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Monthly Archives: August 2016

“Apple has just announced that next quarter they will quadruple their sales of their iPhone X+ as every person on the planet now owns one.”

If that were a real announcement the stock price should immediately skyrocket higher, right? Nope, it didn’t.

In fact, it didn’t move at all.

Why? Because, no one bought or sold a single share.

How can that be?

Because the whole world is now “passively” investing.

Well, that’s the way a lot of advisors are proposing as the way you should invest. The problem is that it is lazy money management, so why are you paying for the advice, but more importantly, markets don’t function that way.

Larry Swedroe wrote a piece just recently admonishing active portfolio managers and suggesting that everyone should just passively invest. After all, the primary argument for passive investing is that active fund managers can’t beat their  indices over time which is clearly demonstrated in the following chart.


There are large numbers of active fund managers who have posted stellar returns over long-term time frames. No, they don’t beat their respective benchmarks every year, but beating some random benchmark index is not the goal of investing to begin with. The goal of investing is to grow your “savings” over time to meet your future inflation-adjusted income needs without suffering large losses of capital along the way.

Don’t get me wrong, I admire Larry very much. However, it is important to understand a couple of important concepts around the “fallacy” of passive investing.

First, while my example above is extreme, the problem with even 20% of the market being “passive” is the liquidity issues surrounding the market as a whole. With more ETF’s than individual stocks, and the number of outstanding shares traded being reduced by share buybacks, the risk of a sharp and disorderly reversal remains due to compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.

As Howard Marks, mused in his ‘Liquidity’ note:

“ETF’s have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

Secondly, individual investors are NOT passive even though they are investing in “passive” vehicles. Today, more than ever, advisors are actively migrating portfolio management to the use of ETF’s for either some, if not all, of the asset allocation equation. However, they are NOT doing it “passively.”

The rise of index funds has turned everyone into “asset class pickers” instead of stock pickers. However, just because individuals are choosing to “buy baskets” of stocks, rather than individual securities, it is not a “passive” choice but rather “active management” in a different form.  

While the idea of passive indexing works while all prices are rising, the reverse is also true. The problem is that once prices begin to fall the previously “passive indexers” will become “active panic sellers.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic and damaging ending.

It is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are stacked against substantial market gains from current levels.

As my partner, Michael Lebowitz, noted:

“Nobody is going to ring a bell at the top of a market, but there are plenty of warped investment strategies and narratives from history that serve the same purpose — remember internet companies with no earnings and sub-prime CDOs to name two.”

Investors need to be cognizant of and understand why the chorus of arguments in favor of short-sighted and flawed strategies are so prevalent. The meteoric rise in passive investing is one such “strategy” sending an important and timely warning.

Remember, everyone is “passive” until the selling begins. 

Oh, I almost forgot, the other problem with the whole “passive investing” mantra is that “getting back to even” is not a successful investment strategy to begin with.

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

Economy & Fed


Most Read On RIA

Research / Interesting Reads

“What’s the difference between a pro and an amateur? Professionals look for what’s wrong with a setup. Amateurs only look for what’s right.” ― Mark Harila

Questions, comments, suggestions – please email me.

This past weekend, the Administration announced a tentative deal with China to temporarily postpone the burgeoning “trade war.” While the details of the deal are yet to be worked out, the concept is fairly simple – China will reduce the existing “trade deficit” by over $200 billion annually with the U.S. by reducing tariffs and allowing more goods to flow into China for purchase. On Monday, the markets reacted positively with industrial and material stocks rising sharply as it is expected these companies will be the most logical and direct beneficiaries of any deal.

Unfortunately, there are several reasons the whole scenario is quite implausible. Amitrajeet Batabyal recently explained the problem quite well.

“With China, the U.S. imports a whopping $375 billion more than it exportsHow could it whittle that down to $175 billion? There are three ways.

  • First, China could buy more U.S. goods and services.
  • Second, Americans could buy less Chinese stuff.
  • Finally, both actions could happen simultaneously.

The kinds of Chinese goods that Americans buy tend to be relatively inexpensive consumer goods, so even a dramatic decline is likely to have only a trivial impact on the deficit. And since China explicitly controls only one lever — its imports — it’ll have to buy a lot more American-made things to achieve this goal.

For this to happen, without upsetting other trade balances, the American economy would have to make a lot more than it currently produces, something that isn’t possible in so short a time frame.”

While the Administration will be able to claim a “trade victory” over a deficit reduction agreement, such is unlikely to lead to more economic growth as promised.

If we assume China does indeed spend an additional $200 billion on U.S. goods, those purchases will increase flows into the U.S. dollar, causing dollar strengthening relative to not only the Yuan but also other currencies as well. Since U.S. exports comprise about 40% of domestic corporate profits, a stronger dollar will counter the benefits of China’s purchase as other foreign importers seek cheaper goods elsewhere.

For China, a stronger dollar also makes imports to their country more expensive. To offset that, China will need to “sell” more of its U.S. Treasury holdings to “sanitize” those transactions and stabilize the exchange rate. This is not “good news” for Treasury Secretary Steve Mnuchin who would lose the largest foreign buyer for U.S. Treasuries.  This particularity problematic with the national debt expected to increase by at least one trillion dollars in each of the next four years.

There has been a lot of angst in the markets as of late as interest rates have risen back to the levels last seen, oh my gosh, all the way back to 2011. Okay, a bit of sarcasm, I know. But from all of the teeth gnashing and rhetoric of the recent rise in rates, you would have thought the world just ended. The chart below puts the recent rise in rates into some perspective. (The vertical dashed lines denote similar rate increases previously.)

It is important to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. From 2014-2016China was dumping U.S Treasuries, and converting the proceeds back into Yuan, in an attempt to stem the outflows and resulting depreciation of their currency. Since 2016, China has been buying bonds as the Yuan has appreciated.

If China does indeed increase U.S. imports, the stronger dollar will increase the costs of imports into China from the U.S. which negatively impacts their economy. The relationship between the currency exchange rate and U.S. Treasuries is shown below.

With respect to the “trade deficit,” there is little evidence of a sustainable rise in inflationary pressures. The current inflationary push has come primarily from the transient effect of a disaster-related rebuilding cycle last year, along with pressures from rising energy, health care, and rental prices. These particular inflationary pressures are not “healthy” for the economy as they are “costs” which must be passed along to consumers without a commensurate rise in wages to offset them.

Asia is the source of most global demand for commodities, while also a huge supplier of goods into the US. Asian currencies have followed U.S. bond yields higher and lower since the 1990s, as well as followed commodity prices higher and lower over that time. There has only been one previous period when this relationship failed which was in 2007 and 2008.

With the Chinese financial system showing signs of increasing stress, any threat which devalues the currency will lead to further selling of Treasuries. Rising import costs due to a forced “deficit balancing,” will likely have more of a negative impact to the U.S. than currently believed.

Sum-Zero Game

While much of the mainstream media continues to expect a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then productivity, population, wage and consumer debt growth become key inputs into that equation. Unfortunately, productivity is hardly growing in the U.S. as well as in most developed nations. Further, wage and population growth remain weak as consumers remain highly leveraged. This combination makes a surge in economic growth highly unlikely particularly as rate increases reduce the ability to generate debt-driven consumption.

With unemployment rates near historic lows and production measures near highs, the problem of meeting Chinese demand will be problematic. As Amitrajeet states:

“That’s because when a nation’s economy is using its resources to produce goods efficiently, economists say that it has reached its production possibility frontier and cannot produce more goods.”

