Monthly Archives: September 2016

Major Market Buy/Sell Review: 02-24-20

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

  • As noted last week: “With the market now trading 12% above its 200-dma, and well into 3-standard deviations of the mean, a correction is coming.” That correction started last Friday.
  • Currently, there is a strong bias to “buy the dip” of every corrective action. We recognize this and given the S&P 500 hit initial support on Friday we did add 1/2 position of VOOG to the Dynamic Model. The model is underallocated to equities and has a short hedge so we are taking this opportunity to add slowly. However, we suspect there is more to this corrective action to come this week.
  • As noted previously, extensions to this degree rarely last long without a correction. The is more work to be done before the overbought and extended condition is corrected. We will look to add to our holdings during that process.
  • Short-Term Positioning: Neutral Due To Extension
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $320
    • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

  • As goes the S&P 500, goes the DIA, especially when MSFT & AAPL are the two top holdings and drivers of the advances in both indexes.
  • Like SPY, DIA is very overbought and extended from long-term means and the correction this past week has started to reverse that condition. Dow 30k will have to wait for now.
  • Wait for this correction to complete before adding further exposure.
  • Short-Term Positioning: Neutral due to extensions
    • Last Week: Hold current positions
    • This Week: Hold current positions
    • Stop-loss moved up to $280
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • Despite the correction on Friday which centered on “big Tech,” it did little to reverse the extreme conditions of the market.
  • The correction this past week has not done nearly enough reversal to warrant adding exposure here.
  • With the Nasdaq “buy signal” at extremely overbought levels, there is likely more correction to come.
  • Short-Term Positioning: Neutral due to extensions.
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $215
  • Long-Term Positioning: Neutral due to valuations

S&P 600 Index (Small-Cap)

  • Small caps have failed to participate with the markets and under performance is weighing on portfolios.
  • The buy signal has continued to correct as small-caps are struggling to maintain recent support levels.
  • We may remove our exposure to small-caps and focus our attention more on domestic large cap value for now.
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop loss moved up to $69
  • Long-Term Positioning: Neutral

S&P 400 Index (Mid-Cap)

  • MDY remains extremely extended above the 200-dma, so more corrective action is likely. MDY is still on a buy-signal but is pushing rather extreme deviations from long-term means.
  • The previous breakout level held which is very bullish, so if the overbought condition can get worked off with some consolidation, we will have a good entry point to add exposure.
  • Short-Term Positioning: Neutral
    • Last Week: No holding
    • This Week: No holding
  • Long-Term Positioning: Bullish

Emerging Markets

  • EEM rallied and failed at resistance last week, which is concerning.
  • Like small-caps, we are going to reduce our exposure to international holdings and return our focus on large cap value for now.
  • The Dollar (Last chart) is also suggesting we reduce our exposure to international positioning. The dollar has reversed and broke out to new highs suggesting there is more upside to the dollar currently.
  • We are maintaining our holdings, but will likely remove our holdings soon.
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss set at $42
  • Long-Term Positioning: Neutral

International Markets

  • Like EEM, EFA also rallied off support last week but failed at recent highs.
  • As with EEM, the key to our positioning is the US Dollar which is rallying strongly.
  • We are going to likely remove our international exposure soon and return our focus back to large cap value.
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss set at $67
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • Oil has rallied over the last week showing some signs of life. However, oil stocks have yet to reflect the improvement. We suspect they will soon if oil can continue to rise.
  • As noted last week, “Oil is extremely oversold so a counter-trend rally is highly likely.”
  • We got a little bounce this past week, but need follow through this week.
  • We remain on hold for now, but are getting more interested.
  • Short-Term Positioning: Neutral
    • Last Week: No positions
    • This Week: No positions
    • Stops Triggered for any direct crude oil positions.
  • Long-Term Positioning: Bearish

Gold

  • As noted last week: “Gold rallied sharply and broke out to new highs, suggesting there was something amiss with the stock market exuberance.”
  • The correction came this past week, confirming Gold’s message was correct.
  • On Friday, gold rallied sharply off support and with the buy signal intact, higher levels are likely.
  • Our positioning looks good, but we are likely going to get a stock market bounce next week, allowing a better entry point to add to Gold positions.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole position adjusted to $145
    • Long-Term Positioning: Bullish

Bonds (Inverse Of Interest Rates)

  • As with Gold, Bonds were also suggesting something was amiss with the market. Bonds broke out to new highs this past week, and after adding exposure previously, the rally was a welcome hedge against stock market volatility.
  • Hold positions for now, but look for a bit of correction before adding more weight.
  • Bonds are very close to triggering a sell-signal. Suggesting higher prices are likely (Lower yields)
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss is moved up to $136
    • Long-Term Positioning: Bullish

U.S. Dollar

  • As noted previously: “The dollar has rallied back to that all important previous support line. IF the dollar can break back above that level, and hold, then commodities, and oil, will likely struggle.”
  • This past week, the dollar surged through that resistance and is now extremely overbought short-term. Looking for a reflexive rally in stocks next week that pulls the dollar back towards the breakout level of last week.
  • The rising dollar is not bullish for Oil, commodities or international exposures. So watch carefully.
  • The “buy” signal has been triggered suggesting the dollar is going to move higher from here.

Earnings Lies & Why Munger Says “EBITDA is Bull S***”

Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.

What is most fascinating is that so many individuals invest hard earned capital based on these manipulated numbers. The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future. 

As Drew Bernstein recently penned for CFO.com:

“Non-GAAP financials are not audited and are most often disclosed through earnings press releases and investor presentations, rather than in the company’s annual report filed with the Securities and Exchange Commission.

Once upon a time, non-GAAP financials were used to isolate the impact of significant one-time events like a major restructuring or sizable acquisition. In recent years, they have become increasingly prevalent and prominent, used by both the shiniest new-economy IPO companies and the old-economy stalwarts.”

Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back.

Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making.

An in-depth study by Audit Analytics revealed that 97% of companies in the S&P 500 used non-GAAP financials in 2017, up from 59% in 1996, while the average number of different non-GAAP metrics used per filing rose from 2.35 to 7.45 over two decades.

This growing divergence between the earnings calculated according to accepted accounting principles, and the “earnings” touted in press releases and analyst research reports, has put investors at a disadvantage of understanding exactly what they are paying for.

As BofAML stated:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power. 

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant, and since 2013, the number has been on a steady rise.

So, why do companies regularly report these Non-GAAP earnings? Drew has the answer:

“When management is asked why they resort to non-GAAP reporting, the most common response is that these measures are requested by the analysts and are commonly used in earnings models employed to value the company. Indeed, sell-side analysts and funds with a long position in the stock may have incentives to encourage a more favorable alternative presentation of earnings results.”

If non-GAAP reporting is used as a supplemental means to help investors identify underlying trends in the business, one might reasonably expect that both favorable and unfavorable events would be “adjusted” in equal measure.

However, research presented by the American Accounting Association suggests that companies engage in “asymmetric” non-GAAP exclusions of mostly unfavorable items as a tool to “beat” analyst earnings estimates.

How The Beat Earnings & Get Paid For It

Why has there been such a rise is Non-GAAP reporting?

Money, of course.

“A recent study from MIT has found that when companies make large positive adjustments to non-GAAP earnings, their CEOs make 23 percent more than their expected annual compensation would be if GAAP numbers were used. This is despite such firms having weak contemporaneous and future operating performance relative to other firms.” – Financial Executives International.

The researchers at MIT combed through the annual earnings press releases of S&P 500 firms for fiscal years 2010 through 2015 and recorded GAAP net income and non-GAAP net income when the firms disclosed it. About 67 percent of the firms in the sample disclose non-GAAP net income.

The researchers then obtained CEO compensation, accounting, and return data for the sample firms and found that “firms making the largest positive non-GAAP adjustments… exhibit the worst GAAP performance.”

The CEOs of these firms, meanwhile, earned about 23 percent more than would be predicted using a compensation model; in terms of raw dollars. In other words, they made about $2.7 million more than the approximately $12 million of an average CEO.

It should not be surprising that anytime you compensate individuals based on some level of performance, they are going to figure out ways to improve performance, legal or not. Examples run rampant through sports from Barry Bonds to Lance Armstrong, as well as in business from Enron to WorldCom.

This was detailed in a WSJ article:

One out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings.”

This rather “open secret” of companies manipulating bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to flatter earnings is not new.

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

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

Manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings adjustments, share-buybacks, etc. reach an effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues.

There’s a big difference between companies’ advertised performance, and how they actually did. We discussed this recently by looking at the growing deviation between corporate earnings and corporate profits. There has only been one other point where earnings, and stock market prices, were surging while corporate profits were flat. Shortly thereafter, we found out the “truth” about WorldCom, Enron, and Global Crossing.

The American Accounting Association found that over the past decade or so, more companies have shifted to emphasizing adjusted earnings. But those same companies’ results under generally accepted accounting principles, or GAAP, often only match or slightly exceed analysts’ predictions.

“There are those who might claim that so far this century the U.S. economy has experienced such an unusual period of economic growth that it has taken analysts and investors by surprise each quarter … for almost two decades. This view strains credulity.” – Paul Griffin, University of California & David Lont, University of Otago

After reviewing hundreds of thousands of quarterly earnings forecasts and reports of 4,700 companies over 17 years, Griffin and Lont believe companies shoot well above analysts’ targets because consistently beating earnings per share by only a penny or two became a red flag.

“If they pull out all the accounting tricks to get their earnings much higher than expected, then they are less likely to be accused of manipulation.” 

The truth is that stocks go up when companies beat their numbers, and analysts are generally biased toward wanting the stock they cover to go up. As we discussed in “Chasing The Market”, it behooves analysts to consistently lower their estimates so companies can beat them, and adjusted earnings are making it easier for them to do it.

For investors, the impact from these distortions will only be realized during the next bear market. For now, there is little help for investors as the Securities and Exchange Commission has blessed the use of adjusted results as long as companies disclose how they are calculated. The disclosures are minimal, and are easy to get around when it comes to forecasts. Worse, adjusted earnings are used to determine executive bonuses and whether companies are meeting their loan covenants. No wonder CEO pay, and leverage, just goes up.

Conclusion & Why EBITDA Is BullS***

Wall Street is an insider system where legally manipulating earnings to create the best possible outcome, and increase executive compensation has run amok,. The adults in the room, a.k.a. the Securities & Exchange Commission, have “left the children in charge,” but will most assuredly leap into action to pass new regulations to rectify reckless misbehavior AFTER the next crash.

For fundamental investors, the manipulation of earnings not only skews valuation analysis, but specifically impacts any analysis involving earnings such as P/E’s, EV/EBITDA, PEG, etc.

Ramy Elitzur, via The Account Art Of War, expounded on the problems of using EBITDA.

“One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA, and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”

The article is worth reading and chocked full of good information, however, here are the four-crucial points:

  1. EBITDA is not a good surrogate for cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading to a false sense of liquidity.
  2. Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
  3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
  4. EBITDA, just like net income is very sensitive to accounting manipulations.

The last point is the most critical. As Charlie Munger recently stated:

“I think there are lots of troubles coming. There’s too much wretched excess.

I don’t like when investment bankers talk about EBITDA, which I call bulls— earnings.

It’s ridiculous. EBITDA does not accurately reflect how much money a company makes, unlike traditional earnings. Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”

In a world of adjusted earnings, where every company is way above average, every quarter, investors quickly lose sight of what matters most in investing.

“This unfortunate cycle will only be broken when the end-users of financial reporting — institutional investors, analysts, lenders, and the media — agree that we are on the verge of systemic failure in financial reporting. In the history of financial markets, such moments of mental clarity most often occur following the loss of vast sums of capital.” – American Accounting Association

Imaginary worlds are nice, it’s just impossible to live there.

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Catch Up On What You Missed Last Week


Did The Market Just Get Infected?

Just last week, we were asking the opposite question, as traders were believing that the market had immunity to the risks from the “coronavirus.”

This was a point we discussed with our RIAPRO subscribers (Try for 30-days RISK FREE) in Monday’s technical market update.

“As noted last week: ‘With the market now trading 12% above its 200-dma, and well into 3-standard deviations of the mean, a correction is coming.’ But the belief is currently ‘more stimulus’ will offset the ‘virus.’

This is probably a wrong guess.

Extensions to this degree rarely last long without a correction. Maintain exposures, but tighten up stop-losses.”

That correction came hard, and fast on Thursday and Friday.

For the week, the market declined, but it was the “5-Horseman Of The Rally” (Apple, Microsoft, Google, Facebook, Amazon) which led the way lower. This is the first time we have seen a real rotation out of the “momentum chase” into fixed income and was a point we discussed in Thursday’s RIAPRO Intermarket Analysis Report. To wit:

“Stocks and bonds play an interesting ‘risk on/risk off’ relationship over time. As shown above while stocks are extremely outperforming bonds currently, the relationship is now suppressed to levels where a reversion would be expected. This suggests that we will likely see a a correction in equity prices, and a rise in bond prices (yields lower), in the near future.”

Currently, this is just a correction within the ongoing bullish trend, however, there are things occurring that do not rule out the possibility of a larger correction in the short-term.

Carl Swenlin from Decision Point (h/t G. O’Brien) came to a similar conclusion.

“Yesterday (Thursday) SPY penetrated the bottom of a short-term rising wedge, but couldn’t make it stick. Today was a different story, but the support line drawn across the January top impeded excessive downward progress. The VIX didn’t quite reach the bottom Bollinger Band, but it is possible that we will see continued weak price action similar to the short January decline if the VIX breaks through the band. Being so close to the band, the VIX is also oversold, so it is also possible that we’ll see a bounce.”

“The intermediate-term market trend is UP and the condition is SOMEWHAT OVERBOUGHT. The negative divergences spell trouble., and all four indicators are below their signal line and falling.

The market has so resilient that it is hard to think that anything more than a minor pullback is possible. A critical breakdown below the January top hasn’t happened yet, but that could be the first move on Monday. Indicators in the short- and intermediate-term are falling, and negative divergences are abundant, so I think that next week will be negative. That may just be the beginning.”

We agree with that assessment. Remember, it never just starts raining; clouds gather, skies darken, wind speeds pick up, and barometric pressures decline. When you have a consensus of the evidence, you typically carry an umbrella.

Evidence is clearly mounting, and one of the bigger concerns to the market, and particularly to the commodity space, is the surge in the U.S. dollar. This past Monday, we wrote:

“As noted previously, the dollar has rallied back to that all important previous resistance line. IF the dollar can break back above that level, and hold, then commodities, and oil, will likely struggle.”

That is exactly what happened over the last two weeks and the dollar has strengthened that rally as concerns over the ‘coronavirus’ persist. With the dollar testing previous highs, a break above that resistance could result in a sharp move higher for the dollar.

The rising dollar is not bullish for Oil, commodities or international exposures. The ‘sell’ signal has began to reverse. Pay attention.”

This surge in the dollar is also responsible for the sharp drop in bond yields as money is flooding into USD denominated assets due to the coming global impact from the coronavirus.

This is a substantial risk to the markets over the rest of this year which has not been factored into asset prices as of yet.

Furthermore, the main driver behind stock prices since last October has been the flood of liquidity from the Federal Reserve. However, that push of liquidity has quietly gone subsided over the last few weeks.

This was well telegraphed by the Fed previously but was reasserted this past week as the Fed noted it was in no rush to cut rates and would continue reducing “repo operations,” both into, and following, April.

Given the “bull thesis” has been “liquidity trumps all other risks,” with the Fed funds rate at 1.5% currently, and liquidity flows being reduced, “risks” now have a stronger hand. When you combine reduced liquidity with a surging U.S. Dollar, and collapsing yields, investors should reassess their positioning accordingly.

As my friend Victor Adair from Polar Futures Group stated on Friday:

“The EURUSD jumped sharply (after falling steadily YTD) and the spooz took another leg down. Could there have been a European institutional account positioned in US stocks which suddenly decided, like the Jeremy Irons character in the Margin Call movie, that they didn’t “hear the music” anymore, and decide to sell? If they had owned US stocks without hedging their FX risk the temptation to hit the SELL button given the recent huge rallies in both US stocks and the US Dollar would have been huge! I think the S&P 500 can continue lower.”

Positioning Review & Update

We have been concerned about the potential for a correction for the last three weeks. Given that we previously took profits near the market peak in January, there was not a tremendous amount of work we needed to do on the equity side of the ledger.

However, this past Monday we did extend the duration of our bond portfolio a bit, and changed some of the underlying mixes of bonds, to prepare for a correction. With the sharp yield spike over the last couple of days, those positioning changes worked well to reduce volatility.

We are using this correction to rebalance some of our equity risks as well. The bull market is still intact, so it is not time to be bearish in terms of positioning, just yet. However, we are maintaining our hedges for now until we get a better understanding of where the markets are headed next.

