either less than 10x earnings, or greater than 20x. I have then used those composites for Bob’s potential outcomes given valuations are currently greater than 20x on a trailing reported basis.

(Starting investment of $100,000 with $7500 annual savings)

Again, the outcome for Bob’s financial future comes up meaningfully short.

A Fix For Bob’s Financial Insecurity

Ryan quoted Barry again:

“It isn’t the market crashes that get investors, it’s the high blood pressure. They trade excessively and their investment philosophies are all over the place. They do things they shouldn’t, then stick with it when they shouldn’t. They flip from one style to the other. They’re overconfident. They make emotional decisions.”

Ryan, Barry and I can all agree on that point.

Psychology makes up fully 50% of the reason investors underperform over time. But notice, the other 50% relates to lack of capital to invest. (See this) Again, where is that capital going to come from to “buy low?”

These biases come in all shapes, forms, and varieties from herding, to loss aversion, to recency bias. They are all the biggest contributors to investing mistakes over time.

These biases are specifically why the greatest investors in history have all had a very specific set of rules they followed to invest capital and, most importantly, manage the risk of loss.  (Here’s a list)

Here’s what you won’t find on that list. “Be apathetic.”

So, what’s Bob to do?

There is NO argument Bob needs to save and invest in order to reach his retirement goal and sustain his income in retirement. 

A simple solution can be designed using a well-known growth stock mutual fund and intermediate bond fund. The management method is simple. When the S&P index is above the 12-month moving average, you are 100% invested in the growth mutual fund. When the S&P index is below the 12-month moving average you are 100% invested in the bond mutual fund. I have compared the outcome to just “buy and holding” and “dollar cost averaging” into JUST the growth stock mutual fund.

For Bob, the difference is between meeting his retirement goals or not.

Over the next 10-years, given where current valuation levels reside, forward returns are going to be substantially lower than they have been over the last 10-years. This doesn’t mean there won’t be some “rippin'” bull markets during that time, there will also be some corrections along the way.

Just remember:

“Getting Back To Even Does Not Equal Making Money.” 

Planning To Win

With valuations elevated, the economic cycle very long in the tooth, and the 3-D’s applying downward pressure to future economic growth rates, investors, along with Bob, need to consider the following carefully.

  • Expectations for future returns and withdrawal rates should be downwardly adjusted.
  • The potential for front-loaded returns going forward is unlikely.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered.
  • Drawdowns from portfolios during declining market environments accelerate the principal bleed. Plans should be made during rising market years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for retirement income planning. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of plans for variable rates of future returns.

Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely want. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money – the TIME that was needed to reach their retirement goals.

Investing for retirement, no matter what age you are, should be done conservatively and cautiously with the goal of outpacing inflation over time. This doesn’t mean that you should never invest in the stock market, it just means that your portfolio should be constructed to deliver a rate of return sufficient to meet your long-term goals with as little risk as possible.

Don’t be apathetic about your money. 

There should be no one more concerned about YOUR money than you, and if you aren’t taking an active interest in your money – why should anyone else?

The Most Overvalued Market Of All-Time? – Sep 13, 2017 @ Noon EST

By an increasing number of metrics, today’s financial markets are more overvalued than we’ve ever seen before. The price-to-sales ratio for the S&P 500 has never been this high. The same is true for its price-to-earning-growth ratio. Interest rates have never been this low — in 5,000 years of human history!

A principal driver of this situation, of course, is the fact that over $12 trillion in “thin air” money has been printed up by the world’s central banks since the start of the Great Recession. And so far in 2017, a fresh $200 billion is being added to the pile each month(!)

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First, it was Hurricane “Harvey” and an expected $180 billion in damages to the Texas coastline. Now, “Irma” is speeding her way to the Florida coastline dragging “Jose” in her wake. Those two hurricanes, depending on where they land will send damages higher by another $100 billion or more in the weeks ahead.

The immediate funding needed for relief to Americans is what you would truly deem to be “emergency measures.”

But that is not what I am talking about today.

Nope, I am talking about Central Banks. On Thursday, Mario Draghi, of the ECB, announced their latest monetary policy stance:

“At today’s meeting, the Governing Council of the ECB decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.00%, 0.25% and -0.40% respectively. The Governing Council expects the key ECB interest rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases.

Regarding non-standard monetary policy measures, the Governing Council confirms that the net asset purchases, at the current monthly pace of €60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. The net purchases are made alongside reinvestments of the principal payments from maturing securities purchased under the asset purchase programme. If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the programme in terms of size and/or duration.”

Ladies and Gentlemen, these are “emergency measures.” According to the Bank for International Settlements:

“Policy tools that involve the active use of central bank balance sheets – both the assets and the liabilities – can help monetary authorities to navigate the policy challenges during times of financial stress and when interest rates are close to zero.