This makes Chinese promises largely illusory given the structural hurdles in China to allow for increased purchases of American exports much less the sheer amount of goods the United States would have to produce to meet Beijing’s demand.

As stated, with the United States economy already running near its full productive capacity, it is virtually impossible to produce enough new goods to meet Chinese demands, especially in the short term.

Sure, the United States could stop selling airplanes, soybeans and other exports to other countries and just sell them to China instead. Such actions would indeed shrink the United States trade deficit with China, but the trade deficit with the entire world would remain unchanged.

In other words, it’s a sum-zero game.

More importantly, if the U.S. cannot deliver the goods and services needed by China the entire agreement is worthless from the start. More importantly, China’s “concessions,” so far, are things it had planned to do anyway. As noted by Heather Long via the Washington Post:

“The Chinese have one of the fastest-growing economies and middle classes in the world. Chinese factories and cities need more energy, and its people want more meat. It’s no surprise then that China said it was interested in buying more U.S. energy and agricultural products. The Trump administration is trying to cast that as a win because the United States will be able to sell more to China, but it was almost certain that the Chinese were going to buy more of that stuff anyway.

What Trump got from the Chinese is ‘the kind of deal’ that China would be able to offer any U.S. president,’ said Brad Setser, a China expert at the Council on Foreign Relations. ‘China has to import a certain amount of energy from someone and needs to import either animal feed or meat to satisfy Chinese domestic demand.’

China has been buying about $20 billion worth of U.S. agricultural products a year and $7 billion in oil and gas, according to government data. Even if China doubled — or tripled — purchases of these items, it won’t equal anywhere near a $200 billion reduction in the trade deficit.”

But where China really won the negotiation was when the United States folded and agreed to suspend “trade tariffs.” While the current Administration is keen on “winning” a deal with China, without specific terms (such as a defined amount of increased purchases from the U.S. and the ability to meet that demand) the “deal” has little meaning. China has a long history of repeatedly reneging on promises it has made to past administrations.

By agreeing to a reduction of the “deficit” in exchange for “no tariffs,” China removed the most important threat to their economy as it will take 18-24 months before the current Administration realizes the problem.

“Yes, it’s good for both sides not to be in a trade war, but the Chinese had more to lose economically from the tariffs. The Trump administration rolling back its $150 billion tariff threat against China is a good ‘get’ for the Chinese.”

As with all things, there are always two sides to the story. While the benefits of reducing the trade may seem like a big win for America, reality could largely offset any benefits. If the goal was simply to be seen as the winner, Trump may have won the prize. But, it will likely be China laughing all the way to the bank.

Before February 2018, the S&P 500 was positive for a record 15 months in a row. Despite the seemingly perfect track record, a series of daily record highs, and unprecedented levels of positive investor sentiment, the market’s tone changed abruptly in the last few days of January. Since the record highs achieved on January 26th, 2018, the S&P 500 initially fell by 11% and subsequently recovered about half that loss.

The natural reaction for most investors following jolts to markets and changes in its behavior is to link the unexpected price declines with specific catalysts. In Thinking, Fast and Slow, Daniel Kahneman, a renowned Nobel laureate and behavioral psychologist, states, “[All] headlines do is satisfy our need for coherence.

By assuming one knows the cause for a market event and how that cause may evolve, a great level of comfort can be attained. The catalysts blamed for the recent market swoon are higher interest rates, a hawkish Federal Reserve, trade and tariff threats, and volatility strategies gone awry.

While these are certainly affecting the market, we are not easily comforted by headlines.

We believe that constructing portfolios based on longer-term market and economic trends and not short-term market noise is the proper approach to managing money. In this article, we provide context to the recent price action and highlight the true fundamental and technical drivers of the market. Before a discussion of the current market environment, it is helpful to revisit a six month period beginning in August of 2015 that is analogous to today.


After grinding higher during the first seven months of 2015, the equity markets hit a speed bump in mid-August. With little warning, the S&P 500 declined more than 11% over a six-day period. After two months of sharply increased volatility, the market recouped its losses. The rebound was short-lived, and the market subsequently fell 13%, ending below the lows seen in August. From that point, the bull market regained its positive momentum, and the S&P rallied over 50% to the late January 2018 record highs. We cite this tumultuous period because it helps differentiate a bull market correction from a bear market.  The “catalysts” of the 2015 correction were strong indications of interest rate hikes from the Federal Reserve, an appreciating U.S. dollar, and warnings that said dollar strength was having negative economic effects on many foreign countries, most importantly China.

These concerns were valid, but they proved temporary. The dollar would continue to appreciate for another year and then head sharply lower as we are currently witnessing. China and other nations were able to depreciate their currencies and provide fiscal and monetary stimulus to overcome the effects of a stronger dollar. The Fed has raised rates, but at a slow enough pace to ward off financial concerns.

Those investors that rode out the unpleasant volatility of 2015 were rewarded for their steadfastness. Other investors, worried about mounting losses, diverged from their longer-term investment strategies and realized losses that in turn reduced their ability to compound wealth.


By first presenting the 2015 experience, we show that even the most bullish markets, as we are currently in, are frequently met with periods that are not only counter-trend but highly uncomfortable. Periods such as 2015 are not only natural but healthy.

The graph below shows market volatility as measured by the difference between daily highs and lows. In 2017 the average difference was 0.51% (black line) as compared to the 1.32% (red line) difference that has thus far occurred in 2018.

To put these moves into context, the average daily volatility for the five years preceding 2017 was 0.97%. In other words, daily price movement is certainly heightened in recent months, but it is not as alarming when compared to historical market volatility.

Further, it is important to keep in mind that most media outlets present daily market changes in dollar terms and not percentages. When shown this way, the recent sell-off seems larger than those of prior bear markets. For instance, the daily changes in the Dow Jones Industrial Average for the first week of April 2018 were as follows: -459, +389, +231, +241, and -573. The 573 point loss on April 6th was 65 points worse than the 508 point decline on Black Monday 1987. Black Monday remains the largest one-day loss in the DJIA in percentage terms at 22.6%. The recent 573 point loss was only about 2.5% of the total value of the DJIA. A similar decline like Black Monday would result in a loss of over 5,500 points.

It is quite possible that recent volatility is sending a signal that the upward trend since 2009 is reversing. As such, we believe it is important to closely follow the fundamental and technical drivers of equity markets and tactically manage risk accordingly. Below we provide a review of the current factors we think are most relevant. The highlighted factors are the ones we think will dictate market movements over the next few months.

Factors supporting further equity appreciation:

  1. The unemployment rate is at 3.9%, the lowest level since October 2000.
  2. Economic growth has shown signs of improvement in the U.S. and many developed nations.
  3. The S&P CoreLogic Case-Shiller 20-City Home Price Index is at 209.28, about 3 points above the all-time high seen at the peak of the housing bubble in July 2006.
  4. Small Business Optimism is at the highest level since September 1983, and the Michigan Current Consumer Sentiment gauge is at 17-year highs.
  5. Partially as a result of tax reform, corporate earnings growth is strong and running well above the historical average.
  6. The recent tax reform reduces taxes for corporations from a statutory rate of 39% to 21%.
  7. The current U.S. Consumer Price Index is slightly above the Fed’s inflation target but relatively tame at 2.4% and 2.1% excluding-food and energy.
  8. Increased deficit spending related to tax reform, the latest spending bill and the possibility of infrastructure spending, are all stimulative and further support already improving economic growth.
  9. Changes in global trade terms, something the administration is aggressively pursuing, may be net beneficial to the economy.
  10. Corporate equity buy-backs are expected to grow at a record pace in 2018.