Currently, there are several levels of support short-term. The market bounced off initial support at the 38.2% retracement level at the end of the day on Friday. However, we suspect we will likely see more follow-through next week, particularly if the dollar continues to strengthen. Downside risk currently resides at 3250, but a break below that level will suggest a much bigger correction is underway.

Longer-term, given the unrecognized impact of the virus on the economy, we expect a bigger decline down the road. As Doug Kass noted on Thursday:

“Caution is warranted. What we have all learned of the virus is that it is easily transmitted. It is asymptomatic, well established and it is spreading. As I have also noted its spreading has been under reported and, unlike other market headwinds, the liquidity provided by central bankers will have NO impact on the damage inflicted by the virus’ contagion.

Among other issues, global travel will be decimated and this will have unusual ‘knock on’ effects. Tourists, especially Chinese ones, spend lots of money. This will be a GLOBAL problem as China was to be a source of big growth for this sector. Retailers of EVERYTHING are going to miss budgets and economies like Japan and South Korea are going to be devastated by the impact.

In Japan, this will come after a massive (and ill timed) tax increase. Tech will play the role of major (not minor) collateral damage as long held supply chains are damaged/crushed.

Most investors, focused on price action, have little idea what could hit them.”

We are keenly aware of the risk, and while we are not “selling heavily and moving to cash” currently, it doesn’t mean we won’t.

We are paying attention to what the market is saying, and following directions accordingly.

Are you?



The MacroView

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See You Next Week

By Lance Roberts, CIO


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Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

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

Sector-by-Sector

Improving – Discretionary (XLY), Real Estate (XLRE), and Utilities (XLU)

As noted previously, we reduced exposure to Utilities, Real Estate, and Discretionary due to their extreme overbought condition. Unfortunately, that overbought extension has not been alleviated enough at this time to add back to our holdings. We started to see a bit of correction in Discretionary this past week, but the plunge in yields pushed Real Estate and Utilities further into orbit. We will see a correction in yield-related positions in the next couple of weeks.

Current Positions: Reduced XLY, XLU, XLRE

Outperforming – Technology (XLK), Communications (XLC)

We previously recommended taking profits in Technology, which has not only been leading the market but has gotten extremely overbought. The correction in the markets last week hit the Technology sector the hardest, but Communications fell also. Hold positions for now, and be patient and let this correction play itself out before adding exposure.

Current Positions: Target weight XLK, Reduced XLC

Weakening – Healthcare (XLV)

We noted previously we had added to our healthcare positioning slightly. No changes are required currently, but the current correction is pulling some of the overbought conditions out of the sector. We will re-evaluate our holdings next week.

Current Position: Target weight (XLV)

Lagging – Industrials (XLI), Financials (XLF), Staples (XLP), Materials (XLB), and Energy (XLE)

On Thursday and Friday, we finally begin to see the early signs of the correction we have been talking about over the last couple of weeks. The correction did little so far to work off the extreme overbought and extended conditions. However, it is a start and we will wait and see what happens from here.

If we get sectors back to oversold, and markets are holding the bullish trendline support, we will recommend adding exposure to these areas. For now, be patient.

Current Position: Reduced weight XLY, XLP, Full weight AMLP, 1/2 weight XLF, XLB and XLI

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – Despite the rally in the broader markets, Small- and Mid-caps continue to underperform currently. Both markets sold off on Friday, with Small-cap stocks breaking below support at the 50-dma. Mid-caps look stronger but failed at recent highs establishing a short-term double top. Neither small or mid-caps are oversold currently, so there is more risk to the downside particularly if we begin to see further economic impacts from the corona-virus.

Current Position: KGGIX, SLYV

Emerging, International (EEM) & Total International Markets (EFA)

Emerging and International Markets, look a lot like small-caps above. Both had gotten extremely overbought and needed to correct. That correction broke support and their respective 50-dma. With neither market oversold currently, and the dollar getting stronger, we are likely going to close our of our positions on any bounce next week that fails to move above the 50-dma.

Current Position: EFV, DEM

Dividends (VYM), Market (IVV), and Equal Weight (RSP) – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with economic growth and inflation. We are currently maintaining our core positions unhedged for now. If we see deterioration in the broader markets, we will begin to add short-positions to hedge our long-term core holdings.

Current Position: RSP, VYM, IVV

Gold (GLD) – Over the last few weeks, we have been discussing that gold has been consolidating near recent highs. This past week, Gold broke out and surged higher as stock markets fell into a correction. Gold is extremely overbought, so be patient for now and move stops up to the recent breakout levels.

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

Bonds (TLT) –

Bonds also broke out to new highs on Friday as the dollar rallied as money rotated into bonds for “safety” as the market weakened. After previously recommending adding to bonds, hold current positions for now. Bonds are extremely overbought now, so be cautious, we added a small portion of TLT to portfolios last week, and added PTIAX to rebalance weighting and extend our current duration.

Current Positions: DBLTX, SHY, IEF, Added TLT & PTIAX

Sector / Market Recommendations

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

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

Portfolio/Client Update:

Finally, the market cracked last week and gave us a little room to operate. It is too early to become too “negative,” as the market is still convinced the Fed will intervene sooner, or later, with liquidity to offset the risk of the coronavirus. Despite the “sell-off” on Friday, investors don’t want to “miss out” on the liquidity party when it happens, so we will likely see the “buy the dip” crowd show up next week.

Over the last couple of weeks, we have made some minor changes to the portfolio which change very little in terms of the overall makeup. While this rebalancing of risk did not dramatically increase equity exposure, we are very aware of our positioning and risk and will take action accordingly.

We are being deliberately slow in on-boarding client portfolios into our models, and are monitoring risks very closely. We are not in a rush to make any drastic moves in either direction, and prefer to wait for the market to “tell us” what we need to do.

We taken profits, moved up stop-loss levels, and have hedged our risks. We will take action when necessary.

Be assured we are watching your portfolios very closely. However, if you have ANY questions, comments, or concerns, please don’t hesitate to email me.

Portfolio Actions Taken Last Week

  • New clients: Slowing adding exposure as needed.
  • Dynamic Model: Added 1/2 position in VOOG on Friday, as we continue to build out our “core” equity positioning in the portfolio. We still remain hedged with the Short-S&P 500 position to balance risk while trying to build out the overall model.
  • Equity Model: Sold 1/2 of DBLTX and added an equal amount of PTIAX to rebalance our bond exposure in portfolios to further hedge downside risk.
  • ETF Model: Sold 1/2 of DBLTX and added an equal amount of PTIAX to rebalance our bond exposure in portfolios to further hedge downside risk.

Note for new clients:

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


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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

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

Click Here For The “LIVE” Version Of The 401k Plan Manager

See below for an example of a comparative model.


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

401k Plan Manager Live Model

As an RIA PRO subscriber (You get your first 30-days free) you have access to our live 401k p

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

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

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

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

#MacroView: Japan, The Fed, & The Limits Of QE

This past week saw a couple of interesting developments.

On Wednesday, the Fed released the minutes from their January meeting with comments which largely bypassed overly bullish investors.

“… several participants observed that equity, corporate debt, and CRE valuations were elevated and drew attention to  high levels of corporate indebtedness and weak underwriting standards in leveraged loan markets. Some participants expressed the concern that financial imbalances-including overvaluation and excessive indebtedness-could amplify an adverse shock to the economy …”

“… many participants remarked that the Committee should not rule out the possibility of adjusting the stance of monetary policy to mitigate financial stability risks, particularly when those risks have important implications for the economic outlook and when macroprudential tools had been or were likely to be ineffective at mitigating those risks…”

The Fed recognizes their ongoing monetary interventions have created financial risks in terms of asset bubbles across multiple asset classes. They are also aware that the majority of the policy tools are likely ineffective at mitigating financial risks in the future. This leaves them being dependent on expanding their balance sheet as their primary weapon.

Interestingly, the weapon they are dependent on may not be as effective as they hope. 

This past week, Japan reported a very sharp drop in economic growth in their latest reported quarter as a further increase in the sales-tax hit consumption. While the decline was quickly dismissed by the markets, this was a pre-coronovirus impact, which suggests that Japan will enter into an “official” recession in the next quarter.

There is more to this story.

Since the financial crisis, Japan has been running a massive “quantitative easing” program which, on a relative basis, is more than 3-times the size of that in the U.S. However, while stock markets have performed well with Central Bank interventions, economic prosperity is only slightly higher than it was prior to the turn of century.

Furthermore, despite the BOJ’s balance sheet consuming 80% of the ETF markets, not to mention a sizable chunk of the corporate and government debt market, Japan has been plagued by rolling recessions, low inflation, and low-interest rates. (Japan’s 10-year Treasury rate fell into negative territory for the second time in recent years.)

Why is this important? Because Japan is a microcosm of what is happening in the U.S. As I noted previously:

The U.S., like Japan, is caught in an ongoing ‘liquidity trap’ where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments, and risk begins to outweigh the potential return.

Most importantly, while there are many calling for an end of the ‘Great Bond Bull Market,’ this is unlikely the case. As shown in the chart below, interest rates are relative globally. Rates can’t increase in one country while a majority of economies are pushing negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.”

As my colleague Doug Kass recently noted, Japan is a template of the fragility of global economic growth. 

“Global growth continues to slow and the negative impact on demand and the broad supply interruptions will likely expose the weakness of the foundation and trajectory of worldwide economic growth. This is particularly dangerous as the monetary ammunition has basically been used up.

As we have observed, monetary growth (and QE) can mechanically elevate and inflate the equity markets. For example, now in the U.S. market, basic theory is that in practice a side effect is that via the ‘repo’ market it is turned into leveraged trades into the equity markets. But, again, authorities are running out of bullets and have begun to question the efficacy of monetary largess.

Bigger picture takeaway is beyond the fact that financial engineering does not help an economy, it probably hurts it. If it helped, after mega-doses of the stuff in every imaginable form, the Japanese economy would be humming. But the Japanese economy is doing the opposite. Japan tried to substitute monetary policy for sound fiscal and economic policy. And the result is terrible.

While financial engineering clearly props up asset prices, I think Japan is a very good example that financial engineering not only does nothing for an economy over the medium to longer-term, it actually has negative consequences.” 

This is a key point.

The “Stock Market” Is NOT The “Economy.”

Roughly 90% of the population gets little, or no, direct benefit from the rise in stock market prices.

Another way to view this issue is by looking at household net worth growth between the top 10% to everyone else.

Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population.


“This is not economic prosperity.

This is a distortion of economics.”


From 2009-2016, the Federal Reserve held rates at 0%, and flooded the financial system with 3-consecutive rounds of “Quantitative Easing” or “Q.E.” During that period, average real rates of economic growth rates never rose much above 2%.

Yes, asset prices surged as liquidity flooded the markets, but as noted above “Q.E.” programs did not translate into economic activity. The two 4-panel charts below shows the entirety of the Fed’s balance sheet expansion program (as a percentage) and its relative impact on various parts of the real economy. (The orange bar shows now many dollars of increase in the Fed’s balance sheet that it took to create an increase in each data point.)

As you can see, it took trillions in “QE” programs, not to mention trillions in a variety of other bailout programs, to create a relatively minimal increase in economic data. Of course, this explains the growing wealth gap, which currently exists as monetary policy lifted asset prices.

The table above shows that QE1 came immediately following the financial crisis and had an effective ratio of about 1.6:1. In other words, it took a 1.6% increase in the balance sheet to create a 1% advance in the S&P 500. However, once market participants figured out the transmission system, QE2 and QE3 had an almost perfect 1:1 ratio of effectiveness. The ECB’s QE program, which was implemented in 2015 to support concerns of an unruly “Brexit,” had an effective ratio of 1.5:1. Not surprisingly, the latest round of QE, which rang “Pavlov’s bell,” has moved back to a near perfect 1:1 ratio.

Clearly, QE worked well in lifting asset prices, but as shown above, not so much for the economy. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

But Will It Work Next Time?

This is the single most important question for investors.

The current belief is that QE will be implemented at the first hint of a more protracted downturn in the market. However, as suggested by the Fed, QE will likely only be employed when rate reductions aren’t enough. This was a point made in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications the U.S. economy maybe be heading towards the next recession. 

Interestingly, David compared three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

So, 2-years ago David lays out the plan, and on Wednesday, the Fed reiterates that plan.

Does the Fed see a recession on the horizon? Is this why there are concerns about valuations?

Maybe.

But there is a problem with the entire analysis. The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures.

In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was running at $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with a $4.2 Trillion balance sheet with interest rates 3% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

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

Importantly, QE, and rate reductions, have the MOST effect when the economy, markets, and investors are extremely negative.

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

Such was the case in 2009. Not today.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

Summary

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade, and there is rising evidence that growth is beginning to decelerate.

Furthermore, we have much more akin with Japan than many would like to believe.

  • A decline in savings rates
  • An aging demographic
  • A heavily indebted economy
  • A decline in exports
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

While another $2-4 Trillion in QE might indeed be successful in keeping the bubble inflated for a while longer, there is a limit to the ability to continue pulling forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. There is evidence the cycle peak has been reached.

If the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be larger than currently imagined. The Fed’s biggest fear is finding themselves powerless to offset the negative impacts of the next recession. 

If more “QE” works, great.

But as investors, with our retirement savings at risk, what if it doesn’t.

#FPC: Dave Ramsey Is Right & Very Wrong About Permanent Life Insurance (Pt. 2)

Last week’s piece was on why Dave Ramsey is right and wrong about permanent life insurance and some of the reasons you may consider using a permanent life insurance policy. 

To reiterate last week’s sentiment-permanent life insurance is not for most, but if you:

  • Max out your retirement savings
  • Make too much to contribute to a Roth
  • Have accumulated a large savings account
  • Want to gain flexibility from taxes
  • Want growth, but would like some protection from high valuations
  • Have a large estate that needs estate tax protection

Keep reading…

Let’s discuss some of the benefits of these policy’s:

  • No 1099’s– your cash value isn’t taxed year to year like most non-qualified investments, in fact if used properly the funds will never be taxed
  • Distributions aren’t considered income (when done properly) so unlike your pre-tax 401K, you’ll be using these funds tax free, which will be a big deal in retirement
  • No Income limitations-that’s right say goodbye to those income limitations most are familiar with on IRA’s
  • No Contribution Limits– it’s difficult to super charge your savings in tax free or tax deferred accounts due to the contribution limits.  In 2020, you can contribute $19,500 to an employer sponsored plan with a catch-up provision of $6,500 for those over 50. In an IRA you’re much more limited. You may contribute up to $6,000 with an additional $1,000 catch up provision for workers 50 or older. Another great tool that’s finally gaining the recognition it deserves is the HAS or Health Savings Account. If you have access to an HSA an individual may contribute $3,550 and a family can contribute $7,100. If you’re maxing out all of these and hopefully utilizing a Roth you’re likely in pretty good shape, but where do those additional funds go?
  • No age requirement for distributions– cash value can be used at any time. Need funds for kid’s college, or retired early prior to 59 1/2-no problem.
  • Likelihood of tax reform impacting your policy is low– this is a little loop-hole that many think may change in the future because of the ability to grow and distribute funds on a tax free basis. With the path the government is on I’m concerned not to have this tool. The 80’s were the last time changes were made to these types of plans and current policy holders were grandfathered to have no changes made to their policies, but only impacting future policy holders. The belief is that the precedent has been set and it would be unfair to materially impact the plans already underway.
  • Creditor Protection-most all states offer some sort of creditor protection some full and some partial. Check with your state to determine how protected you are from potential creditors or judgments.

All these advantageous aspects why don’t we hear more about these types of tools or why do they get a bad wrap?

Dave Ramsey is right. They’re not for everyone. BUT for the few who already know how to save, high income earners or those just looking to be a little more strategic this could be a viable option.

I think many also have an aversion to these products because they are misunderstood or they felt the pressure of someone trying to make a hard sell. Let’s be very clear, a recommendation for such a policy should only come after a thorough financial plan is done. We often say planned, not sold, they are a complex piece to an already complicated puzzle.

Buyer Beware:

Many agents, or “financial advisors,” who sell insurance are held captive to 1 firm and 1 product or are limited in some way. Here I use the term “financial advisors” very loosely, because many are just salesman trying to make a quick buck, not advisors. Have hammer, see nail. Unfortunately, it’s not that easy or at least it shouldn’t be.

I believe any and all financial decisions should be made holistically by looking at the big picture through a telescope and then bringing it back down to each star in your universe with a microscope. Not sparing any detail. After all, each piece of the puzzle must fit and work together. Ideally, you want to work with someone who is independent from working only with one firm so they may scorch the earth to find the best policy for you and your family.

Life insurance, or an annuity, is also not a tool you put all of your funds in and if anyone advises so, RUN!

In the coming weeks we’ll discuss how to use permanent life insurance for cash accumulation or estate planning, what to look for in a policy and the different types of permanent life insurance available.