But wait, this is what Draghi said next:

“The economic expansion, which accelerated more than expected in the first half of 2017, continues to be solid and broad-based across countries and sectors.”

So, what is it?

If you actually have “solid and broad-based” economic growth across countries and sectors, why are you still flooding the system with “emergency measures,” and keeping interest rates near zero?

That’s a rhetorical question.

The reality is that Central Banks are keenly aware of the underlying economic weakness that currently exists as evidenced by the inability to generate inflationary pressures. They also understand that if the financial markets falter, the immediate feedback loop into the global economic environment will be swift and immediate.

This is why there continue to be direct purchases of equities by the ECB and the BOJ. Which is also the reason why, despite nuclear threats, hurricanes, geopolitical tensions and economic disconnects, the markets remain within a one-day striking distance of all-time highs. (Charts courtesy of Yardeni Research)

Of course, the question becomes just exactly what will Central Banks do when economies on a global scale slip back into the next cyclical recession? There is a “limit” to the amount of “assets” that can be held by the Central banks unless the markets are to become entirely centralized by the tentacles of the real “vampire squid.”

As the BIS concludes:

“Let me remind you too about the considerable fiscal risks that many countries face – risks that could at some point confront central banks with extremely difficult choices.”

In the meantime, here is what I am reading this weekend.


Politics/Fed/Economy


Video

Ray Dalio’s recent TED Talk – “How To Build A Company Where The Best Ideas Win”


Markets


Research / Interesting Reads


“Sometimes the market does something so stupid it takes your breath away.” – Jim Cramer

Questions, comments, suggestions – please email me.

What to do?  This is not as an innocuous question as one might think. For most American families, who have to balance their living standards to their income, they face this conundrum each and every month.  Today, more than ever, the walk to the end of the driveway has become a dreaded thing as bills loom large in the dark crevices of the mailbox.

What to do?

In a continuation of last week’s discussion on consumer debt, the conundrum exists because there is not enough money to cover the costs of the current living standard.

“The average family of four have few choices available to them as discretionary spending becomes problematic for the bottom 80% of the population whose wage growth hasn’t kept up with the standard of living.”

The burden of debt that was accumulated during the credit boom can’t simply be disposed of. Many can’t sell their house because they can’t qualify to buy a new one and the cost to rent are now higher than current mortgage payments in many places. There is no ability to substantially increase disposable incomes because of deflationary wage pressures, and despite the mainstream spin on recent statistical economic improvements, the burdens on the average American family are increasing.

Nothing brought this to light more than the recent release of the Fed’s Report on “The Economic Well-Being Of U.S. Households.” The overarching problem can be summed up in one chart:

Of course, the recent rise in consumer credit to all-time highs supports that analysis.

Don’t be fooled by the rise in “student loan” debt either. That is NOT representative of a mass hoard of individuals all clamoring into classrooms across the country to garner the benefits of higher education. According to a 2016 Student Loan Hero survey, individuals have other plans for student loan funds which are easy to acquire.

Or as Bloomberg noted in their survey, 1-in-5 American students will use their student loans to pay for expenses such as vacations, dining out and entertainment. To wit:

“Texas A&M graduate Eric Hazard recalls the excitement of student loan refund day.

‘Checks were celebrated across the campus as almost like a bonus for being a college kid. [Students] would go directly to the bank to cash it. I bought electronics for my dorm room and drinks. You know you have to pay it back, but you don’t have a timeline in your mind about what that was going to look like. I just knew it would happen later.'”

Of course, the problem comes when the bills come due. Can you spell “d-e-l-i-q-u-e-n-c-y.”

So, therein lies the “Great American Consumer Conundrum.” If 70% of the economy is driven by personal consumption, what happens when consumers simply hit the wall?

There is a limit.

Under more normal circumstances rising consumer credit would mean more consumption. The rise in consumption should, in theory, led to stronger rates of economic growth. I say, in theory, only because the data doesn’t support the claim.

Prior to 1980, when the amount of debt used to support consumption was fairly stagnant, the economy, wages, and personal consumption expanded. However, as I noted previously, that all changed with financial deregulation in the early 80’s which fostered three generations of debt driven excesses.

In the past, if they wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates and lax lending standards put excess credit in the hands of every American.  (Seriously, my dog Jake got a Visa in 1999 with a $5000 credit limit)  This is why during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth rate slowed in America along with incomes.

Therefore, as the gap between the “desired” living standard and disposable income expanded it led to a decrease in the personal savings rates and increase in leverage. It is a simple function of math. But the following chart shows why this has likely come to the inevitable conclusion, and why tax cuts and reforms are unlikely to spur higher rates of economic growth.

Beginning in 2009, the gap between the real disposable incomes and the cost of living was no longer able to be filled by credit expansion. In other words, as opposed to prior 1980, the situation is quite different and a harbinger of potentially bigger problems ahead. The consumer is no longer turning to credit to leverage UP consumption – they are turning to credit to maintain their current living needs.