Factors providing headwinds to equity appreciation:

  1. The current U.S. economic expansion has lasted 107 months and counting. Based on data since 1945, covering 11 business cycles, the average is 58 months, and the longest was 120 months (1991-2001).
  2. The Federal Reserve is planning to adhere to a gradual series of interest rate hikes and balance sheet reduction over the coming year. Other central banks are planning similar actions.
  3. The Federal Reserve has lost 44 years of policy-making experience with the departures of Yellen, Fischer, Dudley, and
  4. Geopolitical risks are extensive. Problems include instability in the Middle East, Southern Asia and the United Kingdom as well as friction between the U.S. and North Korea, Iran, and China.
  5. Equity valuations are at levels that have historically been met with hefty drawdowns.
  6. Longer-term interest rates have begun rising to levels not witnessed since 2011.
  7. The yield curve continues to flatten, which has historically served as a recession warning.
  8. Inflationary pressures could cause the Fed to withdraw liquidity at a faster pace than the market is expecting.
  9. Short volatility trading strategies may impose more market pressure.
  10. Trade debate could turn into a trade war, hurting both the domestic and global economy.

Our Approach

Per Goldman Sachs, “The average bull market ‘correction’ is 13 percent over four months and takes just four months to recover.” If recent developments in the equity markets are in fact a correction, a market decline of 13% would put the S&P 500 at 2500.

However, caution and prudence suggest that we consider that recent volatility may be signaling the beginning of a larger than normal correction, possibly even a bear market. We are fully aware that equity valuations are at historically high levels, and we are growing increasingly concerned that the reduction in the Fed’s balance sheet will negatively affect money flows to the equity markets. Further, with deficits rising rapidly and the Fed reducing their Treasury bond holdings, we must consider the effect of higher interest rates on economic growth.  As discussed in, Stoking the Embers of Inflation, there exists the possibility the Fed is unknowingly creating inflation while they and most investors believe they are dampening it. Lastly, it is possible that volatility in all asset classes rises and remains elevated for a sustained period. This is not necessarily a bad thing, as it may produce new opportunities. More importantly, it serves as a reminder to ensure that the expected return on investments per unit of expected risk is commensurate with your goals.

Evaluation of the positive and negative factors that drive the markets is time consuming but a necessary effort. The negative factors listed above are not trivial. At the same time, the positive economic impulses can often outweigh the negative ones, thus providing more horsepower to drive the market higher.

* There is no quick answer to capture the holy grail of investment results.
* The only certainty is the lack of certainty.

If this morning’s downturn in futures holds up, the S&P (-20) and the Nasdaq (-72) Indices will have been down four days in the last five.

I moved back to a net short position late Friday/early Monday and I have been consistently expanding my shorts and reducing my longs since then (I now stand at medium size net short) – based on the recent move into the top end of my projected trading range and predicated on my (mostly) fundamental assessment of reward versus risk (which has turned quite negative).

Yesterday’s market decline was particularly hard felt in retail (where I recently sold off most of my longs) and defense (where I took a pass) – a possible signpost of more sector problems ahead.

I continue to see a new regime of volatility and the possibility of an expanded trading range.

More Lessons

Another lesson may be learned today and possibly over the next few months: Be fearful of the merchants of attention (particularly in the business media) that almost universally parade in a bullish costume. In their world and in the world of Twitter (TWTR) and other social media platforms – they never lose money. “First level thinking,” the absence of rigorous analysis and “group stink” are all – in the long and intermediate run – often harmful to your investment well being.

Stay independent and rigorous in approach and avoid generally useless (independent) indicators (e.g., unusual call activity that is typically quite usual and/or a quick/superficial look at a chart) that are used to hook retail investors (to buy a service) and make things seem easier than they are in selecting equities.

Always think second level and read Howard Mark’s book.
The investment mosaic is complicated and the past (trend(s)) or random factoids are not the sole factor to making investment/trading decisions – it involves the interaction of fundamental, technical, sentiment, psychology, valuation and a host of other known and unknown factors. If simply looking at past history was the route, librarians would be the wealthiest investors in the world.

As an aside, the primary reason I posited that President Trump would “make economic uncertainty and market volatility great again” #muvga is that superficial, untethered, non-researched, first level and hastily crafted policy is dangerous in a flat, networked and interconnected world. So it is with our trading and investment decisions – they are complex and require deep and time consumptive research.

In late 2012 I wrote a column entitled “There is No Secret Sauce.” Here is an abridged version:

Yesterday Tim “Not Phil or Judy” Collins and I went back and forth on the merits of technical analysis. (Here are my comments, and here are Tim’s.)

Let me start today with an expansion of my statement made on Tuesday that there is no secret investment sauce or elixir that will deliver traders and investors a recipe for investment success. There is no quick answer to capture the holy grail of investment results — not in charts, algorithms or historical patterns or pattern-recognition formulas.

On the latter point, Jim “El Capitan” Cramer appropriately and roundly criticized pattern-recognition observations on “Mad Money” last night — he called them worthless, incorrectly authoritative, a pernicious and a lazy exercise that serves as nothing more than a “lovey blanket” (i.e., a piece of cloth that makes you secure but provides, in reality, little security).

And I agree strongly with Jim.

But I understand why many want to believe. Taken by themselves, charts, algorithms and/or historical patterns provide a veneer of authenticity in just the sort of easy and quick sound bite conclusion that traders and investors are drawn to. I frequently see blind faith in the effectiveness in some of these exercises in our comments section every day, and, frankly, it concerns me. These approaches (and others) provide an attempt to simplify an awfully complex investment mosaic. Similar to Jim’s “lovey blanket,” they provide a false sense of security.

Investment selection is not as simple as interpreting a chart (through technical analysis); it is a complicated combination of macroeconomic factors, the level of interest rates, individual stock analysis, sentiment, valuation and many other factors. Technical analysis, in particular, should be used in conjunction with the above, not as a means unto itself. Again, there is no secret sauce in analyzing a stock’s price chart — a chart simply tells us where a stock has been, not where it is going.

Though I am a fundamentalist, I am not attempting to say that the answer is found either through fundamental or technical analysis.

I utilize and incorporate valuation, sentiment, macroeconomic factors, interest rates and many other factors in my investment process, but fundamental research is the foundation of all my decisions.
Fundamental research, when done properly is hard work — done well, it takes time. I research companies (and you see my conclusions in my diary) hopefully in a hard-hitting analytical way, and I often look to develop variant views from consensus (on both shorts and longs).

I choose not to utilize technical analysis in a meaningful way in my stock selection and decision-making process, however, as fundamental analysis (as a dominant determinant) just works for me. Technical analysts feel the same way in not adopting fundamental analysis, and I respect their views but deeply question decisions that are made solely on a technical basis or that are based on algortihms and/or pattern recognition.

Though technical analysis is only a small part of my investment decision process, I do refer to the charts, and when I do, I want to hear from someone like Tim Collins, as few do it better than him. Tim is in the class of my favorites, which also includes the Divine Ms. M., Rev Shark, Justin Mamis, “Uncle” Bob Farrell, Jeff Hirsch and Walt Deemer. (In fact, I have endorsed books on technical analysis by Jeff Hirsch and Walt Deemer.)