#WhatYouMissed On RIA: Week Of 02-17-20

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

The Week In Blogs

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Our Latest Newsletter

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What You Missed At RIA Pro

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

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The Best Of “The Lance Roberts Show

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Video Of The Week

Quick 4-minute review of the markets back to extreme deviations from long-term averages which suggested the correction we saw on Thursday and Friday were likely.

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Our Best Tweets Of The Week

See you next week!

Gone Fishing Newsletter: The Inflation Edition

We are thrilled to present a recent article from Samantha LaDuc, the Founder of LaDucTrading.com and the CIO at LaDuc Capital LLC. 

Samantha LaDuc is known for timing major inflection points in equities, commodities, bonds/rates, currencies and volatility. As a Macro-to-Micro strategic technical analyst, educator and trader, she makes her insights available to active traders and investors who want to minimize risk while seizing year-making opportunities.  


Spoiler Alert: We have no inflation in commodities.

Healthcare, Education, Concert Tickets … absolutely.

Image

But what about the stuff we consume and use every day?

CRB Commodities is made up of the following weighting:

  • Softs (Coffee, Sugar, Orange Juice) 23.5%
  • Energy 17.6%
  • Grains 17.6%
  • Precious Metals 17.6%
  • Industrials (Copper & Cotton) 11.8%
  • Meats 11.8%

Commodities – Big Picture on a Monthly Time-frame – show that we are still in a multi-decade low.

“Yields have been falling, reflecting concerns about global growth, and also the dramatic change of direction by central banks, which was itself largely driven by fears for growth. The 10-year Treasury yield is now almost a full percentage point lower than it was two years ago, and its trend is clearly downward. Indeed, if we take inflation expectations into account, the real 10-year Treasury yield has just gone negative.

According to the Bloomberg commodity indexes, industrial metals have now under-performed precious metals over the period since Donald Trump was elected U.S. president; and the price of oil is collapsing anew relative to gold. These moves only make sense if people are worried about growth.” – John Authers, Bloomberg

Sounds dreary, and John’s commentary was before the CoronaVirus outbreak really grabbed American businesses’ attention.

Despite my bearish leanings as detailed here: Perfect Storm: CoronaVirus and Market Risks, from my vantage point, we ‘should’ bounce soon (yellow circle). If not, we have more serious deflation to deal with – not just disinflation in the commodity patch.

Now let’s drop the USD softly behind the same chart and add some annotations. We have potential for a bounce, but also a lot of resistance and indecision. No clean signal yet. Still chop. And a DXY that has been range-bound for 4 years! Clearly, the US Dollar makes the weather for commodities and Foreign Exchange volatility as at an All Time Low. You know my saying: Outliers Revert With Velocity. Watch the USD for The Tell.

I should also add to this Intermarket analysis with the Macro read: it’s bearish inflation.

 @ISABELNET_SA Chart is suggesting that M2 velocity YoY leads US core inflation by 21 months. It has been quite accurate for more than 20 years. And it portends lower.

Image

Commodities are Dead, Long Live Commodities?

So why fight the trend? Humor me for ‘the other side” of the argument. Let’s assume inflation catches a bounce, pulling up commodities and yields with it, what segments are most likely to rise?

Food – Softs, Grains, Meats: China is experiencing strong Food price inflation from drought conditions (Rice), culling of all that Pork (and soon Chicken?). But in the US, these input prices are declerating (Coffee, Corn, Hogs, etc). With the new Coronavirus shutting off the flow of goods into and out of China for the time-being – and I suspect until April/May – we could start to see a tick up in Food Prices. Worst case, as the pandemic spreads, people with be unwilling/unable to go to work which could also trigger supply chain constraints. Prices could accelerate quickly on supply contraction.

Energy: What’s the bull case for Energy? Oversold, “value” play with high trailing dividend yields? They are high for a reason and still major laggard of all SPY sectors for several years now. Oil investment is waning not expanding (given Trump’s energy policies). So aside from a geopolitical ‘flare’ to temporarily disrupt supply, like with Iran, the case for sustainable higher oil is weak. And if/when Venezuela comes back online, it would be a big hit to the bull case (more supply). In the meantime, we have demand destruction out of China as a result of the CoronaVirus and general trends in decreasing demand due to:

1) Deglobalization
2) Decarbonization
3) Debt saturation
4) Donald Trump

Industrials: Copper is the big one, and it is at 2016 levels, so not expressing an economic growth look. Translation: The Trump Bump (2017) has been Dumped.

Precious Metals: Here are two charts that sum up my frustration on the perception versus reality of bidding up precious metals.

(Separate from the whole Palladium and Platinum play, which I have written about since early November as a bullish thesis.)

Treasury yields are negative after adjusting for inflation so that is supposed to be a plus for gold….

But, Gold/Silver Mining stocks are looking weary and potentially rolling over.

OK, I may have talked you out of a Commodity bump, but stick with me.

Commodities, The New Bonds?

Just over a year ago, the Fed finished systematically hiking rates (after 8 of them) as ECB quit QE. Today, Fed has lowered rates 3 times in 2019 and market is pricing in 2 more cuts for 2020! Fed clearly seems to unwind their 2017 tightening to avoid what happened in Fall of 2018 where U.S. stocks collapsed nearly 20% from Oct 3 to Dec 31st. Basically, the Fed realized it had spent three years tightening into a low inflation, low growth U.S. economy, and the global economy was too fragile to handle the liquidity and tightening drain.

But rate cuts at this point have reached the law of diminishing returns and Repo operations to inject capital in the money markets seems inadequate to jump-start growth. Fiscal policies in combination may be the fuel that flame inflation, in which case, commodities could recover and rally, but there are some heady headwinds:

Headwinds:

  1. Demand destruction from slowing global growth from Coronavirus in particular, economic cycle and ‘protectionist’ trends in general.
  2. Lower yields pull commodities with it, (and vice versa), but right now Fed has their proverbial thumb on any increases.
  3. Global central banks have suppressed volatility by anchoring expectations with “lower for longer”, thereby enhancing the effect of rate cuts which suppresses commodities.
  4. A more dovish Fed also reduces the US-Foreign bond yield spread which strengthens the dollar, thereby suppressing local currency valuation while burdening thier USD funding obligations.
  5. A stronger dollar is tailwind to commodity run (inversely related since commodities are priced in USD).

Tailwinds:

  1. Local and Coordinated Global Fiscal Policies trigger global economic optimism; Debt and Deficit hawks be damned.
  2. Containment of CoronaVirus psychologically and financially allow for economic expansion. Both will drive yields higher.

Until these factors reveal themselves, yields are falling and at risk of breaking critical support.

Top 10 Reasons for Bond Reversal:

From Buy Bonds, Wear Zirconia:

  1. Yields are approaching my buy point just above All Time Lows.
  2. Bonds/Yields are on their respective Bollinger Bands/Keltner Channel bands (yellow circle on weekly chart) which often acts as resistance causing a rubberband.snap-back effect.
  3. Seasonal tendency to Sell Bonds starts Jan 31st.
  4. Nomura’s Charlie McElligott  “1m Price Reversal” trade has run its course (1.94 drop to 1.64 in 10 yr yield since Dec 18th)
  5. Duration infatuation” (the safety-trade) often kicks in at the first sign of trouble, but then unwinds.
  6. The “normal” viral drag on US10Yr has the following tendency – yields fall then bounce back sharply.
  7. Fed won’t want the yield curve inversion which already erased half of the Q4 steepening.
  8. UPDATED PRE FOMC: Fed may need to guide inflation above target … which in turn supports a steeper curve, SO there is strong potential for final 2020 rate cut to CAUSE inflation expectations to rise.
  9. And the best reason potentially of all: Stocks are now Yielding More Than Bonds Again

“In the early summer of last year, the 10-Year Treasury Note was bid up considerably, resulting in it yielding less than the S&P 500’s dividend yield. In fact, at the point of the largest divergence between the two in late August, the dividend yield of the S&P 500 was 56.9 bps higher than the yield on the 10-Year Treasury. Although the disparity between the two has shrunk from that August peak, that trend has generally continued in the months since then, though equities’ surge into the end of the year saw bonds briefly yielding more in December. Since the start of the new year, stocks once again hold a higher yield, especially today as worries about the coronavirus have resulted in the selling of risk assets (raising the S&P 500’s yield) and subsequent buying of safe-havens (lowering the 10-Year Treasury yield). Now, the spread between the S&P 500’s dividend yield and that of the 10-Year is at its widest level in favor of the S&P 500 since October 10th.” –  DATATREK

I am nothing if not persistent.

Here is my client post from January 24th on this related subject: All Alone With My Higher Yield Thesis:

High Yield corporate debt is in trouble with Oil dropping 20% since Jan 7th and Shale companies facing their biggest loan refinancing wall in 20 years. When HY credit passes 358 bp then Momentum will very likely sell off – like happened in early September 2019 – and Value will finally catch a sustainable bid! And when Hedge Funds cover their Value shorts,  they sell Bonds! And when bonds get sold, with momentum selling off too, rates rip and we have a perfect storm set up for a massive VIX spike and gamma flipping.”

That is still my baseline projection. Market just doesn’t see it yet.


LaDuc Trading/LaDuc Capital LLC Is Not a Financial Advisor, RIA or Broker/Dealer.  Trading Stocks, Options, Futures and Forex includes significant financial risk. We teach and inform. You enter trades at your own risk. Learn more.

Intermarket Analysis & Review: 02-20-20

We are adding a NEW REPORT we will be rotating on Thursday’s which looks at the intermarket analysis between various asset classes, commodities, rates, and currency. The goal is to identify opportunities in areas which may be breaking historical correlations, or are confirming changes in trends.

What Is Intermarket Analysis?

Intermarket analysis is a method of analyzing markets by examining the correlations between different asset classes. In other words, what happens in one market could, and probably does, affect other markets, so a study of the relationship(s) can prove to be beneficial to the trader.

  • Intermarket analysis is a method of analyzing markets by examining the correlations between different asset classes.
  • A simple correlation study is the easiest type of intermarket analysis to perform, where results range from -1.0 (perfect negative correlation) to +1.0 (perfect positive correlation).
  • The most widely accepted correlation is the inverse correlation between stock prices and interest rates, which postulates that as interest rates go up, stock prices go lower, and conversely, as interest rates go down, stock prices go up.

Each week we will highlight a few of these intermarket relationships which have caught our attention.

Please feel free to EMAIL ME any other intermarket relationships which you think are important and I will try and include them.

Rates Vs S&P 500

Stocks and bonds play an interesting “risk on/risk off” relationship over time. As shown above while stocks are extremely outperforming bonds currently, the relationship is now suppressed to levels where a reversion would be expected. This suggests that we will likely see a a correction in equity prices, and a rise in bond prices (yields lower), in the near future.

Small Cap Vs Large Cap

Small cap stocks have not participated in the rally over the last year as earnings growth slows and money has rotated to chasing the largest large-cap names for both safety and liquidity in an extremely stretched market. With small cap stocks more affected by global supply disruptions, expect a correction in small cap stocks. Very likely, given the historical relationship, this correction will occur in concert with a correction in large cap stocks as well.

Energy Vs Stocks Vs Oil

Energy has been underperforming the major markets for quite some time. Of the few sectors in the market today that may represent some level of value, energy may be one of them. Not surprisingly, there is a very high correlation between oil prices and energy stocks. Currently, both the commodity and energy are extremely oversold.

However, expectations of a weaker dollar, due to ongoing Federal Reserve interventions, could be a boost to oil prices in 2020, however, there are still many deflationary pressures weighing on the sector. Given the extremely low correlation between energy stocks and the markets, we could well see a rotation into energy in the year ahead. Keep a watch on our sector report weekly for updates on positioning.

Large Cap Growth Vs. Value

Over the last few years, as the Federal Reserve has been continually intervening into the financial markets, large cap growth, and primarily momentum, have dominated the returns versus value oriented stocks and sectors.

With the historical correlation between growth and value at historically low levels, we are potentially seeing an early rotation into value from growth. It is too early to make a full commitment to value in portfolios, but starting to add value to a growth portfolio makes a lot of sense. Currently, everything is extremely overbought (both value and growth) so caution is advised.

Gold Miners Vs Gold

We have been long gold and gold miners for a while since gold bottomed earlier in 2019. However, currently, gold miners are very overbought but are in the process of reversing their “sell signal” from October of last year.

With the Federal Reserve pumping in liquidity, concerns over inflation have returned which is good for gold. While we are long gold miners, the junior miners have begun to outperform the majors. There is much more risk in the junior miners due to balance sheet concerns, but in a “risk on” market that seems to matter little. Keep a watch for our weekly Portfolio Position reports for updates on our gold and related holdings.

International Vs Domestic Markets

International has lagged domestic stocks since 2010. The previous improvement in relative performance faded quickly, and with a strengthening dollar in the works, there is risk to the sector. While relative valuations are cheaper on the relative basis, slower economic growth is making exposure to international stocks less attractive.

With the correlation between international and domestic markets at historic lows, a rotation bet seems logical. We agree, however, let’s wait for confirmation before making large bets. Watch our weekly Position and Index Reports for updates on our international holdings.

Emerging Vs. Domestic Markets

Emerging markets are exactly the same story as international markets above. Again, emerging markets are extremely extended and the correlation between emerging and domestic markets is improving.

Again, let’s wait for further confirmation, and a better entry point, before getting aggressive on the sectors. Watch our weekly Position and Index Reports for updates on our emerging market holdings.

Commodities Vs US Dollar

This is probably THE most important chart of the series as the dollar affects not only commodities, but our energy analysis, international and emerging markets, and ultimately the stock market itself.

With the dollar showing some signs of strengthening due to the global virus, there remains a disadvantage to commodities, gold, oil and energy, international and emerging markets. It is too early to bet “weak dollar” plays, but the very oversold condition of commodities to the USD suggests we may see an opportunity emerge soon.

Currently, the stronger dollar is weighing on commodities, however, commodities are very oversold short-term. Look for a bounce which starts to show some signs of relative strength, combined with a reversal of the dollar.

Have a great weekend.

Decoding Media Speak & What You Can Do About It

Just recently, the Institutional Investor website published a brilliant piece entitled “Asset Manager B.S. Decoded.”

“The investment chief for one institution-sized single-family fortune decided to put pen to paper, translating these overused phrases, sales jargon, and excuses into plain — and satirical — English.”

A Translation Guide to Asset Manager-Speak

  • Now is a good entry point = Sorry, we are in a drawdown
  • We have a high Sharpe ratio = We don’t make much money
  • We have never lost money = We have never made money
  • We have a great backtest = We are going to lose money after we take your money
  • We have a proprietary sourcing approach = We invest in whatever our hedge fund friends do
  • We are not in crowded positions = We missed all the best-performing stocks
  • We are not correlated = We are underperforming while the market keeps going up
  • We invest in unique uncorrelated assets = We have an illiquid portfolio which can’t be valued and will suspend soon
  • We are soft-closing the fund = We want to raise as much money as we can right now
  • We are hard-closing the fund = We are definitely open for you
  • We are not responsible for the bad track record at our prior firm = We lost money but are blaming all our ex-colleagues
  • We have a bottom-up approach = We have no idea what markets are going to do
  • We have a top-down process = We think we know what markets will do but really who does?
  • The markets had a temporary mark-to-market loss = Our fundamental analysis was wrong and we don’t know why we lost money
  • We don’t believe in stop-loss limits = We have no risk management

Wall Street is a business.

The “business” of any business is to make a profit. Wall Street makes profits by building products to sell you, whether it is the latest “fad investment,” an ETF, or bringing a company public. While Wall Street tells you they are “here to help you grow your money,” three decades of Wall Street shenanigans should tell you differently.

I know you probably don’t believe that, but here is a survey that was done of Wall Street analysts. It is worth noting where “you” rank in terms of their concern, and compensation.

Not surprisingly, you are at the bottom of the list.

While the translation is satirical, it is also more than truthful. Investors are often told what they “want” to hear, but actual actions are always quite different, along with the eventual outcomes.

So, what can you do about it?

You can take actions to curb those emotional biases which lead to eventual impairments of capital. The following actions are the most common mistakes investors repeatedly make, mostly by watching the financial media, and what you can do instead.

1) Refusing To Take A Loss – Until The Loss Takes You.

When you buy a stock it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early, or just plain wrong. It amounts to the same thing.

There is no shame in being wrongonly in STAYING wrong.

This goes to the heart of the familiar adage: “let winners run, cut losers short.”

Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in dead, or underperforming, money.

2) The Unrealized Loss

From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until the stock is sold and the money is in the bank? Nonsense!

Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.

People are reluctant to sell a loser for a variety of reasons. For some, it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is just plain stupid.

Realize that your loser may NOT come back. And even if it does, a stock that is down 50% has to put up a 100% gain just to get back to even. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly.

Take your losses ruthlessly, put them out of mind and don’t look back, and turn your attention to your next trade.