There are currently clear signs of stress emerging from credit. Commercial lending has taken a sharp dive as delinquencies have risen. These are signs of both a late stage economic expansion and a weakening environment.

As incomes remain 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 that the economy is on the verge of recovery with statistics like that. Of course, it is the real reason why after 9-years of “emergency measures” from Central Banks globally, they are still using “emergency measures” despite claiming monetary policy victory.

It 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 healthcare goes unabated consuming more of their incomes.

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 an awful lot of hoping.

When people use the word catalyst to describe an event that may prick the stock market bubble, they usually discuss something singular, unexpected and potentially shocking. The term “black swan” is frequently invoked to describe such an event. In reality, while such an incident may turn the market around and be the “catalyst” in investors minds, the true catalysts are the major economic and valuation issues that we have discussed in numerous articles.

Most recently, in 22 Troublesome Facts, 720Global outlined factors that are most concerning to us as investors. As a supplement, we elaborate on a few of those topics and build a compelling case for what may be a catalyst for market and economic problems in the months ahead.

Debt Burden

Debt serves as a regulator of economic growth and is the focus of ill-advised fiscal and monetary policy. It is no coincidence that no matter what economic topic we explore, debt is usually a central theme. Illustrated in the chart below is the actual trajectory of total U.S. debt outstanding (black) through March 2017 and a calculated parabolic curve (red). The parabolic curve uses 1951 as a starting point and a quarterly 1.82% compounding factor to create the best statistical fit to the actual debt curve. If we start with the $434 billion of debt outstanding on December 1951 and grow it by 1.82% each quarter thereafter, the result is the gray line. If debt outstanding continues to follow this parabolic curve, it will exceed $60 trillion by the first quarter of 2020, or nine quarters from now.

Data Courtesy: Federal Reserve

Many economists point to the stability of debt service costs as a reason to ignore the parabolic debt chart. Despite rising debt loads, falling interest rates have served as a ballast allowing more debt accumulation at little incremental cost. While that may have worked in the past, near zero interest rates makes it nearly impossible to continue enjoying the benefits of falling interest rates going forward. Importantly, social safety net obligations, demographics, and political dynamics argue that debt growth is likely to continue accelerating as implied by the chart above. Without interest rates falling in step with rising debt burdens, debt service costs will begin to rise appreciably.

The power of compounding, extolled by Albert Einstein as the eighth wonder of the universe, is as damning in its demands as it is merciful in its generosity. Barring negative interest rates, debt service costs will be an insurmountable burden by 2020. However, if the debt trajectory slows as it did in 2008 that too will bring about painful consequences. In other words, all roads lead to trouble.

Debt growth illustrated above has been an important cog in the consumption engine in the United States. Personal consumption accounts for about 70% of Gross Domestic Production (GDP) growth. Neo-Keynesian and Modern Monetary Theory (MMT) economists argue that those who worry about government debt and deficits just don’t understand deficit finance. We worry because we understand the basic math that will limit the U.S. economy’s ability to further burden itself with debt.

Despite policymakers’ lack of regard for this burden, it is important to keep in mind that, as debt accumulates and consumers become less capable of repaying those debts, deleveraging ensues. This means that households will become unable to sustain the lifestyle to which they have become accustomed. Whether debts will be resolved through repayment or default, economic progress will falter.

Retail Sales

The chart below illustrates the components of retail sales in July 2017. Retail sales measures the dollar amount of finished goods sold as opposed to the Personal Consumption Expenditures index (PCE) which measures the price changes of consumer goods and services.

Data Courtesy: U.S. Census Bureau

As shown above, autos, department stores (general merchandise) and restaurants account for 45% of total retail sales. If any of these sectors exhibit weakness then it is challenging for another sector to offset that weakness given its relative size. If all three of these sectors soften at the same time, as is happening now, then it serves as a warning that consumption is likely to decelerate. This has been a precursor to broad economic weakness and even recession in the past. The sections below review each of these three sectors to help you assess the underlying strength or weakness of these important drivers of consumption and the economy.

Autos

Car and truck sales helped lead the economy out of the recession over the past eight years. The surge in sales to new record levels was not solely due to outright sales but was heavily nourished by extensive use of lease financing.  As shown below, auto sales appear to have peaked in late 2016, and used car prices have been in decline since 2014. Both factors raise concerns over the auto sector’s future contribution to economic growth.

Data Courtesy: Bloomberg

Because of the reliance on leasing, cars rolling off leases topped 4 million units last year and are expected to rise by 11% in 2017 and 2018 and top 5 million units by 2019. This is producing a glut of used cars on dealer lots and fueling the decline in used car prices. Projected used car prices, also known as residual value calculations, are a major component of the lease finance equation. As 11-12 million used vehicles hit the market over the next 2½ years, the stage is set for problems in the leased vehicle market and total car sales.