I keep charts, algorithms and historical pattern recognition in their proper perspective — and so should all of you.

I shortly followed this column with the next one:

As a rejoinder to my last post and to my recent “There Is No Secret Sauce” post, I see too many in our comments section (and elsewhere in the business media) confident and assured in their near-term market outlooks, and I see too many in our comments section (and elsewhere in the business media) confident and assured in directing others toward their personal views.

When wrong, many will say never mind — and where are you then left if you took their advice?

I will repeat for emphasis: Rarely has there been so much uncertainty. Indeed, as I have written, the only thing certain is the lack of certainty.

This is especially true with the avalanche of liquidity by the world’s central bankers (which dulls natural price discovery) and the large advance in the averages (over the last few years) being threatened by balance sheet deleveraging, political uncertainty, the worrisome trend in corporate profits and structural headwinds.

As my Grandma Koufax used to say, “Dougie, my there is a lot of moving parts in this game.”

This renders near-term market forecasts as no better than a coin flip.

But as I have written repeatedly, the market is not static; it is constantly changing based on fundamentals (principally) but also sentiment, interest rates, valuations and fund flows (among other factors).

The investment mosaic is complicated and there is no secret sauce — not algos, charts or opinions — that can deliver with confidence the short-term direction in stocks.

I always worry that subscribers react to a special algo or the simplicity of charts and opinions.

If you do, you will likely be disappointed.

In fact, I have found that the stronger the conviction, the more likely the data will reveal a lousy idea or market view.
I wish Mr. Market was that easy to outsmart, but he isn’t. Mr. Market is always in a state of flux — more so today than in the past.

I always worry that subscribers react to the simplicity of charts or any other secret sauce.

Before you make a move in this environment, be sure you do your own research, take a few deep breaths and consider risk and reward.

Doing so takes time and hard work – because there is no special sauce that can be quickly heated up.

We wonder how they do it.

Those who make handling money look effortless.

I have documented and monitored the money habits of fiscally-fit people for years.

The following ten appear prominently on the list.

1 – The fiscally-fit crowd considers “paying yourself first” sacrosanct.

They passionately believe that saving is equally as important as paying fixed expenses like rents or mortgages. This rule has been a part of their lives early on. Back to their youth. They never compromise this habit.

The “pay yourself” mindset is the foundation to their overall financial success. Whether a specific dollar amount or a percentage of income is directed monthly into savings or investments, the action is as important as the money itself. It represents a display of control which in turn enhances confidence.

2 – Thinking in monthly payments is detrimental to long-term financial health.

The fiscally-fit are not compelled to take on recurring obligations because they can afford the payments. The long-term financial impact of the liability is a deciding factor. For example, a $30,000 auto loan at 3% interest for 3 years results in a monthly outlay of $872.44. A 5 year loan calculates to $539.06. Many consumers gravitate towards lower payments. This crowd is motivated to pay less in total interest charges. With a saving of $937 over the life of the loan, the 3-year obligation is favored.

3 – Money is a consistent and healthy “worry.”

Like a low hum in the background of their lives, worry is a factor that resonates throughout the minds of the fiscally fit. A dose of worry is perceived as healthy since it fosters discipline, encourages patience and prevents this group from becoming complacent when it comes to monitoring financial progress. Professionals who preach a “don’t sweat it I’ll make the investment decisions,” mantra and come across as overconfident are dismissed. Financial advisors especially are sought as partners and sounding boards. Decisions are not made in haste.

4 – Unforeseen risk is right around the corner.

These individuals anxiously plan for risks that can hurt their financial standing no matter how remote the possibilities. They perceive disabilities, accidents or deaths as foreseeable threats. They prepare through formal insurance planning, usually in partnership with an objective financial professional. Insurance benefits available at work are maximized first. From there, additional coverage is purchased to cover spouses and fill in gaps that employer benefits do not. Term and permanent life insurance options are popular.

5 – Credit card debt is anathema.

Credit cards are popular to gain rewards and perks. Although having access to credit is important, debt is paid in full monthly to avoid usurious interest rate charges. Travel benefits are especially attractive. NerdWallet has identified the best travel cards. At the end of the year, credit card statements which consolidate expenditures and organize them by categories are utilized as a self-check on spending patterns and areas of overspending are target for correction.

6 – Planning especially for retirement, strengthens financial success.

Formal planning validates good habits, uncovers weaknesses and outlines actionable steps to meet goals. There’s no fear or denial when it comes to facing money truths that emerge when a written plan is developed. A clear plan should prioritize financial life goals that motivate the fiscally fit to achieve results based on personalized return benchmarks and not some comparison to an arbitrary stock index.

There’s little discouragement when monetary changes occur as a good plan allows flexibility for various outcomes. Occasionally, expectations need to be tempered as progress doesn’t meet expectations. I’ve known members of this set who have taken radical steps to secure a strong financial future including massive shifts in spending and impressive downsizing in lifestyles.

7 – Paying retail is not an option.  

They’re not cheap, just savvy shoppers. There’s no such thing as immediate gratification when it comes to purchasing goods and services like autos, appliances and furniture. Even organizing vacations is an assignment in frugality. This group does their homework and are endless seekers of deals. They favor used and are known to scoop up floor models. Even “lightly damaged” items are not out of the question. Blemishes are usually cosmetic in nature and prices too attractive to pass up on washers, dryers, refrigerators and other durables. They do not fall for long-term “no-interest” offers unless the debt can be paid off before interest charges are applied.

8 – Money mistakes are forever lessons.

Financial mishaps are never forgotten. The fiscally-fit do not languish in the past. They take responsibility for mistakes and never repeat them. Whether it’s an investment “too good to be true” that busted or lending money to friends or family that was never paid back, they are not afraid to say no, mark financial boundaries and move on without guilt.

9 – Emergency reserves are a priority.

There’s a passion, a slight paranoiato preserve capital for emergency spending. Anywhere from three to six months of fixed living expenses is optimum. If reserves fall, resources are re-directed even if it means postponing retirement funding until replenished. Online banks are increasingly popular compared to brick-and-mortar options due to higher yields, no monthly fees and surprisingly easy access to funds when needed. Want to run with this elite financial pack? Examine NerdWallet’s list of top high yield online savings accounts.

10 – A 401(k) isn’t all that.

The fiscally fit use several investment vehicles that complement tax-deferred accounts like 401(k) plans. This provides flexibility when distributions are required at retirement. Having various buckets that allow retirees to blend tax free, capital gain and ordinary income results in greater tax control and can make a difference to how much Social Security is taxed.

Financial success comes down to good habits.

These habits are common sense forged to simple actions applied long term.

However, simple is never as easy as it sounds, is it?

Don’t fret.

Small improvements lead to big results over time.

Written By Byron Kidder and Richard Rosso, CFP.

“Let me introduce an entity called You, Inc. This is a small, tightly controlled, privately-held company with the bulk of its productive assets invested in nontraded units of your future salary and wages. Your objective as CEO, CFO, and chairman of the board is to maximize shareholder value of You, Inc. while minimizing the financial risks faced by the corporation.” – Moshe A. Milevsky, Ph.D. – Author of “Are You A Stock Or A Bond?”

We get so tied up in our work and performing that we forget or (worse) put off the Human Capital Investment until we have time between projects.  It drops on our priority list because there is never any “left over” time available after our commitments are finished.

The human capital investment means YOU are your greatest investment.  A lifetime money-making powerhouse.  You need to be higher on the priority list.