3) More Risk

It is often touted the more risk you take, the more money you will make. While that is true, it also means the losses are more severe when the tide turns against you.

In portfolio management, the preservation of capital is paramount to long-term success. If you run out of chips the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, even if it earns nothing in a “ZIRP” world.

This gives you liquid cash to buy opportunities and keeps you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency:”

This is the emergency that always occurs when you have the least amount of cash available – (Murphy’s Law #73)

4) Bottom Feeding Knife Catchers

Unless you are really adept at technical analysis, and understand market cycles, it’s almost always better to let the stock find its bottom on its own, and then start to nibble. Just because a stock is down a lot doesn’t mean it can’t go down further. In fact, a major multi-point drop is often just the beginning of a larger decline. It’s always satisfying to catch an exact low tick, but when it happens, it’s usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”

Nobody, and I mean nobody, can consistently nail the bottom or top ticks. 

5) Averaging Down

Don’t do it. For one thing, you shouldn’t even have the opportunity, as a failing investment should have already been sold long ago.

The only time you should average into any investment is when it is working. If you enter a position on a fundamental or technical thesis, and it begins to work as expected, thereby confirming your thesis to be correct, it is generally safe to increase your stake in that position, on the way up.

6) Don’t Fight The Trend

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it’s usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you.

It doesn’t make sense to counter trade the prevailing market trend. Don’t try and short stocks in a strong uptrend and don’t own stocks that are in a strong downtrend. Remember, investors don’t speculate – “The Trend Is Your Friend”

7) A Good Company Is Not Necessarily A Good Stock

There are some great companies that are mediocre stocks, and some mediocre companies that have been great stocks over a short time frame. Try not to confuse the two.

While fundamental analysis will identify great companies, it doesn’t take into account market and investor sentiment. Analyzing price trends, a view of the “herd mentality,” can help in the determination of the “when” to buy a great company that is also a great stock.

8) Technically Trapped

Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working.

But always be aware of the fact that as market conditions change, so will the efficacy of indicators. Indicators that work well in one type of market may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions change.

There is no “Holy Grail” indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.

9) The Tale Of The Tape

I get a kick out of people who insist that they’re long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. More likely than not, the panic was induced by listening to financial television.

Watching “the tape” can be dangerous. It leads to emotionalism and hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed. Turn off the television, get to a quiet place, and then calmly and logically execute your plan.

10) Worried About Taxes

Don’t let tax considerations dictate your decision on whether to sell a stock.  Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.

“If you are paying taxes – you are making money…it’s better than the alternative”

Conclusion

Don’t confuse genius with a bull market. It’s not hard to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. The market whips all our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.

Managing risk is the key to survival in the market and ultimately in making money. Focus on managing risk, market cycles and exposure.

The law of change states: Change will occur, and the elements in the environment will adapt or become extinct, and that extinction in and of itself is a consequence of change. 

Therefore, even if you are a long-term investor, you have to modify and adapt to an ever-changing environment otherwise, you will become extinct.

To navigate through this complex world, we suggest investors need to be open-minded, avoid concentrated risks, be sensitive to early warning signs, constantly adapt and always prepare for the worst.” – Tim Hodgson, Thinking Ahead Institute

Investing is not a competition.

It is a game of long-term survival.

Start by turning off the mainstream financial media. You will be a better investor for it.

I hope you found this helpful.

Selected Portfolio Position Review: 02-19-2020

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

With this basic tutorial, we will now review some positions in our Equity Portfolio which are either a concern, an opportunity, or are doing something interesting.

AAPL – Apple, Inc.

  • AAPL has been a strong performer and we trimmed our exposure to the stock in January.
  • AAPL warned of an impact to their production from the Coronavirus which we think has NOT been priced into the stock as of yet.
  • We are looking for a correction which will allow us to rebuild our exposure to Apple in the not too distant future.
  • We are maintaining our current stop level, and will look to add to our holding on a pullback to $250-260.
  • Stop is set at $240

DEM – Wisdom Tree Emerging Markets

  • There are several positions we are going to discuss selling out of our portfolio in today’s analysis. One of our primary rules is to “sell laggards,” which tend to perform worse during a market correction.
  • DEM has been holding up despite the impact of the virus, however, we think there is more exposure there to come on the risk side of the ledger, particularly with the U.S. dollar strengthening. We are going to sell this position out of the portfolio soon.
  • We are moving our stop up to $42.50

JPM – JP Morgan

  • We added a position of JPM to the portfolio after the position tested support at the bullish trend line.
  • The buy signal is being reduced and we have a tight stop on the position currently.
  • Stop is set at $130.00

KHC – Kraft Heinz, Co.

  • When we initially added KHC to the portfolio we detailed why were starting to build a long-term position in the holding.
  • Despite the recent sell-off due to impatient traders, the recent earnings report overall was good. Importantly, the CFO commented that the turn-around was proceeding ahead of schedule AND they kept the dividend secure.
  • KHC is currently holding support and we are looking for a stabilization and consolidation of a base to add to our holdings. With a near 6% yield, we can be patient with this holding.
  • Stop is set at $26

LVS – Las Vegas Sands Corp.

  • LVS was a recent add to the portfolio after it successfully tested break support levels with the “buy signal” still intact.
  • LVS is overbought, so we are looking for a pullback or consolidation to add to our position if needed. With a 4.5% dividend, it adds to the “income” of the portfolio as well.
  • Stop is set at $60

NSC – Norfolk Southern Corp.

  • We previously took profits out of NSC before the previous sell-off occurred.
  • Fortunately, we did not get stopped out of our position previously, and the stock has since rallied to new highs.
  • NSC is very overbought and extended, so pullbacks should be used to add to the position.
  • If we get some more consolidation or a bit of correction that holds support, we will look to add back to our position.
  • Stop is moved up to $185.

VMC – Vulcan Materials, Co.

  • VMC has been a good performer for the portfolio particularly as the “trade war” has gotten resolved. However, VMC has been consolidating gains in recent months and his holding support currently.
  • We took profits previously, so we can give VMC to room to consolidate currently, but we aren’t going to sacrifice our gains. So, we are moving our stop-levels up.
  • Stop loss moved up to $132.50

PEP – Pepsi, Inc.

  • PEP continues to perform well and recently triggered a buy signal.
  • We took profits previously out of the position so there isn’t much for us to do now except keep trailing our stop levels higher.
  • A pullback and consolidation that doesn’t violate the 200-dma could provide a good entry point.
  • Stop-loss moved up to $130

PFE – Pfizer, Inc.

  • As you are aware we love the Healthcare sector and remain weighted to that sector in both models. However, not all of our holdings are performing well.
  • We recently added a position in PFE, as we like the company and the 4% yield. However, performance has not followed through.
  • We are very close to being stopped out of the position.
  • Stop-loss set at $36

SLYV – SPDR S&P 600 Small Cap Value

  • As with DEM above, we are getting ready to trim out the laggards in our portfolio. This includes not only SLYV but also EFV as well.
  • SLYV has held support but is subject to impact from the virus. Therefore, to reduce portfolio risk from a market correction we are likely going to sell the position soon.
  • Stop loss is moved up to $51

Digging For Value in a Pile of Manure

A special thank you to Brett Freeze of Global Technical Analysis for his analytical rigor and technical expertise.

There is an old story about a little boy who was such an extreme optimist that his worried parents took him to a psychiatrist. The doctor decided to try to temper the young boy’s optimism by ushering him into a room full of horse manure. Promptly the boy waded enthusiastically into the middle of the room saying, “I know there’s a pony in here somewhere!”

Such as it is with markets these days.

Finding Opportunity

These days, we often hear that the financial markets are caught up in the “Everything Bubble.” Stocks are overvalued, trillions in sovereign debt trade with negative interest rates, corporate credit, both investment grade, and high yield seem to trade with far more risk than return, and so on. However, as investors, we must ask, can we dig through this muck and find the pony in the room.

To frame this discussion, it is worth considering the contrast in risk between several credit market categories. According to the Bloomberg-Barclays Aggregate Investment Grade Corporate Index, yields at the end of January 2020 were hovering around 2.55% and in a range between 2.10% for double-A (AA) credits and 2.85% for triple-B (BBB) credits. That means the yield “pick-up” to move down in credit from AA to BBB is only worth 0.75%. If you shifted $1 million out of AA and into BBB, you should anticipate receiving an extra $7,500 per year as compensation for taking on significantly more risk. Gaining only 0.75% seems paltry compared to historical spreads, but in a world of microscopic yields, investors are desperate for income and willing to forego risk management and sound judgment.

As if the poor risk premium to own BBB over AA is not enough, one must also consider there is an unusually high concentration of BBB bonds currently outstanding as a percentage of the total amount of bonds in the investment-grade universe. The graph below from our article, The Corporate Maginot Line, shows how BBB bonds have become a larger part of the corporate bond universe versus all other credit tiers.

In that article, we discussed and highlighted how more bonds than ever in the history of corporate credit markets rest one step away from losing their investment-grade credit status.

Furthermore, as shared in the article and shown below, there is evidence that many of those companies are not even worthy of the BBB rating, having debt ratios that are incompatible with investment-grade categories. That too is troubling.

A second and often overlooked factor in evaluating risk is the price risk embedded in these bonds. In the fixed income markets, interest rate risk is typically assessed with a calculation called duration. Similar to beta in stocks, duration allows an investor to estimate how a change in interest rates will affect the price of the bond. Simply, if interest rates were to rise by 100 basis points (1.00%), duration allows us to quantify the effect on the price of a bond. How much money would be lost? That, after all, is what defines risk.

Currently, duration risk in the corporate credit market is higher than at any time in at least the last 30 years. At a duration of 8.05 years on average for the investment-grade bond market, an interest rate increase of 1.00% would coincide with the price of a bond with a duration of 8.05 to fall by 8.05%. In that case a par priced bond (price of 100) would drop to 91.95.

Yield Per Unit of Duration

Those two metrics, yield and duration, bring us to an important measure of value and a tool to compare different fixed income securities and classes. Combining the two measures and calculating yield per unit of duration, offers unique insight. Specifically, the calculation measures how much yield an investor receives (return) relative to the amount of duration (risk). This ratio is similar to the Sharpe Ratio for stocks but forward-looking, not backward-looking.

In the case of the aggregate investment-grade corporate bond market as described above, dividing 2.55% yield by the 8.05 duration produces a ratio of 0.317. Put another way, an investor is receiving 31.7 basis points of yield for each unit of duration risk. That is pretty skinny.

After all that digging, it may seem as though there may not be a pony in the corporate bond market. What we have determined is that investors appear to be indiscriminately plowing money into the corporate credit market without giving much thought to the minimal returns and heightened risk. As we have described on several other occasions, this is yet another symptom of the passive investing phenomenon.

Our Pony

If we compare the corporate yield per unit of duration metric to the same metric for mortgage-backed securities (MBS) we very well may have found our pony. The table below offers a comparison of yield per unit of duration ratios as of the end of January:

Clearly, the poorest risk-reward categories are in the corporate bond sectors with very low ratios. As shown, the ratios currently sit at nearly two standard deviations rich to the average. Conversely, the MBS sector has a ratio of 0.863, which is nearly three times that of the corporate sectors and is almost 1.5 standard deviations above the average for the mortgage sector.

The chart below puts further context to the MBS yield per unit of duration ratio to the investment-grade corporate sector. As shown, MBS are at their cheapest levels as compared to corporates since 2015.

Chart Courtesy Brett Freeze – Global Technical Analysis

MBS, such as those issued by Fannie Mae and Freddie Mac, are guaranteed against default by the U.S. government, which means that unlike corporate bonds, the bonds will always mature or be repaid at par. Because of this protection, they are rated AAA. MBS also have the added benefit of being intrinsically well diversified. The interest and principal of a mortgage bond are backed by thousands and even tens of thousands of different homeowners from many different geographical and socio-economic locations. Maybe most important, homeowners are desperately interested in keeping the roof over their head

In contrast, a bond issued by IBM is backed solely by that one company and its capabilities to service the debt. No matter how many homeowners default, an MBS investor is guaranteed to receive par or 100 cents on the dollar. Investors of IBM, or any other corporate bond, on the other hand, may not be quite so lucky.

It is important to note that if an investor pays a premium for a mortgage bond, say a 102-dollar price, and receives par in return, a loss may be incurred. The determining factor is how much cash flow was received from coupon payments over time. The same equally holds for corporate bonds. What differentiates corporate bonds from MBS is that the risk of a large loss is much lower for MBS.

Summary

As the chart and table above reveal, AAA-rated MBS currently have a very favorable risk-reward when compared with investment-grade corporate bonds at a comparable yield.

Although the world is distracted by celebrity investing in the FAANG stocks, Tesla, and now corporate debt, our preference is to find high quality investment options that deliver excellent risk-adjusted returns, or at a minimum improve them.

This analysis argues for one of two outcomes as it relates to the fixed income markets. If one is seeking fixed income credit exposure, they are better served to shift their asset allocation to a heavier weighting of MBS as opposed to investment-grade corporate bonds. Secondly, it suggests that reducing exposure to corporate bonds on an outright basis is prudent given their extreme valuations. Although cash or the money markets do not offer much yield, they are always powerful in terms of the option it affords should the equity and fixed income markets finally come to their senses and mean revert.

With so many assets having historically expensive valuations, it is a difficult time to be an optimist. However, despite limited options, it is encouraging to know there are still a few ponies around, one just has to hold their nose and get a little dirty to find it.

6 Considerations for Long-Term Care Coverage.

Retirement is a a continuous road; mile markers that represent age may be visualized along the path.

However, if one looks to retire at 67 and in relatively good health, it’s a challenge to comprehend what quality of life may be like at 80. It’s easy to understand how 40 may not look too different from 60 from a quality of health perspective. The stretch from 60 to 90 may be so dramatically different, it’s a challenge to envision.

How does one contemplate their own increasing frailty?

People tend to avoid the topic of long-term care which is defined as financial and caregiver resources required to perform daily activities such as bathing and dressing. Services range from temporary home health services to full-time care through assisted living or memory care. At RIA, we find that investors are hesitant to confront the topic of long-term care. It’s understandable. After all,  the mitigation of long-term care risk is expensive. People barely save enough for retirement, overall. Imagine planning for the possible additional six-figure burden of long-term care services.

Also, consumers don’t understand how coverage works, premiums have the ability to skyrocket every few years which can break constrained budgets, and insurance underwriting can be a challenge. It’s reported that over 30% of those who apply for traditional long-term care coverage are rejected for health reasons. Realistically, after age 62, premiums become cost prohibitive for consumers. It’s in their mid-sixties we find people scramble to put together some patchwork plan. We call long-term care the ‘financial elephant in the room.’ You can try to lift it, move it to another area of your financial house however, wherever you go, there it is! 

As we lament at workshops, on the radio, to clients at face-to-face meetings – heck, to anybody who’ll listen! – Long-term care expenses are the greatest threat to a secure retirement. Confounding about this specific study is that over 53% of Boomers are confident about managing long-term care costs yet the majority have nothing set aside. The results lead me to conclude there’s a strong and dangerous case of DENIAL going on here. Is there more to the story? Since 50% of middle-income Boomers maintain less than $5,000 in emergency reserves, saving for retirement AND retirement care is most likely too burdensome.

Don’t ignore the elephant. Prepare for it. If traditional long-term care insurance isn’t in your future, hope isn’t lost. Consider these alternatives.

Bankers Life Center for Secure Retirement in a study conducted by Blackstone Group in October 2018, discovered that middle-income Baby Boomers (those with an annual household income between $30 and $100,000 and have less than $1 million in investable assets), are increasingly concerned about staying healthy enough to enjoy retirement (56%). Yet, an astounding 4 in 5 (79%) of Boomers sampled have no money set aside specifically for retirement care needs.

First Step: Don’t Ignore the Elephant!

Your rightful concern, if I got you thinking, is to take a deep breath and find a Certified Financial Planner® who is also a fiduciary. In other words, your interests above all else. Financial plans laud strengths; plans also expose financial vulnerabilities that require remedy.

Per the Center For A Secure Retirement® study, six out of ten Baby Boomers have a plan for how they will fund retirement. Only one-third have a retirement long-term care strategy which leads me to believe this group is not undertaking holistic financial planning which considers every facet of a fiscal life including the possible need for long-term care from custodial to skilled nursing. I’m not surprised that 88% of Boomers who have included a retirement care strategy reported a positive impact to their overall plan.

Second Step: Cover the Spouse Who’ll Most Likely Live Longest.

I’m not going to lie; the mitigation of long-term care risk using insurance isn’t cheap.  According to the American Association for Long-Term Care Insurance, the best age to apply is in your mid-fifties. To obtain coverage, the current condition of your health matters or you may not qualify. Only 38% of those age 60-69 make the cut. Even if healthy, at a point in life, especially around the mid-sixties, premiums are known to be household budget nightmare. For example, a couple both age 60 in a preferred health class can wind up paying close to $5,000 a year in premiums and will likely experience premium increases over time.