At their peak in February 2016, auto leases accounted for one-third of new car sales and the 6-month moving average remains above 30%. As the leasing option becomes more expensive and the used car supply continues to grow, new auto sales are likely to suffer.

Data Courtesy: Bloomberg

The impact of the used car market on leasing can be seen through the purchase versus lease analysis table shown below. A decline in used car prices (residual values) as is currently forecast dramatically alters lease payments, eliminating leasing as a lower-cost alternative. The bull, base and bear case for used car prices below is based on forecasts from Manheim/Morgan Stanley.

In response to weaker car sales, dealers have slashed prices by the most since the last recession. The auto sector, which represents over 20% of retail sales, is an important economic barometer.

Department Stores

The travails of department stores in recent months have been well-covered. Stores closings and down-sizing stems from weakness in consumer spending but has been rationalized by the “Amazon effect” and preferences for on-line shopping. As recently observed by Evergreen/GaveKal, it’s not the “Amazon Effect”, it’s the “Healthcare Spending Effect” as the average family of four pays $26,000 in healthcare costs. The other problem with the “Amazon” excuse is that, while store traffic has dropped, all department stores have functional, secure websites that consumers can access as easily as Amazon’s web site. According to the Department of Commerce, retail sales for the past 12 months totaled $4.9 trillion of which $403 billion or 8.2% were online. Amazon’s total sales of $150 billion were approximately 3% of total retail sales. Needless to say, there is more to the story than Amazon stealing market share.

On-line retailers are making it hard for department stores to maintain market share but the Amazon narrative sounds more like an attempt to downplay the real problem. Squeezed by weak income gains, higher healthcare and education costs, and the burdensome load of debt from years past, consumers simply have less money to spend and appear less inclined to spend what they do have on apparel and other department store goods.  Further, they have little propensity to borrow to consume more. Since January 2016, department store sales (year over year) declined in every month except two. A continuation of these trends has major implications for retail stalwarts like Macy’s and Nordstrom as well as commercial and retail real estate.

Data Courtesy: Bloomberg

 Restaurants

Restaurants face similar issues as retailers with problems extending across all categories of the food service sector except the high-end segment. Restaurant same store sales have experienced 17 consecutive months of year-over-year declines. According to the July 2017 Restaurant Industry Snapshot, Black Box Intelligence reported:

These are the weakest two-year growth rates in over three years, additional evidence that the industry has not reversed the downward trend that began in early 2015.”

Adjusting for inflation further clarifies the difficulties the sector faces. Wolf Richter at Wolfstreet.com adjusted sales at food service and drinking places for inflation (as shown below) and found that sales, as reported in June 2017, are up only 22% from the post-recession lows and have been stagnant since December 2015.

Not going out to eat is one of the easiest ways to tighten a household budget. The decline in restaurant sales seems to reinforce the increasingly tepid state of consumption.

Consumer Credit Outstanding – Record Highs

Evidence of a challenged consumer drowning in debt continues to build. Credit card debt recently hit a record high at $1.02 trillion, and total consumer credit, which includes auto and education loans and excludes mortgages, is fast approaching $4 trillion.

Data Courtesy: Federal Reserve

Economist Joel Naroff, President of Naroff Economic Advisors, elaborated on the weak consumer: “One of the clearest indicators that households are spending cautiously is the softening of big-ticket purchases… households are maintaining their lifestyles by reducing their savings rate and that is likely restraining spending on discretionary goods.”

Summary

The growth of public and private debt is occurring at a rate faster than wage growth or economic growth. Debt remains the single most important factor in assessing the outlook for the U.S. economy. The business cycle has become incredibly dependent upon the credit cycle which has been hi-jacked by monetary policy. More borrowing leads to better economic growth in the short term, but eventually the music stops, debts must be repaid, and the painful process of deleveraging begins.

Central bank interventions have imprudently disrupted the normal cycle and likely extended it. Unless the Fed can somehow remove human decision-making from the equation, the swings in business cycles remains a permanent feature of the economic system no matter how disfigured from bad monetary policy. What seems to be taking place in the economy today is consumers nearing a point of maximum debt accumulation or consumption exhaustion. Their willingness or ability to take on more credit is slowing and is beginning to become a drag on consumption.

Our assessment of the amount of debt outstanding in conjunction with what we are observing on new and used car lots, at department stores and restaurants offers some indication that we may be near a turning point in the credit cycle. This does not necessarily mean that a recession is imminent but if our concerns are valid, it certainly raises the probability of an economic downturn and quite possibly a catalyst to reverse the direction of asset prices. Given these dynamics and current market valuations, we continue to urge investors to proceed with caution.

 

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