Rosso’s Input:

The top .01% of American households have ruled the roost, foremost since the Great Recession where stocks and real estate have been blessed with turbo tailwinds to returns (thank central banks and low/manipulated rates for much of the windfall).

Ostensibly, owners of capital have seen their wealth move far ahead since the 1970s. Those who build wealth through household income and rely on wages haven’t been so fortunate as the annual percentage change of real hourly wages for the bottom 80% of workers have been on a steady downward slope, especially since the onset of the financial crisis.

Those in the bottom 90% of household wealth held 35% of the nation’s wealth in the mid-1980s. Three decades later, the percentage has fallen 12 points or exactly as much as the wealth of the .01 percent rose according to Matthew Stewart in an enlightening and thorough analysis titled “The 9.9 Percent Is the New American Aristocracy,” where he describes the 9.9% as meritocratic winners who left the 90% or “middle class,” in the dust. They are the professionals – lawyers, doctors, dentists, mid-level investment bankers, MBAs. You get the picture.

Per Stewart’s analysis, as of 2016 it took $1.2 million in net worth to make it into the 9.9 percent, $2.4 million to reach the group’s median and $10 million to get into the top .9 percent.

What am I getting at with all this data? Do you perceive opportunity or discouragement?

An investment in YOU, education, mastering a technical skill that’s in demand, increases the odds of escaping the bottom 90%, especially if synergized by likeability. In fact, likeability can get you hired. A field study by Chad A. Higgins & Timothy A. Judge in the Journal of Applied Psychology outlines how ingratiation (likeability), wins over self-promotion when it comes recruiter perception of fit.

In the popular book “The Science Of Likeability” by Patrick King, likeability is the ability to be more human, to appear genuinely approachable and relatable which could be a challenge in the age of electronic communication such as e-mail and text.

Back to Byron Kidder:

We have become desensitized to the fundamental skills necessary for social and business interactions in our quest for improving efficiency and productivity.  My book, “It’s All About Everything,” is an easy to read step-by-step guide that refreshes these skills while simultaneously awakens your sought-after desire to reconnect with your passion, re-engage with those around you, and produce your vision of success.

Fundamentally, people want to be around and associated with people they like but far too many have difficulty in this area.  They may have picked up bad habits or felt like being likable contrasted with being successful.  Being likable will positively affect your growth, promotions, relationships, etc.  You don’t need to sacrifice being likable to being successful.  It is not a tradeoff.  The great news is that likability can be learned!

Rule 7: Being likable.

Being likable is high on the list since it is Rule 7 of my book and let me assure you that it is in your power to raise your overall likability.  How many times have you worked with somebody who is not likable?

They may have been arrogant, abusive, braggart, inattentive, malicious, or lacked integrity.  After you have worked with them, do you choose to be around them again?  Realistically, you would avoid working with them in the future if possible even if it means a cut to your bottom line.  If you are like me, you remember unlikable people as well as the likable people, just for all the wrong reasons.

Being unlikable is not a career-ending move nor does it mean you should succumb to fate that comes with it.  Few people start out unlikable but end up stuck in a set of patterns that turns into second nature.  Bad habits can be ingrained just as well as good habits.  You may be in a stressful situation, so you start getting grumpier as an attempt to cope.  You may have in your mind a certain personality that is required to do your job, which dictates you need to behave a certain way, but it isn’t part of your natural personality and you are tired of pretending to be something you’re not.

Likeability encompasses a myriad of actions or attitudes that can be learned and changed.  The goal is to increase the positive traits that compliment your integrity.  If you have some set value system in place that dictates how you respond, interact, or live when nobody is watching, then you have a foundation that all scenarios can be measured against and dealt with accordingly.

Ever notice that negative people tend to attract each other?  The same is true for those with integrity.  Your reputation is bolstered by the company you keep.  In my experience, integrity is everything and is the foundation of my book.  I don’t want to have to think about somebody’s motives.  Start small and add likable traits over time.  Rome wasn’t built in a day.  If you act with integrity, your positive energy will draw people to you.  This leads to being consistently inspirational, which is a likable trait.

As with most things in life, there are a few traits that can be implemented for a quick reward and ROI.  Try these first and expand your repertoire over a span of weeks to months.  This includes being:

  • Attentive and focused.
  • Sincere and authentic.
  • Intellectually curious and anxious to learn.

Being attentive to those you work with – a client, colleague, or vendor, will help you provide best in class service.  You would not be successful if it were not for people choosing to do business with you.  Because of this, never let appreciation for your clients go unsaid.  I regularly share with clients that I enjoy working with them and value their relationships.

Get to know internal and external clients.  Internal clients include colleagues, bosses, receptionists – everybody you encounter should have a positive impression of you.  Small tokens of appreciation can simply come down to remembering birthdays or favorite hobbies.

Inform clients how you will be there. Provide several points of contact including a cell phone number. Accept calls above and beyond normal business hours. Back up words with actions.  How many times have people told you they’ll be there if you need anything but disappear or disappoint when needed the most?  Being present when things go wrong will boost reliability and reputation.  When the inevitable happens and mistakes are made, face them head on, never make excuses.  Own up to them. Then propose a corrective plan of action. You’ve now forged a relationship, made a client for life. Based on your reputation for follow-up and follow-through, odds are your chance of promotion will increase, too.

Etiquette cannot be emphasized enough because it shows empathy and inherently directs your focus on serving others. An action as simple as smiling when talking on the phone can make your voice sound more pleasant and confident.

Respond to inquiries quickly and professionally, even if to say you will follow up within the next few hours.  You know the golden rule – treat others as you expect to be treated.

Sincerity and Authenticity Leads to Stronger Relationships.

Focus on client needs is valuable and produces amazing results only if you are sincere and authentic.  Otherwise, you run the risk of coming across as fake or shady.  When positive and focused on others, the energy is contagious.  You are essentially creating a positive feedback loop.  As my buddy Richard Rosso, says, “You know within 3 minutes if someone is genuine or not.”  Likability inherently means you exhibit a certain amount of vulnerability when you are authentic.

Face-to-face meetings with clients are important to building likeability.  You are showing them that you will always be there in a reliable fashion while adding value to the relationship.  Only time can reinforce that you are walking the walk. Trust is the end result of consistently showing attention, care, and appreciation.  Being likable helps get you the time and interactions necessary to build trust.

Trust is built over time, maintained through a myriad of actions and is a big component of likability.  Don’t be afraid to show vulnerability (it’s human!)  Richard has pointed out that “this adds to your memorability.”  He is right.  Likability will be one reason you’re remembered and called upon for repeat business or to handle an important task for superiors.

Intellectually curious and anxious to learn.

Likeability and genuine curiosity are linked. To be curious about other’s interests, family, hobbies, and concerns allows people to open up, share their stories. Taking the time to learn about the people you interact with exhibits care and authenticity.  Focus allows you to understand a client’s unique situation so that solutions may be recommended. Working for a company? Be a detective and learn as much as possible. Study the annual report, learn the mission statement, ask questions to display genuine interest and likeability may gain you a mentor in influential places!

Being likable is a habit; habits are formed through routine and consistency.  Self-assessment and objective discovery are crucial. What are those traits that make you likeable?  Which skills seem foreign but worthwhile to learn?  Taking an internal inventory will allow you to prioritize areas of improvement. Likeable people aren’t afraid or hesitant to ask for help or ask questions to gain understanding, either.