The number of insurance carriers is shrinking – down to less than 12 from more than 100. Recently, Genworth, one of the heavy hitter providers of long-term care insurance temporarily suspended sales of traditional individual policies and an annuity product designed to provide income to cover long-term costs such as nursing home stays.

If you’re astute enough to plan for retirement care and concerned about the impact of dual premiums on the household budget including saving for other goals, work with a Certified Financial Planner to create a scenario to consider at least partial coverage for the spouse with a greater probability of longevity. For example, on average, women outlive men by 7 years.

If single and do not have a reason to leave a legacy to children or grandchildren, it’s likely that asset liquidation can adequately cover a long-term care event. Again, it’s best to work with a CFP Fiduciary who can help create a liquidation strategy.

Third Step: Take the Kids Out of It. 

I’m shocked by parents who assume their adult children will take care of them or ‘take them in’ in the case of a long-term care event. Personally, I find it too painful to interrupt my daughter’s life and impact her physical, emotional and financial health by providing long-term assistance to her dad.

According to www.caregiver.org, 44 million Americans provide $37 billion hours of unpaid informal care for adult family members and friends with chronic illnesses and conditions. Women provide over 75% of caregiving support. Caregiving roles are going to do nothing but blossom in importance as the 65+ age cohort is expected to double by 2030. There will be a tremendous negative impact, financial as well as emotional, on family caregivers who will possibly need to suspend employment, dramatically interrupt their own lives to assist loved ones who require assistance with activities of daily living.

Parents must begin a dialogue with adult children to determine if or how they may become caregivers. Armed with information learned from discussion, I have helped children prepare for some form of caregiving for parents.

A 47-year-old client has added financial support for parents as a specific needs-based goal in her plan; another recently purchased a larger one-story home with an additional and easily accessible bedroom and bath. Yet another has commenced building a granny pod on his property for his elderly (and still independent), mother. All these actions have taken place due to open, continuous dialogue with parents and siblings.

In addition, elder parents have been receptive to allocating financial resources to aid caregiver children. Siblings who reside too far away to provide day-to-day support have been willing to offer financial support as well. However, these initiatives weren’t pushed on children. Children weren’t forced into a situation based on an assumption. If you’re a parent, ask children if they’d be willing to provide care. As an adult child, don’t be afraid to ask parents how they plan to cover long-term care expenses.

Fourth Step: Get Creative. 

Three out of every five financial plans I create reflect deficiencies to meet long-term care expenses. Medical insurance like Medicare does not cover long-term care expenses – a common misperception. Close to 56% of people surveyed in the Bankers Life Center study are under the false impression that Medicare covers long-term care expenses.

The Genworth Cost of Care Survey has been tracking long-term care costs across 440 regions across the United States since 2004.

Genworth’s results assume an annual 3% inflation rate. In today’s dollars a home-health aide who assists with cleaning, cooking, and other responsibilities for those who seek to age in place or require temporary assistance with activities of daily living, can cost over $45,000 a year in the Houston area. On average, these services may be required for 3 years – a hefty sum of $137,000. We use a 4.25-4.5% inflation rate for financial planning purposes to reflect recent median annual costs for assisted living and nursing home care.

As I examine long-term care policies issued recently vs. those 10 years or later, it’s glaringly obvious that coverage isn’t as comprehensive and costs more prohibitive. It will require unorthodox thinking to get the job done.

One option is to consider a reverse mortgage, specifically a home equity conversion mortgage. The horror stories about these products are way overblown. The most astute of planners and academics study and understand how for those who seek to age in place, incorporating the equity from a primary residence in a retirement income strategy or as a method to meet long-term care costs can no longer be ignored. Those who talk down these products are speaking out of lack of knowledge and falling easily for overblown, pervasive false narratives.

Reverse mortgages have several layers of costs (nothing like they were in the past), and it pays for consumers to shop around for the best deals. Understand to qualify for a reverse mortgage, the homeowner must be 62, the home must be a primary residence and the debt limited to mortgage debt. There are several ways to receive payouts.

One of the smartest strategies is to establish a reverse mortgage line of credit at age 62, leave it untapped and allowed to grow along with the value of the home. The line may be tapped for long-term care expenses if needed or to mitigate sequence of poor return risk in portfolios. Simply, in years where portfolios are down, the reverse mortgage line can be used for income thus buying time for the portfolio to recover. Once assets do recover, rebalancing proceeds or gains may be used to pay back the reverse mortgage loan consequently restoring the line of credit.

Our planning software allows our team to consider a reverse mortgage in the analysis. Those plans have a high probability of success. We explain that income is as necessary as water when it comes to retirement. For many retirees, converting the glacier of a home into the water of income using a reverse mortgage is going to be required for retirement survival and especially long-term care expenses.

American College Professor Wade Pfau along with Bob French, CFA are thought leaders on reverse mortgage education and have created the best reverse mortgage calculator I’ve studied. To access the calculator and invaluable analysis of reverse mortgages click here.

Insurance companies are currently creating products that have similar benefits of current long-term care policies along with features that allow beneficiaries to receive a policy’s full death benefit equal to or greater than the premiums paid. The long-term care coverage which is linked to a fixed-premium universal life policy, allows for payments to informal caregivers such as family or friends, does not require you to submit monthly bills and receipts, have less stringent underwriting criteria and allow an option to recover premiums paid if services are not rendered (after a specified period).

Unfortunately, to purchase these policies you’ll need to come up with a policy premium of $50,000 either in a lump sum or paid over five to ten years. However, for example, paying monthly for 10 years can be more cost effective than traditional long-term care policies, payments remain fixed throughout the period (a big plus), and there’s an opportunity to have premiums returned to you if long-term care isn’t necessary (usually five years from the time your $50,000 premium is paid in full). Benefit periods can range from 3-7 years and provide two to five times worth of premium paid for qualified long-term care expenses. As a benchmark, keep in mind the average nursing home stay is three years.

I personally went with this hybrid strategy. For a total of $60,000 in premium, I purchased six years of coverage, indexed for inflation, for a total benefit of close to $190,000.

Also,  pay closer attention to your employers’ benefits open enrollment. It’s amazing to discover how many people have bypassed or didn’t realize their employers offer long-term care insurance coverage. Those with health issues and possibly ineligible for coverage in the open marketplace will find employer-offered long-term care insurance their best deal.

Fifth Step: Formalize a Liquidation/Downsize Plan. 

Consider a liquidation/downsizing hierarchy to subsidize long-term care costs. According to a Deutsche Bank report from January 2018 titled US Wealth and Income Inequality,  a record high 30% of Americans hold no wealth outside their primary residences which makes me wonder how that group is going to fund retirement, let alone long-term care expenses.

We partner with clients who can’t afford premiums or not able to pass long-term care insurance underwriting with liquidation strategies which look to begin 3-5 years before retirement.  Liquidation of a primary residence can be a workable option especially if an individual is widowed or living alone.  Empty-nesters can aspire to sell and move into one-story smaller digs early into or before retirement to lower overall fixed costs. They include in their plan home improvements such as ramps, easy access baths, kitchen cabinets and the cost of caregiver services which complement a spouse or life partner’s long-term care responsibilities. 

Per the Center for Retirement Research from their analysis dated February 11, 2020, most older Americans prefer to age in their homes. However, it’s important to decide whether a current residence is appropriate for the task. In other words, many older Baby Boomers look to remain in large homes with empty rooms and two stories which is absolutely not practical – Especially in the face of property taxes that increase annually, sometimes dramatically! 

The Center’s paper discovered that:

  • Seventy percent of households have very stable homeownership patterns, even over several decades. They either stay in the home they own in their 50s (53 percent) or purchase a new home around retirement and stay for the rest of their life (17 percent).
  • The 30 percent of households that do move consist of two distinct subgroups. Frequent movers (14 percent) appear to face labor market challenges.  Late movers (16 percent) look like a slightly more affluent version of the households that never move, but then face a health shock that forces them out of the home that they owned into a rental unit or a long-term services and supports facility.
  • Overall, the findings largely support the narrative from prior research that most people want to age in place and move only in response to a shock.

Sixth Step: Consider Long-Term Care Riders for Permanent Life Insurance.

Permanent life insurance unlike term, builds cash value. Policies can be ‘over funded’ above the cost of insurance to allocate to a fixed interest sleeve and other investment choices attached through various calculations, to stock indexes such as the S&P 500. There is no chance of loss in cash-value accumulation therefore balances have the true opportunity to compound. 

A living benefits rider allows the insured to accelerate access to death benefits due to certain conditions such as long-term care needs and terminal illness.  There are benefits to utilizing permanent life insurance to subsidize long-term care needs. Premiums remain level (unlike long-term care insurance premiums that tend to increase on a regular basis, sometimes dramatically), second, of course unlike long-term care insurance, at least there’s life insurance or dollars at the end of the road for heirs.

In addition, underwriting for morbidity risk (long-term care) can be draconian compared to mortality risk (life insurance). In other words, medical issues that have potential to affect activities of daily living may not have the same effect on life expectancy; consumers who don’t qualify for long-term care insurance may still qualify for life insurance.  There are a couple of drawbacks to these life insurance riders:  Funds accessed during a lifetime will inevitably reduce the face value or death benefit of a life insurance policy. Second, riders cost money. So, before adding a living benefits rider, through holistic financial planning be certain you require insurance to mitigate long-term care risk. Through proper planning, we discover that four out of every ten clients have assets to liquidate or are able to self-insure.

Retirement care analysis is a deep dive into the overall retirement planning process. Unlike income planning, retirement care planning requires us to face our inevitable physical limitations and the toll it can have on personal finances along with the negative ripple effects on wealth and health of loved ones.

It’s best to expose vulnerability and plan accordingly while there’s precious time to do so.

It’s Not 2000, But The Market Is Mighty Narrow Again

For those of us who were around in 1999-2000 looking at charts and perhaps writing about them, there is an eerie familiarity with the market of today. Back then, when indices and the Nasdaq in particular, were rallying harder each day than the last, market breadth was looking fairly weak. In other words, the big the names were soaring, forcing indexers and ETFs to buy them just to keep their weightings, and the positive feedback cycle roiled on.

I remember, looking at this stuff for BridgeNews and having to forecast where resistance levels might be based on Fibo projections or the top of some trading band. Walking by my desk, it was not unusual for me to exclaim, “This is nuts!” By that way, a much funnier TV show than “This is us”.

Now, I am in no way comparing 2000 and 2020 in any way but they did have one thing in common. Big cap, and mostly big cap tech, was powering ahead while mid-cap and especially small-cap lagged far behind.

No, that does not show up in the advance-decline line, which just managed to set a new high after its late January swoon. A colleague had a good explanation for this, saying that plenty of stocks can be rising but by smaller amounts and far below previous highs. That would certainly explain why the a/d line is rising and up/down volume is mediocre, at best.

Have you looked at a small-cap advance-decline? Not pretty.

Check out these charts:

(Click on image to enlarge)

This is the regular, cap-weighted S&P 500 vs. the equal-weighted version. The trend has been accelerating higher for months. While it is not anything near what it looked like in 1999-2000, it is still quite significant.

(Click on image to enlarge)

Here is the Nasdaq-100 ETF vs. the equal-weighted Nasdaq-100 ETF. To the moon, Alice.

(Click on image to enlarge)

And then let’s look at a mega-cap stock. This is Microsoft MSFT and it looks just as nuts. Don’t forget this is a $1.4 TRILLION stock so every gain packs on huge amounts of market cap.

What happens when this stock finally decides to pull back? It scored an as yet unconfirmed bearish reversal this week on huge volume. And look how far above it is now from its 200-day averages. Nuts!

Considering that it is a member of the Dow, the Nasdaq-100, the S&P 500 and XLK tech ETF, what do you think will happen when this huge member (keep it clean, pervs) corrects? And there is a lot of correcting room before even thinking about a change in a major trend.

There you have it. A narrow market at all-time highs, ignoring news and having utilities among the leading groups.

But don’t worry, the Fed has already committed to more quantitative easing. Whoopee! Kick that can, Jerry.

Technically Speaking: Chasing The Market? Warnings Are Everywhere

This past weekend, we discussed the breakout to all-time highs as the belief the market is immune to risks, due to the Federal Reserve, has become pervasive. As I quoted:

“Yet as a major economic problem looms on the horizon, the cognitive disconnect between current asset prices and reality feels like the market equivalent of ‘peace for our time.’ 

For those investors who perceive the disconnect between risk assets which are priced for a rosy outcome, and the reality of the looming risks to growth and earnings, any attempt to reduce risk leads to underperformance. It is a mind-numbing exercise for investors who see the cognitive dissonance. The frantic race to accumulate securities has cast price discovery to the side.

I have never in my career seen anything as crazy as what’s going on right now, this will eventually end badly.“ – Scott Minerd, CIO of Guggenheim Investments

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

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

Of course, back then, he was mostly referring to warnings he issued for me “not” to do something I was determined to do. Generally, it involved something like trying to replicate Evil Knievel’s jump at Caesar’s Palace using a homemade ramp and a collection of the neighbor’s trash cans.


However, I always based my arguments on sound logic and data analysis:

“But Dad, everyone else is doing it.”

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

Likewise, investors are currently rushing to get back into the market with a near reckless disregard for the consequences.

Simply because “everyone else is doing it.” 

So, before you go “hit the ramp”, there are some warning signs to consider.

Warning 1: Deviations From The Mean

There is a funny story about a “defensive driving” class where the instructor asks the class how many thought they were “above average drivers.” About 80% of the class raised their hands. The funny thing is that all of them were in the class because of traffic violations or accidents. But more to the point, 80% of drivers cannot be above average. It is mathematically impossible.

Likewise, in investing, prices must be both above, and below, the “average price” over a set period for an average to exist. To many degrees, “price” is bound by the laws of physics, the farther from the “average price” the current price becomes, the greater the reversion to, and generally beyond, the average. This is shown in the daily chart below.

Currently, the market is more than 11% above its longer-term daily average price. These more extreme deviations tend not to last an extraordinarily long time. Furthermore, reversions from these more extreme deviations tend to be rather quick.

If we view a weekly basis, we see the same warning.

At more than 12% above the long-term weekly moving average, the market is currently pushing the upper end of historical deviations. There have been higher extremes for certain, but discounting risk often doesn’t end well.

On a monthly basis, the almost 17.5% deviation is hitting levels more associated with drawdowns of 20% of more.

The important point to take away from this data is that “mean reverting” events are commonplace within the context of annual market movements. 

Currently, investors have become extremely complacent with the rally from the beginning of the year and are discounting the potential global-supply shock from the “coronavirus.” The assumption that any disruption will be met by more Central Bank intervention, and higher stock prices, is a likely a risky proposition this late into an economic cycle.

In every given year, there are drawdowns that have wiped out some, most, or all of the previous gains. While the market has ended the year higher, more often than not, the declines have often shaken out many an investor along the way.

Let’s take a look at what happened the last time the market finished a year up nearly 30%. Over the next two years, the market consolidated with a near-zero rate of return.

From a portfolio management standpoint, the markets are very extended, and a correction over the next couple of months is highly likely. While it is quite likely the year will end positive, particularly given the current momentum push, taking some profits now, rebalancing risks, and using the coming correction to add exposure as needed will yield a better result.

Warning 2 – Technical Warnings

The technical warnings also confirm our concerns about a near-term correction.

Each week, we post the chart below for our RIA PRO (Try Risk-Free for 30-days) subscribers, which is a composite index of our weekly technical measures including RSI, Williams %R, Stochastics, etc. Currently, the overbought condition of the market is near points which have denoted more significant corrections.

The market/sector analysis, which is also exclusive to RIA PRO members, shows the rather extreme price deviation in Technology, Real Estate, & Utilities. Also, relative performance shows that it has primarily been those three sectors providing a bulk of the “alpha” year-to-date.  (Also, note the lower left-hand panel which shows virtually every sector back to extreme overbought.)

These are abnormalities that tend not to last long in isolation, and rotations tend to occur rather quickly.

Warning 3 – Economic Concerns

Just recently, Barbara Kolmeyer via MarketWatch discussed thoughts from Julien Bittel of Pictet Asset Management. He gives a pretty stern warning to the litany of economic bulls. To wit:

He sees a lot of similarities between what is happening now and the year 2000—the market peaked in the front half of the year, followed by a recession. Bittel has lots of charts to back up his case, such as this one showing Jolts job openings (which measures U.S. job vacancies), at the lowest since the Global Financial Crisis, often a bad omen for employment:”

“He also highlighted trouble for the U.S. long-term business cycle, ‘linked to the less-cyclical areas of the economy so it’s the credit cycle, consumer confidence and the labor markets…these dynamics are all slowing,’ he said.”

He said what makes his call so contrarian is that most economists see a 25% recession possibility, while equity markets are factoring in only a 2% chance.

‘I think investors are a bit naive going into this year, thinking that the gravy trains or rainbows will continue, but in order for that to happen earnings need to come back in a big way. A sustained move in equity markets that’s driven by multiple expansion cannot maintain itself unless you get a huge recovery in earnings.” – Julien Bittel

Speaking of an earnings recovery, that is unlikely to happen.

Warning 4 – Earnings

It is highly unlikely you are going to get a massive surge in earnings to support lofty asset prices and valuations particularly when you have a global supply-chain shock in progress. While the media has been fawning over the latest earnings season, it really isn’t what it seems.

As noted by FactSet:

“ For Q4 2019 (with 77% of the companies in the S&P 500 reporting actual results), 71% of S&P 500 companies have reported a positive EPS surprise and 67% of S&P 500 companies have reported a positive revenue surprise.”

Wow…that’s impressive and certainly would seem to be the reason behind surging asset prices.

The problem is that “beat rate” was simply due to the consistent “lowering of the bar” as shown in the chart below:

Pay attention to the two charts above.

  1. Earnings declined in 2019 and are projected to continue to decline into 2021. 
  2. Investors are not discounting the decline in earnings, and rising valuations, which will eventually become problematic.

Importantly, as I noted this past weekend:

“With equities now more than 30% higher than they were then, the Fed mostly on hold in terms of rate cuts, and “repo” operations starting to slow, it certainly seems that expectations for substantially higher market values may be a bit optimistic.

Furthermore, as noted above, earnings expectations declined for the entirety of 2019, as shown in the chart below. However, the impact of the “coronavirus” has not been adopted into these reduced estimates as of yet. These estimates WILL fall, and likely markedly so, which as stated above, is going to make justifying record asset prices more problematic.”

“Conversely, if by some miracle, the economy does show actual improvement, it could result in yields rising on the long-end of the curve, which would also make stocks less attractive.

This is the problem of overpaying for value. The current environment is so richly priced there is little opportunity for investors to extract additional gains from risk-based investments.”

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

Here is the market for you, year to date:

  • S&P 500 +4.62%
    • Alphabet +13.74%
    • Microsoft +17.53%
    • Apple +10.92%
    • Amazon +15.53%
    • Tesla +91.24%

(Disclosure: We are long Apple, Amazon, and Microsoft in our equity portfolio.)

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

But as David Rosenberg previously noted:

“The equity market stopped being a leading indicator, or an economic barometer, a long time ago. Central banks looked after that. This entire cycle saw the weakest economic growth of all time coupled with the mother of all bull markets.”

There will be payback for the misalignment of funds.

Past experience suggests that future returns will be far less than historical averages suggest. Furthermore, there is a dramatic difference between investing for 30-years, and whatever time you personally have left to your financial goals. As noted yesterday, many investors are just now getting back to even.

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

The point here is simple.

No professional, or successful investor, every bought and held for the long-term without regard, or respect, for the risks that are undertaken. If professionals are looking at “risk,” and planning on protecting capital from mean-reverting events, then why aren’t you?

Sector Buy/Sell Review: 02-18-20

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

Basic Materials

  • XLB rallied back into resistance on Friday. There is the beginning of downtrend channel forming which needs to be reversed if Materials are going to rally further. The risk of the virus to the global supply chain makes Materials tricky.
  • The sector has gotten back to short-term overbought, but a sell signal is close to being triggered.
  • We currently hold 1/2 a position and until we get a better handle on the “coronavirus” impact we are going to maintain a reduced exposure for now.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions with a tighter stop-loss.
    • This Week: Hold current positions with a tighter stop-loss.
    • Stop-loss moved back to $57 to allow for entry.
  • Long-Term Positioning: Neutral

Communications

  • We previously reduced our allocations slightly to the sector due to the rather extreme extension. The recent correction, and reversal, were not enough to allow us a decent entry point to add back to our holdings.
  • With a “buy signal” in place, but extended, there is more correction likely. This is particularly the case since XLC has not reversed its extreme overbought condition as of yet. XLC must hold support at $50.
  • XLC is currently 2/3rds weight in our portfolios and is pushing levels that have previously led to corrections. Be patient for an entry point.
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions.
    • Stop adjusted to $50
  • Long-Term Positioning: Neutral

Energy

  • XLE is trying to hold critical support levels, but price action remains very weak.
  • We have been trying to add XLE to our portfolios but XLE broke back below the 200-dma, the downtrend line, and now sits at the last level of support and the stop level.
  • With the buy signal close to reversing, but with the sector very oversold. a short-term bounce is likely. Use that bounce to sell into for now.
  • We had noted previously, we were remaining cautious as rallies had repeatedly failed in the past. And, as expected, it happened again.
  • Short-Term Positioning: Bearish
    • Last week: Sell into rally.
    • This week: Sell into rally.
    • No position currently
  • Long-Term Positioning: Bearish

Financials

  • As noted previously, XLF was extremely extended above the 200-dma which put the sector at risk of a more severe correction.
  • The buy signal is correcting but remains a bit extended along but the sector is now approaching oversold.
  • XLF succesfully tested the bullish trend line, which gave us an opportunity to add 1/2 position to our portfolio. However, now XLF is back to more extreme overbought levels but is testing new highs. We will look for a correction to finish building out our holdings.
  • Short-Term Positioning: Bullish
    • Last week: Hold for now.
    • This week: Hold for now.
    • Stop-loss adjusted to $28
  • Long-Term Positioning: Neutral

Industrials

  • XLI remains exceedingly overbought short-term and the “buy signal” remains very extended as well. No rush chasing the sector currently. Also, there is a good risk the “coronavirus” will have a direct impact on the global supply chains of industrial companies.
  • We are holding reduced position weightings until we can assess the impact of the virus on the sector.
  • We have adjusted our stop-loss for the remaining position.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position.
    • Stop-loss adjusted to $77
  • Long-Term Positioning: Neutral

Technology

  • XLK had only a SLIGHT correction and rocketed off to nearly 4-standard deviations above the 200-dma. Currently, just 5-stocks make up 20% of the index, which is what is driving the index higher.
  • We reduced our position in XLK from overweight to target portfolio weight due to the extreme extension and noted a correction is coming. That is still the case currently.
  • The bullish trend line is the first level of support XLK needs to hold while reversing the overbought condition. A failure at that support is going to bring the 200-dma into focus.
  • Be careful chasing the sector currently. Take profits and rebalance risks accordingly.
  • Short-Term Positioning: Bullish
    • Last week: Reduce Overweight to Target Weight
    • This week: Rebalance To Target Weights
    • Stop-loss adjusted to $80
    • Long-Term Positioning: Neutral

Staples

  • Defensive sectors continue to perform as interest rates have fallen and money is rotating to risk-off positioning despite the drive of the market higher.
  • XLP continues to hold its very strong uptrend and remains close to all-time highs.
  • XLP is back to extreme overbought and extended above the 200-dma, however, the “buy signal” has been registered. Look for pullbacks to support to add weight to portfolios. Maintain a stop at the 200-dma.
  • We previously took profits in XLP and reduced our weighting from overweight.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $59
    • Long-Term Positioning: Bullish

Real Estate

  • Last week we noted that XLRE had broken out back to new highs. We took profits recently, and reduced our risk a bit in the position as interest rates are extremely overbought.
  • With XLRE very extended short-term, we previously suggested looking for a short-term reversal in interest rates to create an entry point. That has not occurred as of yet, so patience is needed to add exposure accordingly.
  • We had previously noted that while we are holding our long-position, trading positions could be added to portfolios. Hold off adding any new positions currently and wait for this correction to complete.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold positions.
    • Stop-loss adjusted to $37.00 for profits.
  • Long-Term Positioning: Bullish

Utilities

  • XLU, like XLRE, is benefiting from the decline in interest rates. XLU is extremely extended above the 200-dma, and the “buy signal” is now extremely extended as well.
  • We took profits in our holdings and will wait for a correction back to support to bring our holdings back to overweight. Such will give us a much better risk/reward entry.
  • The long-term trend line remains intact.
  • We are currently at 2/3rds weight.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold positions
    • Stop-loss adjusted to support at $64.00
  • Long-Term Positioning: Bullish

Health Care

  • XLV has remained intact and has rallied after a brief correction which we used to add to our current holdings.
  • The move in Healthcare has started to consolidate and the overextended buy signal has begun to correct. We will look to add to our holdings if support holds and more of the overbought condition is reduced.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions
    • This week: Hold positions.
    • Stop-loss adjusted to $94
  • Long-Term Positioning: Bullish

Discretionary

  • XLY, due to the impact of AMZN, has pushed into rather extreme extensions from the 200-dma.
  • We took profits previously and reduced the position slightly.
  • Hold current positions for now, New positions can be added on a pullback to the breakout level that holds and works off the overbought condition.
  • A “buy signal” has been triggered which gives the sector support.
  • Short-Term Positioning: Neutral
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $120.
  • Long-Term Positioning: Neutral

Transportation

  • XTN held its previous breakout level and is consolidating at recent levels.
  • We remain out of the economically sensitive sector currently particularly due to the impact of the “coronavirus” which will likely have global supply chain impacts.
  • The sector is moving back towards overbought territory short-term, but is working off the extended buy signal. Hold adding new positions for the moment, we will likely see another pullback shortly to buy into if needed.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Major Market Buy/Sell Review: 02-17-20

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

  • As noted last week: “With the market now trading 12% above its 200-dma, and well into 3-standard deviations of the mean, a correction is coming.” But the belief is currently “more stimulus” will offset the “virus.” This is probably a wrong guess.
  • Extensions to this degree rarely last long without a correction.
  • Maintain exposures, but tighten up stop-losses.
  • Short-Term Positioning: Neutral Due To Extension
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $320
    • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

  • As goes the S&P 500, goes the DIA, especially when MSFT & AAPL are the two top holdings and drivers of the advances in both indexes.
  • Like SPY, DIA is very overbought and extended from long-term means.
  • Take profits, but as with SPY, wait for a correction before adding further exposure.
  • Short-Term Positioning: Neutral due to extensions
    • Last Week: Hold current positions
    • This Week: Hold current positions
    • Stop-loss moved up to $280
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • The Nasdaq remains “extremely” extended currently and is 21% above the long-term average which is historically rare. As noted last week, “With QQQ now pushing towards a 4-standard deviation event. A correction is inevitable, it is just a function of time now.”
  • The rally this week has pushed overbought conditions to extremes.
  • The Nasdaq “buy signal” is also back to extremely overbought levels. It is likely a correction is coming and it may be bigger than expected.
  • Short-Term Positioning: Neutral due to extensions.
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $215
  • Long-Term Positioning: Neutral due to valuations

S&P 600 Index (Small-Cap)

  • Small caps corrected more than the major markets, but they also haven’t moved as much.
  • The buy signal has continued to correct as small-caps have struggled to maintain recent support levels.
  • Hold positions for now, but move stops up to recent lows.
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop loss moved up to $69
  • Long-Term Positioning: Neutral

S&P 400 Index (Mid-Cap)

  • MDY remains extremely extended above the 200-dma, so more corrective action is likely. MDY is still on a buy-signal but is pushing rather extreme deviations from long-term means.
  • The previous breakout level held which is very bullish, so if the overbought condition can get worked off with some consolidation, we will have a good entry point to add exposure.
  • Short-Term Positioning: Neutral
    • Last Week: No holding
    • This Week: No holding
  • Long-Term Positioning: Bullish

Emerging Markets

  • EEM held support at the 200-dma which is encouraging, and the extended buy signal is getting worked off.
  • However, the Dollar (Last chart) is the key to our international positioning. The dollar has reversed its move lower and is rising which isn’t beneficial for international or commodity exposures.
  • Also, the coronavirus has yet to be priced into to global risk.
  • We are maintaining our holdings but tightening up stops.
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss set at $42
  • Long-Term Positioning: Neutral

International Markets

  • Like EEM, EFA also rallied off support last week.
  • As we stated last week, “Any good news with the virus and international exposure should rally. EFA looks better than EEM, so we will likely revisit our holding on a rally.” Hopes of a containment of the contagion was what drove markets last week. This is likely fleeting.
  • As with EEM, the key to our positioning is the US Dollar which is rallying strongly.
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss set at $67
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • As noted last week:
  • “Oil completely broke down last week, and collapsed below all of the important levels. Oil is now testing critical support at $51. A failure there and a break into the low $40’s is probable.”
  • The support is barely holding and oil looks extremely weak. However, oil is extremely oversold so a counter-trend rally is highly likely. We got a little bounce this week, but not much.
  • We remain on hold for now, as stops are close to being triggered.
  • Short-Term Positioning: Neutral
    • Last Week: No positions
    • This Week: No positions
    • Stops Triggered for any direct crude oil positions.
  • Long-Term Positioning: Bearish

Gold

  • Gold rallied sharply and broke out to new highs, suggesting there was something amiss with the stock market exuberance.
  • On Friday, gold rallied holding support at the previous breakout level which is bullish.
  • Our positioning looks good particularly since gold has registered a new “buy signal.”
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole position adjusted to $138
    • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • The correction in bond prices we had previously suggested occurred as bonds broke out of their declining trend sending yields lower. That breakout was a decent entry point to add exposure to bonds if you need it. However, that opportunity has now passed.
  • Take profits and rebalance holdings and look for a trade on the equity side short-term. However, another trade for bonds is likely setting up shortly with a buy signal approaching. Be patient.
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss is moved up to $136
    • Long-Term Positioning: Bullish

U.S. Dollar

  • As noted previously: “The dollar has rallied back to that all important previous support line. IF the dollar can break back above that level, and hold, then commodities, and oil, will likely struggle. It may be too early for a sharper dollar decline currently, as the U.S. economy is still the “cleanest shirt in the dirty laundry.”
  • That is exactly what happened over the last two weeks and the dollar has strengthened that rally as concerns over the “coronavirus” persist. With the dollar testing previous highs, a break above that resistance could result in a sharp move higher for the dollar.
  • The rising dollar is not bullish for Oil, commodities or international exposures.
  • The “sell” signal has began to reverse. Pay attention.

McDonald’s, Not A Shelter In The Coming Storm

The amount of time and effort that investors spend assessing the risks versus the potential returns of their portfolio should shift as the economy and markets cycle over time. For example, when an economic recovery finally breaks the grip of a recession, and asset prices and valuations have fallen to average or below-average levels, price and economic risks are greatly diminished. That is not to say there is no risk, just less risk.  

Market and economic troughs are akin to the aftermath of a forest fire. After a fire has ravaged a forest, the risks for another fire are not zero, but they are below average. Counter-intuitively, it is at these points in time when people are most fearful of fire or, in the case of investing, most worried about losses. With reduced risks, investors during these times should be more focused on the better than average rewards offered by the markets and not as concerned with the risks entailed in reaping those rewards.

Conversely, in the ninth inning of a bull market when valuations are well above the norm, and the economy has expanded for a long period, investors need to shift focus heavily to the potential risks. That is not to say there are no more rewards to come, but the overwhelming risks are substantial, and they can result in a permanent loss of wealth. As human beings are prone to do, we often zig when we should zag.

In January, we wrote Gimme Shelter to highlight that risk can be hard to detect. Sure, high flying companies with massive price gains and repeated net losses like Tesla or Netflix are easy to spot. More difficult, though, are those tried and true value stocks of companies that have flourished for decades. Specifically, we provided readers with an in-depth analysis of Coca-Cola (KO). While KO is a name brand known around the world with a long record of dependable earnings growth, its stock price has greatly exceeded its fair value.

We did not say that KO is a sure-fire short sale or even a sell. Instead, we conveyed that when a significant market drawdown occurs, KO has a lot more risk than is likely perceived by most investors. Simply, it is not the place investors should seek shelter in a market storm as they may have in the past.

We now take the opportunity to discuss another “value” company that many investors may consider a stock market shelter or safe haven.

We follow in this series with a review of McDonald’s (MCD).

You Deserve a Break Today

Please note the models and computations employed in this series use earnings per share and net income. Stock buybacks warp earnings per share (EPS), making earnings appear better than they would have without buybacks. The more positive result is simply due to a declining share count or denominator in the EPS equation. Net income and revenue data are unaffected by share buybacks and therefore deliver a more accurate appraisal of a company’s value.

Over the last ten years, the price of MCD has grown at a 13% annual rate, more than double its EPS, and over five times the rate of growth of its net income. The pace at which the growth of its stock price has surpassed its fundamentals has increased sharply over the last three years. During this period, the stock price has increased 46% annually, which is almost four times its EPS growth and more than six times the growth of its net income. 

Of further concern, revenues have declined 5% annually over the last three years, and the most recently reported annual revenues are now less than they were ten years ago when the U.S. and global GDP were only about 60% the size they are today. To pile on, the amount of debt MCD has incurred over the last ten years has increased by 355%.