What if you feel overwhelmed and struggle to remain motivated? It’s easy to grow discouraged as wage growth has remained stagnant; most likely you’ll be expected to accomplish tasks that years ago were delegated to two employees. Listen, you’re human. You’re going to feel frustrated. It’s important to remain centered on the positive. For example, a morning ritual of gratefulness, catching and stopping yourself from complaining and focusing on the bigger picture of serving others will help work through tough periods.

Bottom line? People want to work with people they like.  Likability is one part innate, another part learned behavior. Control over your attitude will boost likability. There are going to be times you won’t care about being likeable.  We all have rough days. The goal is to prevent a string of bad days from changing your personality. Negativity spreads quickly. Likeability and negativity do not mix.

The rules listed in my book, “It’s All About Everything,” will help you raise the bar on likability.  Be yourself, be vulnerable; focus on others and watch the positive energy returned to you.

Have fun with it.  You’ve got this.

You’re on the right path to master likeability!

One of the most dangerous sports in America lasts a total of eight seconds – bull riding. In bull riding, a rider must stay on top of the bucking bull while holding onto the bull rope with one hand for eight seconds and not touching the bull or himself with his free hand. If he does that, it is a qualified ride. If he gets bucked off before eight seconds, it is a no score.

For investors, the difference between success and failure in “riding the bull,” often comes down to knowing when “hang on” and when to “dismount” the bull market. The worst outcome is getting “bucked off” and facing a really “p*ssed off” bull looking to stomp or gore whoever is closest to it.

In this past weekend’s missive, “Consolidating The Breakout,” I updated the projected pathways for the market given the recent break above the cluster of resistance surrounding the 100-day moving average. To wit:

“As shown, in the chart above, this ‘pause’ sets the market up for a continuation of pathway #2a to the next level of resistance. However, there is a reasonable possibility that has opened up of a new path (#2c) which could lead to another retest of the 200-dma if the market breaks the current support.

Pathway #2c is currently a binary outcome and will only exist next week. Either the market will move higher next week and continue following pathway #2a or it won’t. Monday will likely ‘tell the tale’ and I will update this analysis in Tuesday’s report.”

I can now update that analysis with yesterday’s move higher on reports the “trade war” with China has been put on hold to negotiate a reduction in the “trade deficit.”

As I stated, pathway #2c was binary. Given our analysis is based on the “end-of-week” close, if the market breaks above last week’s highs, we will remove pathway #2c.

Where does that leave us now in terms of our portfolio models?

When the market broke above the 100-dma, we used some of the cash we had raised on previous rallies to increase the allocation to equities in our portfolios. However, we still maintain an overweight position on cash currently as a hedge against potential market risk.

This week, we are looking to add further exposure. However, before we do that, we need some confirmation from the market of a push higher. While the markets moved higher yesterday, it remains contained in a short-term trading range. We are looking to add further exposure to equities if the market can close above last week’s closing high. 

Importantly, while we are increasing equity exposure, we do so under the following guidelines:

  • We are still overweight cash in portfolios as the “risk” of a failure has not been absolved as of yet,
  • Positions are carrying a “tighter than normal” stop-loss level, and;
  • We will quickly add negative hedges as necessary on any failure of support. 

Earnings Remain The Biggest Concern

While market performance has certainly improved over the last couple of weeks, it remains overall quite disappointing relative to the jump in Q1 earnings. As noted by Upfina last week:

“Earnings growth has been solid even as stocks have been restless. It makes you wonder if earnings results matter in the near term. The chart below reinforces the notion that earnings beats haven’t mattered. 

As you can see, the average price change from 2 days before the report to 2 days after the report shows earnings beats have led to a 0.3% decline instead of a 1.1% increase which is the 5-year average. The stocks meeting and missing results have also fallen more than average. The beat portion of this chart is the most important because most firms beat results. It’s obviously important to figure out if stocks are actually selling off when bad results come out. “

There are two important things to remember about earnings:

But more importantly, the market may be sniffing out the specific problem I discussed recently – estimates have gone parabolic.

“Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have “sharpened their pencils” and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.”

“The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. ‘Optimism’ is, well, ‘exceedingly optimistic’ for the end of 2019.”

It is not just me that is scratching my head over the optimism. As my friend Doug Kass noted yesterday, so is Dr. Ed Yardeni who recently penned much of the same:

I would like to try some of whatever industry analysts are smoking. You can compare my earnings forecasts to their consensus estimates on a weekly basis in YRI S&P 500 Earnings Forecast on our website. I say “tomato.” They say “tomahto.”

My earnings-per-share estimate for 2018 is $155.00 (up 17.4% y/y). The analysts continue to up the ante and are currently at $160.40 (up 21.5%). My estimate for 2019 is $166.00 (up 7.1%). Theirs is $175.72 (up 9.6%). Perhaps the analysts are just high on life.

Their growth estimate for next year seems too high to me since I expect 2019 earnings growth to settle back down to the historical trend of 7%.”

“However, analysts tend to be too optimistic and often lower their estimates as earnings seasons approach.

While the surge in earnings estimates gives cover for Wall Street analysts to predict surging asset prices, the risk has historically been to the downside. This is because Wall Street has historically over-estimated earnings by about 33% on average.

Yes, while a vast majority of companies have beaten estimates in the first quarter, it is only the case because analysts are never held to their original estimates. If they were, 100% of companies would be missing estimates currently. 

At the beginning of January, analysts overestimated earnings by more than $6/share, reported, versus where they are currently. It’s not surprising volatility has picked up as markets try to reconcile valuations to actual earnings.

Economic Growth Is Set To Explode. Right?

Most likely not.

While there was a short-term boost to economic growth last year which was driven by a wave of natural disasters in the U.S., the boost from “rebuilding” is now beginning to fade.

As noted recently by Morgan Stanley (via Zerohedge):

While we are not yet seeing evidence of falling economic growth, we expect — with near- certainty — that we will have a peak rate of change in S&P 500 y/y earnings growth by 3Q thanks to the spike created by the tax cuts. This was something we cited in our 2018 outlook and one of the primary reasons why we thought P/Es would contract. The good news is that this has already occurred.

The risk for further P/E compression comes if markets start to worry that it’s not just a deceleration of growth on the backside of the peak, but an outright decline in growth. Consensus forecasts do not expect negative growth, but it’s worth considering the potential risk of ‘disappointment’ later this year and in 2019, for two reasons.

  • First, earnings growth expectations for 4Q and 2019 look high to us, given the extremely difficult comparisons created by the tax cuts.
  • Second, even in the absence of an economic recession or material slowdown, we do see growing risk to y/y growth of consumer spending due to the extraordinary one-time boosts that began late last year — hurricane relief, tax cuts and the interest in  cryptocurrency, not to mention the seeming euphoria in stock markets in January that looks unlikely to be repeated.

This suggests that the difficult comparisons are not only the result of tax cuts but perhaps better top-line growth that can’t be repeated. I think it’s too early to worry about this risk today, but it’s not too early to start thinking about it and watching for signs of consumer behavior becoming more tempered. I would also throw in the price of crude oil as an important consideration, given that our economics team estimates that close to one-third of the tax cut benefit to the US consumer may have already been removed by the rise in oil and gasoline prices.

The economy is sensitive to changes in interest rates. This is particularly the case when the consumer, which comprises about 70% of the GDP calculation, is already heavily leveraged. With corporations more highly levered than at any other point in history, and dependent on bond issuance for dividend payments and share buybacks, higher interest rates will quickly stem that source of liquidity. Notice that each previous peak was lower.