MCD is a good company and, like KO, is one of the most well-known brands on the globe. Rated at BBB+, default or bankruptcy risk for MCD is remote, and because of its product line, it will probably see earnings hold up well during the next recession. For many, it is cheaper to eat at a McDonald’s restaurant than to cook at home. Although their operating business is valuable and dependable, those are not reasons to acquire or hold the stock. The issue is what price I am willing to pay in order to try to avoid a loss and secure a reasonable return.

Valuations

Using a simple price to earnings (P/E) valuation, as shown below, MCD’s current P/E for the trailing twelve months is 28, which is about 40% greater than its average over the last two decades.

The following graphs, tables, and data use the same models and methods we used to evaluate KO. For a further description, please read Gimme Shelter.    

Currently, as shown below, MCD is trading 85% above its fair value using our earnings growth model. It is worth noting that MCD, as shown with green shading, was typically valued as cheap using this model. The table below the graph shows that, on average, from 2002-2013, the stock traded 13% below fair value.

We support the graph and table above with a cash flow analysis. We assumed McDonald’s 5.6% long-run income growth rate to forecast earnings for the next 30 years. When these forecasted earnings are then discounted at the appropriate discounting rate of 7%, representing longer-term equity returns, MCD is currently overvalued by 72%.

Lastly, as we did in Gimme Shelter, we asked our friend David Robertson from Arete Asset Management to evaluate MCD’s intrinsic value. His cash flow-based model assigns an intrinsic share price value of 97.27. Based on his work, MCD is currently overvalued by 124%.

Summary

Like KO, we are not making a recommendation on MCD as a short or a sell candidate, but by our analysis, MCD stock appears to be trading at a very high valuation. Much of what we see in large-cap stocks today, MCD included, is being driven by indiscriminate buying by passive investment funds. Such buying can certainly continue, but at some point, the gross overvaluations will correct as all extremes do.

Even if MCD were to “only” decline back to a normal valuation, the losses could be significant and might even exceed those of the benchmark index, the S&P 500. Now consider that MCD may correct beyond the average and could once again trade below fair value.  Even assuming MCD earnings are not hurt during a recession, the correction in its stock price to more reasonable levels could be painful for shareholders.

After A Decade, Investors Are Finally Back to Even

I recently discussed putting market corrections into perspective, in which we looked at the financial impact of a 10-60% correction. But what happens afterward?

During strongly advancing, and very long bull markets, investors become overly complacent about the potential risks of investing. This “complacency” shows up in the resurgence of “couch potato,” “buy and hold,” and “passive indexing” portfolios. While such ideas work as long as markets are relentlessly rising, when the inevitable reversion occurs, things go “sideways” very quickly.

“While the current belief is that such declines are no longer a possibility, due to Central Bank interventions, we had two 50% declines just since the turn of the century. The cause was different, but the result was the same. The next major market decline will be fueled by the massive levels of corporate debt, underfunded pensions, and evaporation of ‘stock buybacks,’ which have accounted for almost 100% of net purchases since 2018.

Market downturns are a historical constant for the financial markets. Whether they are minor or major, the impacts go beyond just the price decline when it comes to investors.”

It is the last sentence I want to focus on today, as it is one of the most important and overlooked consequences of market corrections as it relates to long-term investment goals.

There are a litany of articles touting the massive bull market advance from the 2009 lows, and that if investors had just held onto the portfolios during the 2008 decline, or better yet, bought the March 2009 low, you would have hit the “bull market jackpot.” 

Unfortunately, a vast majority of investors sold out of the markets during the tail end of the financial crisis, and then compounded their financial problems by not reinvesting until years later. It is still not uncommon to find individuals who are still out of the market entirely, even after a decade long advance.

This is what brutal bear markets due to investors psychologically. 

“Bear markets” push investors into making critical mistakes:

  1. They paid premium prices, or rather excessive prices, for the companies they are investing in during the “bull market.” Ultimately, overpaying for value has a cost of lower future returns, as “buying high” inevitably turns into “selling low.” 
  2. Investors Panic as market values decline. It is easy to forget during sharply rising markets the money we invest is the “savings” we are dependent on for our family’s future. Many investors who claim to be “buy and hold” change their mind after large losses. There is a point, for every investors, where they are willing to “get out at any price.”
  3. Volatility is ignored. Volatility is not always a bad word, but rising volatility coupled with large declines, eventually feeds into investor “fear and panic.”
  4. Ignoring Market Analysis. When markets are trending strongly upwards, investors start to “rationalize” why they are overpaying for value in the market. By looking for “confirmation bias,” they tend to ignore any “market analysis” which contradicts their “hope” for higher prices. The phrase “this time is different” is typically a hallmark.

“The underlying theory of buy and hold investing denies that stocks are ever expensive, or inexpensive for that matter, investors are encouraged to always buy stocks, no matter what the value characteristics of the stock market happen to be at the time.” – Ken Solow

The primary problem with “buy and hold” investing is ultimately, YOU!

The Pension Problem

During raging bull markets, individuals do two things which ultimately lead to their financial distress.

  1. Start treating the market like a casino in hopes to “getting rich quick,” and
  2. Reduce their “contributions” given expectations that high returns will “fill the gap.” 

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

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

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

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

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

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

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

This is the same problem for the average American faces when planning for 6-8% average annual returns on their investment strategy. Why should you save money if the market can do the work for you? Right?

This is a common theme in much of the mainstream advice. To wit:

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

The problem with Ms. Orman’s statement is that it requires the 25-year old to achieve an 11.25% annual rate of return (adjusting for inflation) every single year for the next 40-years.

That certainly isn’t very realistic.

However, under-saving is one of the primary problems which leaves investors well short of their financial goals by retirement.

The other problem, as noted above, is the most important part of the analysis overlooked by promoters of “buy and hold” investing.

Let me explain.

Getting Back To Even, Isn’t Even

Here is the common mainstream advice.

“If you had invested $100,000 at the market at the peak of the market in 2000, or in 2007, your portfolio would have gotten back to even in 2013. Since then, your portfolio would have grown to more than $200,000.

Here is the relative chart proving that statement is correct. (Real, inflation-adjusted, total return of a $100,000 investment.)

No one talks much about investors who have been in the market since the turn of the century, but it is one of the problems why so many Americans are underfunded for retirement. While Wall Street claims the market delivers 6% annual returns, or more, the annual rate of return since 2000, on an inflation-adjusted, total return basis, is just shy of 4%.

However, since most analysis used to support the “buy and hold” thesis starts with the peak of the market in 2007, that average return does indeed come in at 6.64%.

Here is the problem.

While your portfolio got back to even, on a total return basis, 6 or 13-years after your initial investment, depending on your start date, you DID NOT get back to even.

Remember your investment plan? Yes, that plan touted by the mainstream media, which says to assume a return of 6% annually?

The chart below shows $100,000 invested at 6% annually from 2000 or 2007.

So, what’s wrong with that?

An investor tripled their money from 2000 and doubled it from 2007.

Unfortunately, you didn’t get that.

Let’s overlay our two charts.

If your financial plan was based on reduced saving rates, and high rates of return, you are well short of you goals for retirement if you started in 2000. Fortunately, for investors who started in 2007, congratulations, you are now back to even.

Unfortunately, there are few investors who actually saw market returns over the last 12-years. As noted, a vast majority of investors who were fully invested into the market in 2007, were out of the market by the end of 2008. After such a brutal beating, it took years before they returned to the markets. Their returns are vastly different than what the mainstream media claims.

While there is a case to be made for “buy and hold” investing during rising markets, the opposite is true in falling markets. The destruction of capital eventually pushes all investors into making critical investment mistakes, which impairs the ability to obtain long-term financial goals. 

You may think you have the fortitude to ride it out. You probably don’t.

But even if you do, getting back to even isn’t really an investment strategy to reach your retirement goals.

Unfortunately, for many investors today who have now reached their financial goals, it may be worth revisiting what happened in 2000 and 2007. We are exceedingly in the current bull market, valuations are elevated, and there is a rising belief “this time is different.” 

It may be worth analyzing the risk you are taking today, and the cost it may have on “your tomorrow.” 

Gone Fishing Newsletter: The Inflation Edition

We are thrilled to present a recent article from Samantha LaDuc, the Founder of LaDucTrading.com and the CIO at LaDuc Capital LLC. 

Samantha LaDuc is known for timing major inflection points in equities, commodities, bonds/rates, currencies and volatility. As a Macro-to-Micro strategic technical analyst, educator and trader, she makes her insights available to active traders and investors who want to minimize risk while seizing year-making opportunities.  


Spoiler Alert: We have no inflation in commodities.

Healthcare, Education, Concert Tickets … absolutely.

Image

But what about the stuff we consume and use every day?

CRB Commodities is made up of the following weighting:

  • Softs (Coffee, Sugar, Orange Juice) 23.5%
  • Energy 17.6%
  • Grains 17.6%
  • Precious Metals 17.6%
  • Industrials (Copper & Cotton) 11.8%
  • Meats 11.8%

Commodities – Big Picture on a Monthly Time-frame – show that we are still in a multi-decade low.

“Yields have been falling, reflecting concerns about global growth, and also the dramatic change of direction by central banks, which was itself largely driven by fears for growth. The 10-year Treasury yield is now almost a full percentage point lower than it was two years ago, and its trend is clearly downward. Indeed, if we take inflation expectations into account, the real 10-year Treasury yield has just gone negative.

According to the Bloomberg commodity indexes, industrial metals have now under-performed precious metals over the period since Donald Trump was elected U.S. president; and the price of oil is collapsing anew relative to gold. These moves only make sense if people are worried about growth.” – John Authers, Bloomberg

Sounds dreary, and John’s commentary was before the CoronaVirus outbreak really grabbed American businesses’ attention.

Despite my bearish leanings as detailed here: Perfect Storm: CoronaVirus and Market Risks, from my vantage point, we ‘should’ bounce soon (yellow circle). If not, we have more serious deflation to deal with – not just disinflation in the commodity patch.

Now let’s drop the USD softly behind the same chart and add some annotations. We have potential for a bounce, but also a lot of resistance and indecision. No clean signal yet. Still chop. And a DXY that has been range-bound for 4 years! Clearly, the US Dollar makes the weather for commodities and Foreign Exchange volatility as at an All Time Low. You know my saying: Outliers Revert With Velocity. Watch the USD for The Tell.

I should also add to this Intermarket analysis with the Macro read: it’s bearish inflation.

 @ISABELNET_SA Chart is suggesting that M2 velocity YoY leads US core inflation by 21 months. It has been quite accurate for more than 20 years. And it portends lower.

Image

Commodities are Dead, Long Live Commodities?

So why fight the trend? Humor me for ‘the other side” of the argument. Let’s assume inflation catches a bounce, pulling up commodities and yields with it, what segments are most likely to rise?

Food – Softs, Grains, Meats: China is experiencing strong Food price inflation from drought conditions (Rice), culling of all that Pork (and soon Chicken?). But in the US, these input prices are declerating (Coffee, Corn, Hogs, etc). With the new Coronavirus shutting off the flow of goods into and out of China for the time-being – and I suspect until April/May – we could start to see a tick up in Food Prices. Worst case, as the pandemic spreads, people with be unwilling/unable to go to work which could also trigger supply chain constraints. Prices could accelerate quickly on supply contraction.

Energy: What’s the bull case for Energy? Oversold, “value” play with high trailing dividend yields? They are high for a reason and still major laggard of all SPY sectors for several years now. Oil investment is waning not expanding (given Trump’s energy policies). So aside from a geopolitical ‘flare’ to temporarily disrupt supply, like with Iran, the case for sustainable higher oil is weak. And if/when Venezuela comes back online, it would be a big hit to the bull case (more supply). In the meantime, we have demand destruction out of China as a result of the CoronaVirus and general trends in decreasing demand due to:

1) Deglobalization
2) Decarbonization
3) Debt saturation
4) Donald Trump

Industrials: Copper is the big one, and it is at 2016 levels, so not expressing an economic growth look. Translation: The Trump Bump (2017) has been Dumped.

Precious Metals: Here are two charts that sum up my frustration on the perception versus reality of bidding up precious metals.

(Separate from the whole Palladium and Platinum play, which I have written about since early November as a bullish thesis.)

Treasury yields are negative after adjusting for inflation so that is supposed to be a plus for gold….

But, Gold/Silver Mining stocks are looking weary and potentially rolling over.

OK, I may have talked you out of a Commodity bump, but stick with me.

Commodities, The New Bonds?

Just over a year ago, the Fed finished systematically hiking rates (after 8 of them) as ECB quit QE. Today, Fed has lowered rates 3 times in 2019 and market is pricing in 2 more cuts for 2020! Fed clearly seems to unwind their 2017 tightening to avoid what happened in Fall of 2018 where U.S. stocks collapsed nearly 20% from Oct 3 to Dec 31st. Basically, the Fed realized it had spent three years tightening into a low inflation, low growth U.S. economy, and the global economy was too fragile to handle the liquidity and tightening drain.

But rate cuts at this point have reached the law of diminishing returns and Repo operations to inject capital in the money markets seems inadequate to jump-start growth. Fiscal policies in combination may be the fuel that flame inflation, in which case, commodities could recover and rally, but there are some heady headwinds:

Headwinds:

  1. Demand destruction from slowing global growth from Coronavirus in particular, economic cycle and ‘protectionist’ trends in general.
  2. Lower yields pull commodities with it, (and vice versa), but right now Fed has their proverbial thumb on any increases.
  3. Global central banks have suppressed volatility by anchoring expectations with “lower for longer”, thereby enhancing the effect of rate cuts which suppresses commodities.
  4. A more dovish Fed also reduces the US-Foreign bond yield spread which strengthens the dollar, thereby suppressing local currency valuation while burdening thier USD funding obligations.
  5. A stronger dollar is tailwind to commodity run (inversely related since commodities are priced in USD).

Tailwinds:

  1. Local and Coordinated Global Fiscal Policies trigger global economic optimism; Debt and Deficit hawks be damned.
  2. Containment of CoronaVirus psychologically and financially allow for economic expansion. Both will drive yields higher.

Until these factors reveal themselves, yields are falling and at risk of breaking critical support.

Top 10 Reasons for Bond Reversal:

From Buy Bonds, Wear Zirconia:

  1. Yields are approaching my buy point just above All Time Lows.
  2. Bonds/Yields are on their respective Bollinger Bands/Keltner Channel bands (yellow circle on weekly chart) which often acts as resistance causing a rubberband.snap-back effect.
  3. Seasonal tendency to Sell Bonds starts Jan 31st.
  4. Nomura’s Charlie McElligott  “1m Price Reversal” trade has run its course (1.94 drop to 1.64 in 10 yr yield since Dec 18th)
  5. Duration infatuation” (the safety-trade) often kicks in at the first sign of trouble, but then unwinds.
  6. The “normal” viral drag on US10Yr has the following tendency – yields fall then bounce back sharply.
  7. Fed won’t want the yield curve inversion which already erased half of the Q4 steepening.
  8. UPDATED PRE FOMC: Fed may need to guide inflation above target … which in turn supports a steeper curve, SO there is strong potential for final 2020 rate cut to CAUSE inflation expectations to rise.
  9. And the best reason potentially of all: Stocks are now Yielding More Than Bonds Again

“In the early summer of last year, the 10-Year Treasury Note was bid up considerably, resulting in it yielding less than the S&P 500’s dividend yield. In fact, at the point of the largest divergence between the two in late August, the dividend yield of the S&P 500 was 56.9 bps higher than the yield on the 10-Year Treasury. Although the disparity between the two has shrunk from that August peak, that trend has generally continued in the months since then, though equities’ surge into the end of the year saw bonds briefly yielding more in December. Since the start of the new year, stocks once again hold a higher yield, especially today as worries about the coronavirus have resulted in the selling of risk assets (raising the S&P 500’s yield) and subsequent buying of safe-havens (lowering the 10-Year Treasury yield). Now, the spread between the S&P 500’s dividend yield and that of the 10-Year is at its widest level in favor of the S&P 500 since October 10th.” –  DATATREK

I am nothing if not persistent.

Here is my client post from January 24th on this related subject: All Alone With My Higher Yield Thesis:

High Yield corporate debt is in trouble with Oil dropping 20% since Jan 7th and Shale companies facing their biggest loan refinancing wall in 20 years. When HY credit passes 358 bp then Momentum will very likely sell off – like happened in early September 2019 – and Value will finally catch a sustainable bid! And when Hedge Funds cover their Value shorts,  they sell Bonds! And when bonds get sold, with momentum selling off too, rates rip and we have a perfect storm set up for a massive VIX spike and gamma flipping.”

That is still my baseline projection. Market just doesn’t see it yet.