With economic growth running at lower levels of annualized growth rates, the “bang point” for the Fed’s rate hiking campaign is likely substantially lower as well. Currently, there are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until a recession occurs and earnings fall in tandem.

More importantly, the expectation for a profits-driven surge in asset prices fails to conflate with the reality that valuations have been the most important driver of higher stock prices throughout history.

While we are increasing equity exposure from a “trading” perspective, we remain much more concerned by the in the longer-term from the underlying issues which have been unkind to forward returns:

  • Yields are rising which deflates equity risk premium analysis,
  • Valuations are not cheap,
  • The Fed is extracting liquidity, along with other Central Banks slowing bond purchases, and;
  • Further increases in interest rates will only act as a further brake on economic growth.

Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

This time will likely be no different.

We remain “cautiously optimistic” and are happy just “riding the bull” for now.

As every good Texan knows, all “bull riders” get thrown if they stay in the saddle too long. The trick is to “hold on tight” with one hand and “dismount and run for safety” when the buzzer sounds.

The consequences of getting thrown have not been kind.

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.

A combination of so-called “demand pull” and “cost-push inflation” is sending up feedstock costs and interest expenses to levels that I believe will soon lead to a marked contraction in U.S. corporate profit margins.

In fact, we already saw this phenomenon in first-quarter earnings reports across a host of industries, from consumer-packaged goods to social media. While the cut in U.S. corporate-tax rates has mostly masked these drags and headwinds, the rising cost of everything will likely worsen in the year(s) to come.

For example:

  • Interest Costs Are Climbing. The Federal Reserve is raising interest rates and reducing its balance sheet’s size The European Central Bank will soon follow as it tapers its own quantitative-easing program.
  • Energy Costs Are Making New Highs. Rising oil prices are a tax on consumption.
  • Commodity Prices Are Rising. Lumber and steel are just two of the commodities that are bolting higher.
  • Labor Costs Are Growing. A November midterm-election “blue wave” of Democratic congressional victories might only accelerate the trend.
  • Trucking/Transportation Costs are Exploding. Every single good that’s transported is costing much more to deliver.
  • A Strengthening U.S. Dollar. This weighs on U.S. trade, as well as on multinationals who export products.
  • Regulatory Expenses Are a New Threat to Technology/Social Media. There’s little doubt that Alphabet/Google (GOOG) , (GOOGL) , Facebook (FB) , Twitter (TWTR) et al. will have to accelerate hiring of compliance people and others who monitor and supervise the dissemination of personal data. This will place a new drag to profits.

These influences are occurring at a time when U.S. and global economic figures growing more and more ambiguous, earnings-per-share comparisons are becoming more challenging and the U.S. deficit is swelling (see here and here).

Valuation Worries

Valuations are higher than most recognize when measured against feeble economic growth and too-optimistic EPS forecasts

Gluskin Sheff’s David Rosenberg last week delivered an interesting report with the chart below, which shows that investors are paying more for less U.S. economic growth. He concluded that U.S. stocks have only been so expensive only 9% of the time in history:

Here’s a good take on Rosenberg’s analysis from my pal Lance Robert’s Real Investment Advice

“The market is currently overpriced and overvalued by about a third. While investors can certainly bid up prices in the short-term, the long-term fundamentals will eventually come to play.

With households more exposed to financial assets currently than at any other point in history, the next downturn will be greatly exacerbated by the “panic” that ensues. As you can see in the chart above, the last two peaks in this ratio almost perfectly coincided with the dot-com crash and the 2008 financial crisis.

David [Rosenberg’s] most salient point came from a quote from Federal Reserve Bank of San Francisco. He pointed out that, having access to tons of research, they themselves admit that equity valuations are so stretched that there will be no returns in the next decade: “Current valuation ratios for households and businesses are high relative to historical benchmarks … We find that the current price-to-earnings ratio predicts approximately zero growth in real equity prices over the next 10 years.”

Basically, the Fed is giving investors an explicit warning that the market will ‘mean revert.’ But revert, doesn’t mean stop at the mean.

According to David’s calculations, if the household net worth/GDP ratio reverted to the mean, savings rates would go from 2% to 6%. As a result, GDP would go down 3%, which would have nasty consequences for the economy and, in turn, stocks. Just something to think about.”

With a moderating trajectory of economic growth and rising cost pressures, I believe that 2018-19 consensus EPS forecasts are too optimistic.

Edward Yardeni’s post: What Are Stock Industry Analysts Smoking? further illustrates the risk that companies might not realize current profit forecasts. Here, the difference between Yardeni and the consensus comes closer into focus:

The Bottom Line

Valuations are high, particularly in light of how much (or how little) economic growth that we’re seeing. The end of global quantitative easing is also at hand, while feedstock costs of all breeds are rising.

Add it all up and this might be a good time to derisk, as the possibility of stagflation looms ever closer. The bottom line: Investors are paying too much for stocks given slowing economic and corporate-profit growth, coupled with the pressure of rising costs of all kinds.

Over the weekend, I was digging through some old posts and ran across a speech given by Dr. Woody Brock in 2012. Dr. Brock, is an economist who holds 5-degrees in Math and Economics. He is also the author of “American Gridlock” which is must read for anyone investing money in the markets.

The speech is as important today, as it was in 2012.

There is a huge debate over “Austerity” versus “Spending.” While conservatives in government talk a “good game” about cutting spending, budgeting and debt reduction, the exact opposite has been the case over the past several Administrations both “conservative” and “liberal” alike.

The irony is that increases in debt lead to further increases in debt as economic growth must be funded with further debt. As this money is used for servicing debt, entitlements, and welfare, instead of productive endeavors, there is no question that high debt-to-GDP ratios reduce economic prosperity over time. In turn, the Government tries to fix the “economic problem” by adding on more “debt.” The Lowest Common Denominator provides more information on the accumulation of debt and its consequences.

However, the word “deficit” has no real meaning.

Dr. Brock used the following example of two different countries.

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

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

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

According to Keynesian theory, some microeconomic-level actions, if taken collectively by a large proportion of individuals and firms, can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession).

Keynes contended that a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  In other words, when there is a lack of demand from consumers due to high unemployment, the contraction in demand would force producers to take defensive actions to reduce output.

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

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

The problem, as noted by Dr. Brock, is that government spending has shifted away from productive investments, like the Hoover Dam, that create jobs (infrastructure and development) to primarily social welfare, defense and debt service which has a negative rate of return.  According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

In other words, the U.S. is “Country A.” 

As Dr. Brock aptly stated in his speech:

“Today we are borrowing our children’s future with debt. We are witnessing the ‘hosing’ of the young.'”

Whistling Past The Graveyard

The U.S. has the labor, resources, and capital for a resurgence of a “Marshall Plan.” The development of infrastructure has high rates of return on each dollar spent. Instead, the government has spent, and continues to spend, trillions bailing out banks, boosting welfare support, supporting Wall Street and reducing corporate tax rates which have a negative rate of return.

In the meantime, the aging of the population continues to exacerbate the underfunded problems of Social Security, Medicare, and Medicaid which is roughly $70 trillion and growing. It is simply a function of demographics and math.

As Dr. Brock noted:

“Mathematics and Sex create performance anxiety in men – because you can’t fake the outcome of either.”

Two recent studies show the problem clearly.

Demographics is an easy problem to see and mathematically calculate. The ratio of workers per retiree, as retirees are living longer (increasing the relative number of retirees), and lower birth rates (decreasing the relative number of workers), present a massive headwind to economic solvency. 

Just last week, the Institute for Family Studies, published a report showing the decline in the fertility ratio to the lowest levels since 1970,

With fertility rates low, the future “support-ratio” will continue to be a problem.

The second, and more immediate, problem is the vastly underfunded savings of the “baby boomer” generation heading into retirement. To wit:

” Anxiety over retirement and how to support oneself after calling it a career is impacting many Americans. A recent poll found that one in three adults has less than $5,000 in retirement savings.”

This is simple math.

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached or will reach retirement age between 2011 and 2030. A vast majority of them are “under saved” and primarily unhealthy.

This combination ensures the demand on the health care system, along with Medicaid and Medicare, will increase at a rate faster than it can supply. Bankruptcy, without substantive changes, is inevitable. The Affordable Care Act is a prime example of wrongly directed resources. While the goal of “affordable health care for everyone” is noble, the legislation only acted to massively increase the costs of healthcare, and the demand on the system, without improving the delivery and supply of the care itself. The shift of demand, without an equal shift in the supply, ensures that the entire system eventually bankrupts itself.

Of course, it isn’t just the social welfare and healthcare system that is effectively “broken,” but the economic model itself.

The Real Crisis

The real crisis that is to come will be during the next economic recession. While the decline in asset prices, which are normally associated with recessions, will have the majority of its impact at the upper end of the income scale, it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

With consumers again heavily leveraged with subprime auto loans, mortgages, and student debt, the reduction in employment will further damage what remains of personal savings and consumption ability. That downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers.

At some point, the realization of the “real American crisis” will be realized. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

For many, retirement years will not be golden. They will simply be more years of working to make ends meet as the commercials of “old people on sailboats,” promoted by Wall Street, will become a point of outrage. While the media continues to focus on surging asset prices as a sign of economic health, the reality is far different.

The real financial crisis in the future won’t be the “breadlines” of the 30’s, but rather the number of individuals collecting benefit checks and the dilemma of how to pay for it all.

As Dr. Brock suggests – it is truly “American Gridlock” as the real crisis lies between the choices of “austerity” and continued government “largesse.” One choice leads to long-term economic prosperity for all, the other doesn’t.

The most recent quarterly letter from Grantham, Mayo, van Otterloo (GMO) contains an interesting argument about bonds. Over the past five years, bonds have provided great performance, but also more diversification from stocks than they have since the Great Depression. That, along with a tamer stock market, has helped balanced portfolios have lower volatility than usual. Indeed the Vanguard Balanced Index Fund (VBAIX) has a five-year standard deviation of 6%, according to Morningstar. Over the longer term, volatility of balanced portfolios has been around 10%.

Ben Inker, author of the letter, argues that if an investor, over the last five years, had wanted to target a volatility of 10% — the historical long-term volatility of a balanced portfolio – such would have entailed a leveraged portfolio of 143% stocks, 96% bonds, and -139% cash. Moreover, levering up a balanced portfolio 139% would mean achieving returns of more than 7% annualized over cash, according to GMO’s asset class return forecast.

But Inker isn’t advocating using such leverage, as so many “risk parity” portfolios do. This situation amounts to a free lunch that Inker doubts will persist into the future. It’s possible that risk and risk premia have fallen so that levering up to achieve returns is less dangerous than it used to be. But it’s more likely that the recent “easy” environment is a temporary one in Inker’s opinion. As he puts it:

”Even if the natural volatility of the economy has fallen over time and even if policy response is better than it was 80 years ago, neither markets nor economies are all that well-behaved. Stability breeds instability, as Human Minsky pointed out 40 years ago.”

Why do stocks usually have a premium over bonds?

To arrive at his conclusion, however, Inker recounts some recent history, reminding readers of the basic difference between stocks and bonds along the way.

First stocks are riskier to buyers than issuers. Companies can go bankrupt, after all, and the equity is usually worth nothing in that instance. But, according to Inker, that “idiosyncratic risk” is not why stock investors have achieved such a premium historically. The other reason why stocks typically offer a long term premium over bonds is that equity losses occur at exactly the moment it is most painful to own them.

After all, stocks usually go down when the whole economy goes down. So, if you have a stock-heavy portfolio, your portfolio is likely to tank exactly when you lose your job, compounding your misery.

However, if fears of economic downturns have diminished, then the risk premium that stocks usually have over bonds might dry up. It wouldn’t make sense for stocks to offer higher long term returns in an environment that suddenly became safe and free from recessions. And Inker argues that’s what happened right before the Financial Crisis. Riskier assets were poised to deliver lower long term returns than less risky assets. And as much of a shock as the crisis was to this point of view:

“The rapid recovery corporate cash flow in the aftermath and the consequent lower levels of distress than previous cycles experienced have served to assuage investors’ economic concerns.” 

The passage of time from the last crisis has also convinced today’s investors that they could withstand a new one regardless of how they behaved last time.

Not only have fears of economic downturns receded, but it has seemed easier than ever to protect portfolios. High quality bonds did their job in the last crisis (provided you held enough of them). Recessions help high quality bonds in two ways: deflation makes existing coupons more attractive, and central banks lower rates.

What has made bond performance (and bonds’ low correlation to stocks) so astonishing in recent years is that bonds have posted great returns in the absence of a recession. Bonds are not supposed to behave quite this well and in quite this uncorrelated fashion from stocks in non-recessionary environments. Don’t look for that negative correlation to continue, and don’t try to juice your returns by levering up a balanced portfolio.

An interesting email hit my desk this morning:

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

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

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

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

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

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

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

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

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

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

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

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

As Upfina concludes:

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

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

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

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

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

Economy & Fed


Most Read On RIA

Research / Interesting Reads

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

Questions, comments, suggestions – please email me.

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

10-Rules That Work

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

1) You are a speculator – not an investor

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Howard Marks once wrote that:

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

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

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

10) Benchmarking performance only benefits Wall Street

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

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

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

It’s all about the risk

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

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

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

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

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

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

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

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

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

Some other short term concerns:

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

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

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

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

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

At least based on my perception of the fundamentals.


Consider the following companies:

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

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

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

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

Look back to the list above:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

It’s a moment of truth

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

As of December 2016, it was 8.3 months.

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

I’ll explain.

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

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

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

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

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

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

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

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

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

Per Crestmont:

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

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

Recency Bias

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

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

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

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

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

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

Hindsight Bias

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Let me summarize my top ten, current market concerns:

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

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

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

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

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

Source: Zero Hedge

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

“But, while ‘everyone loves a good bullish thesis,’ let me restate the reduction in the markets previous pillars of support:

  • The Fed is raising interest rates and reducing their balance sheet.
  • The yield curve continues to flatten and risks inverting.
  • Credit growth continues to slow suggesting weaker consumption and leads recessions
  • The ECB has started tapering its QE program.
  • Global growth is showing signs of stalling.
  • Domestic growth has weakened.
  • While EPS growth has been strong, year-over-year comparisons will become challenging.
  • Rising energy prices are a tax on consumption
  • Rising interest rates are beginning to challenge the valuation story. 

“While there have been several significant corrective actions since the 2009 low, this is the first correction process where liquidity is being reduced by the Central Banks.”

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

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

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

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

That was a mistake.

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

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

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

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

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

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

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

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

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

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

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

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

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