LaDuc Trading/LaDuc Capital LLC Is Not a Financial Advisor, RIA or Broker/Dealer.  Trading Stocks, Options, Futures and Forex includes significant financial risk. We teach and inform. You enter trades at your own risk. Learn more.

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Catch Up On What You Missed Last Week


Market Believes It Has Immunity To Risks

As noted last week, the spread of the coronavirus has had little impact on the markets so far.

“”The market bounced firmly off the 50-dma and rallied back to new highs on Thursday. While Friday saw a bit of retracement, which isn’t surprising given the torrid move early in the week, the ‘virus correction’ was recovered. Importantly, sharp early-week rally kept ‘sell’ signal from triggering,

Chart Updated Through Friday

In review, we previously took some profits out of portfolios as we were expecting between a 3-5% correction to allow for a better entry point to add equity exposure. While the “virus correction” did encompass a correction of 3%, it was too shallow to reverse the rather extreme extension of the market.

The continued rally this past week has fully reversed the corrective process and returned the markets to 3-standard deviations above the 200-dma. Furthermore, all daily, weekly, and monthly conditions have returned to more extreme overbought levels as well.

This was a point we discussed with our RIAPRO subscribers (Try for 30-days RISK FREE) in Thursday’s technical market update. To wit:

  • On a weekly basis, the market backdrop remains bullish with a weekly buy signal still intact.
  • However, that buy signal is extremely extended and has started to reverse with the market extremely overbought on a weekly basis.
  • This is an ideal setup for a bigger correction so some caution is advised.
  • With the market trading above 2-standard deviations, and testing the third, of the intermediate term moving average, some caution is suggested in adding additional exposure. A correction is likely over the next month which will provide a better opportunity. Remain patient for now.

It is here that investors tend to go astray.

In the short-term, the market dynamics are indeed bullish which suggests that investors remain invested at the current time.

However, on a long-term basis, the picture becomes much more concerning.

  • As noted above, this chart is not about short-term trading but the long-term management of risks in portfolios. This is a quarterly chart of the market going back to 1920.
  • Note the market has, only on a few rare occasions, been as overbought as it is currently. The recent advance has pushed the market into 3-standard deviations above the 3-year moving average. In every single case, the reversion was not kind to investors.
  • Secondly, in the bottom panel, the market has never been this overbought and extended in history.
  • As an investor it is important to keep some perspective about where we are in the current cycle, there is every bit of evidence that a major mean reverting event will occur. Timing is always the issue which is why use daily and weekly measures to manage risk.
  • Don’t get lost in the mainstream media. This is a very important chart.

Nothing Out Of Kilter

This past week Ed Yardeni via Yardeni Research, made a good point:

“The markets must figure that the coronavirus outbreak will be contained soon and go into remission, as did SARS, MERS, and Ebola. If that doesn’t happen, then there will be a vaccine that will make us feel better. It won’t be a miracle cure coming from a drug company. Rather, it will be injections of more liquidity into the global financial markets by the major central banks.

On Tuesday, Fed Chair Jerome Powell implied that the Fed is on standby to do just that. In his testimony on monetary policy to Congress, he said, ‘Some of the uncertainties around trade have diminished recently, but risks to the outlook remain. In particular, we are closely monitoring the emergence of the coronavirus, which could lead to disruptions in China that spill over to the rest of the global economy.’”

Not surprisingly, the “ringing of Pavlov’s bell” once again sent investors scurrying to take on risk.

Interestingly, however, was that during Powell’s testimony to the Senate Banking Committee this past week, he said:

“There is nothing about this economy that is out of kilter or imbalanced.”

Okay, I’ll bite.

“Mr. Powell, if there is nothing out of kilter or imbalanced in the economy, then why are you flooding the system with a greater level of ’emergency’ measures than seen during the ‘financial crisis.'”

It is at this point that I feel like Mr. Lorensax from “Ferris Bueller’s Day Off.”

“Anyone…Anyone…”

  • Side Note: The irony of that particular clip, is that Mr. Lorensax is asking his class about the “The Smoot-Hawley Act,” which was intended to raise revenue via tariffs and lift the U.S. out of the “Great Depression.” Just as with Trump’s recent “tariff” and “trade war,” neither worked as intended.

There is clearly something amiss within the financial complex. However, investors have been trained to disregard the “risk” under the assumption the Federal Reserve has everything under control.

Currently, it certainly seems to be the case as markets hover near all-time highs even as earnings, and corporate profit, growth has weakened. If the coronavirus impacts the global supply chain harder than is currently anticipated, which is likely, the deviation between prices and earnings will become tougher to justify.

Scott Minerd, the CIO of Guggenheim Investments, had a salient point:

Yet as a major economic problem looms on the horizon, the cognitive disconnect between current asset prices and reality feels like the market equivalent of “peace for our time.” The average BBB bond yields just 2.9 percent. A recent 10-year BB-rated healthcare bond came to market at 3.5 percent and subsequently was increased in size from $1 billion to $1.7 billion due to excess demand.

For those investors who perceive the disconnect between risk assets which are priced for a rosy outcome and the reality of the looming risks to growth and earnings, any attempt to reduce risk leads to underperformance. It is a mind-numbing exercise for investors who see the cognitive dissonance. The frantic race to accumulate securities has cast price discovery to the side.

I have never in my career seen anything as crazy as what’s going on right now, this will eventually end badly.

Of course, it will.

The only problem, as he notes, is that between now and then, there is a demand for performance regardless of the underlying risk. Or rather, there is a widely adopted belief the markets can never have a decline again as witnessed by an email I received last week:

“Why do you think there will ever be a correction when the central banks are never going to let credit contract. I see no corrections. Ever. When the US enters a recession, the reality is it will be the biggest buy signal yet. There is literally nowhere to go but up in this market.”

The lessons taught by previous bear markets are always forgotten during enduring bull markets which seem without end. The relearning of those lessons are always painful.

The Path Ahead

The path ahead for stocks is much less certain than in late 2018 when we were coming off deeply depressed sentiment levels, and the Fed was rapidly reversing monetary policy from “tightening” to “easing.”

With equities now more than 30% higher than they were then, the Fed mostly on hold in terms of rate cuts, and “repo” operations starting to slow, it certainly seems that expectations for substantially higher market values may be a bit optimistic.

Furthermore, as noted above, earnings expectations declined for the entirety of 2019, as shown in the chart below. However, the impact of the “coronavirus” has not been adopted into these reduced estimates as of yet. These estimates WILL fall, and likely markedly so, which as stated above, is going to make justifying record asset prices more problematic.

Conversely, if by some miracle, the economy does show actual improvement, it could result in yields rising on the long-end of the curve, which would also make stocks less attractive.

This is the problem of overpaying for value. The current environment is so richly priced there is little opportunity for investors to extract additional gains from risk-based investments.

There is one true axiom of the market which is always forgotten.

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

If you feel you must chase the markets currently, then at least do it with a set of guidelines to follow in case things turn against you. We printed these a couple of weeks ago but felt there are worth mentioning again.

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  2. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move. This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
  3. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tends to lead when markets fall. Like “weeds choking a garden,” pull them.
  4. Add to sectors, or positions, that are performing with, or outperforming the broader market.
  5. Move “stop-loss” levels up to current breakout levels for each position. Managing a portfolio without “stop-loss” levels is like driving with your eyes closed.
  6. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
  7. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

While we remain optimistic about the markets currently, we are also taking precautionary steps of tightening up stops, adding non-correlated assets, raising some cash, and looking to hedge risk opportunistically.

Just because it isn’t raining right now, doesn’t mean it won’t. Nobody has ever gotten hurt by keeping an umbrella handy.



The MacroView

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

See You Next Week

By Lance Roberts, CIO


Financial Planning Corner

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You’ll be hearing more about more specific strategies to diversify soon, but don’t hesitate to give me any suggestions or questions.

by Danny Ratliff, CFP®


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

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

Sector-by-Sector

Improving – Discretionary (XLY) and Utilities (XLU)

As noted previously, we reduced exposure to Utilities and Discretionary due to their extreme overbought condition. Unfortunately, that overbought extension has not been alleviated enough at this time to add back to our holdings. We will likely see a correction in the next couple of weeks to re-evaluate our positioning.

Current Positions: Reduced XLY, XLU

Outperforming – Technology (XLK), Communications (XLC)

We previously recommended taking profits in Technology, which has not only been leading the market but has gotten extremely overbought. The rally in markets last week only further extended those overbought conditions in both Technology and Communications. Hold positions for now, and be patient for a correction to add additional exposure.

Current Positions: Target weight XLK, Reduced XLC

Weakening – Financials (XLF), Healthcare (XLV)

We noted previously added a position in Financials to our portfolios, which we will look to build into over the few weeks. We also had previously added to our healthcare slightly. Both positions ran back to overbought and need more of a correction before considering adding to them.

Current Position: 1/2 Weight (XLF), Target weight (XLV)

Lagging – Industrials (XLI), Real Estate (XLRE), Staples (XLP), Materials (XLB), and Energy (XLE)

With the Fed continuing to pump money into the financial markets, bond yields continue to drop which is supportive for interest rate sectors like Real Estate and Utilities. We previously reduced our holdings to these sectors and we need a correction to work off some of the excesses before adding back to our holdings. Both XLRE and XLU are EXTREMELY extended currently.

Industrials rallied back to new highs without working off the overbought condition. With industrials at 3-standard deviations above the long-term mean, be patient adding additional exposures.

Materials tested and failed previous highs and are testing those highs again. With the sector very overbought there is a risk of a reversal, particularly with the sector very close to registering a “sell signal.”

Energy is deeply oversold and due for a rally. We added to our position of AMLP previously, however, we are maintaining tight stops.

Staples remains in a strong uptrend and has not provided an entry point to add exposure safely.

Current Position: Reduced weight XLY, XLP, XLRE, Full weight AMLP, 1/2 weight XLB and XLI

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – Despite the rally in the broader markets, Small- and Mid-caps continue to underperform currently. Both markets rallied last week but have failed to set new highs. Small caps did recover their 50-dma, while mid-caps are currently testing previous highs. Overbought conditions are rather extreme in both.

Current Position: KGGIX, SLYV

Emerging, International (EEM) & Total International Markets (EFA)

Emerging and International Markets, look a lot like small-caps above. Both had gotten extremely overbought and needed to correct. That correction broke supports and the subsequent rally failed to set new highs. Both markets have climbed back above their respective 50-dma, but are testing that support line. We remain long our holdings currently, but are closely evaluating our positioning.

Current Position: EFV, DEM

Dividends (VYM), Market (IVV), and Equal Weight (RSP) – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with economic growth and inflation. We are currently maintaining our core positions unhedged for now. If we see deterioration in the broader markets, we will begin to add short-positions to hedge our long-term core holdings.

Current Position: RSP, VYM, IVV

Gold (GLD) – Over the last few weeks, gold has been consolidating near recent highs. Gold remains overbought but continues to hold important support. We are at full weight in the positions, however, if this consolidation continues, supports hold, and the overbought condition recedes, we will consider over-weighting our holdings.

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

Bonds (TLT) –

Bonds rallied back towards previous highs on Friday as money rotated into bonds for “safety” as the market weakened. After previously recommending adding to bonds, hold current positions for now and take profits next week to rebalance risks accordingly. Bonds are extremely overbought now, so be cautious, we added a small portion of TLT to portfolios last week to extend our current duration.

Current Positions: DBLTX, SHY, IEF, Added TLT

Sector / Market Recommendations

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

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

Portfolio/Client Update:

The market rallied this past week on continued expectations that the Fed will intervene sooner, or later, with liquidity to offset the risk of the coronavirus. As such, investors don’t want to “miss out” on the liquidity party when it happens, so they are front-running the event.

This past week, we made a couple of very minor changes to the portfolio which change very little in terms of the overall make up.

Importantly, this rebalancing of risk did not dramatically increase equity exposure. This is because, as noted above, the longer-term technical outlook remains “cautious.”

Yes, we realize we are very late-cycle, we also know that with the Fed, and global Central Banks, still intervening, we must give deference to the “bullish bias.” At the moment, that bias clearly remains, and functioned as we discussed last week.

If you have any questions, please don’t hesitate to email me.

There we no additional portfolio actions this past week.

  • New clients: Slowing adding exposure as needed.
  • Dynamic Model: Added LVS, and a Short-S&P 500 hedge to balance risk while trying to build out the overall model.
  • Equity Model: Sold SLYV to make room to add LVS. Also added TLT to our bond portfolio to lengthen duration a little bit. Given the portfolio is fully allocated to the market positions now have to be shifted to make changes.
  • ETF Model: Add a starting position of TLT to our bond portfolio to lengthen the duration of our current bond mix.

Note for new clients:

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


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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

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

Click Here For The “LIVE” Version Of The 401k Plan Manager

See below for an example of a comparative model.


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

401k Plan Manager Live Model

As an RIA PRO subscriber (You get your first 30-days free) you have access to our live 401k p

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

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

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

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

#MacroView: Debt, Deficits & The Path To MMT.

In September 2017, when the Trump Administration began promoting the idea of tax cut legislation, I wrote a series of articles discussing the fallacy that tax cuts would lead to higher tax collections, and a reduction in the deficit. To wit:

“Given today’s record-high levels of debt, the country cannot afford a deficit-financed tax cut. Tax reform that adds to the debt is likely to slow, rather than improve, long-term economic growth.

The problem with the claims that tax cuts reduce the deficit is that there is NO evidence to support the claim. The increases in deficit spending to supplant weaker economic growth has been apparent with larger deficits leading to further weakness in economic growth. In fact, ever since Reagan first lowered taxes in the ’80’s both GDP growth and the deficit have only headed in one direction – higher.”

That was the deficit in September 2017.

Here it is today.

As opposed to all the promises made, economic growth failed to get stronger. Furthermore, federal revenues as a percentage of GDP declined to levels that have historically coincided with recessions.

Why Does This Matter?

President Trump just proposed his latest $4.8 Trillion budget, and not surprisingly, suggests the deficit will decrease over the next 10-years.

Such is a complete fantasy and was derived from mathematical gimmickry to delude voters to the contrary. As Jim Tankersley recently noted:

The White House makes the case that this is affordable and that the deficit will start to fall, dropping below $1 trillion in the 2021 fiscal year, and that the budget will be balanced by 2035. That projection relies on rosy assumptions about growth and the accumulation of new federal debt — both areas where the administration’s past predictions have proved to be overconfident.

The new budget forecasts a growth rate for the United States economy of 2.8 percent this year — or, by the metric the administration prefers to cite, a 3.1 percent rate. That is more than a half percentage point higher than forecasters at the Federal Reserve and the Congressional Budget Office predict.

It then predicts growth above 3 percent annually for the next several years if the administration’s economic policies are enacted. The Fed, the budget office and others all see growth falling below 2 percent annually in that time. By 2030, the administration predicts the economy will be more than 15 percent larger than forecasters at the budget office do.

Past administrations have also dressed up their budget forecasts with economic projections that proved far too good to be true. In its fiscal year 2011 budget, for example, the Obama administration predicted several years of growth topping 4 percent in the aftermath of the 2008 financial crisis — a number it never came close to reaching even once.

Trump’s budget expectations also contradict the Congressional Budget Office’s latest deficit warning:

“CBO estimates a 2020 deficit of $1.0 trillion, or 4.6 percent of GDP. The projected gap between spending and revenues increases to 5.4 percent of GDP in 2030. Federal debt held by the public is projected to rise over the ­coming decade, from 81 percent of GDP in 2020 to 98 percent of GDP in 2030. It continues to grow ­thereafter in CBO’s projections, reaching 180 percent of GDP in 2050, well above the highest level ever recorded in the United States.”

“With unprecedented trillion-dollar deficits projected as far as the eye can see, this country needs a serious budget. Unfortunately, that cannot be said of the one the President just submitted to Congress, which is filled with non-starters and make-believe economics.” – Maya Macguineas

Debt Slows Economic Growth

There is a long-standing addiction in Washington to debt. Every year, we continue to pile on more debt with the expectation that economic growth will soon follow.

However, excessive borrowing by companies, households or governments lies at the root of almost every economic crisis of the past four decades, from Mexico to Japan, and from East Asia to Russia, Venezuela, and Argentina. But it’s not just countries, but companies as well. You don’t have to look too far back to see companies like Enron, GM, Bear Stearns, Lehman, and a litany of others brought down by surging debt levels and simple “greed.” Households, too, have seen their fair share of debt burden related disaster from mortgages to credit cards to massive losses of personal wealth.

It would seem that after nearly 40-years, some lessons would have been learned.

Such reckless abandon by politicians is simply due to a lack of “experience” with the consequences of debt.

In 2008, Margaret Atwood discussed this point in a Wall Street Journal article:

“Without memory, there is no debt. Put another way: Without story, there is no debt.

A story is a string of actions occurring over time — one damn thing after another, as we glibly say in creative writing classes — and debt happens as a result of actions occurring over time. Therefore, any debt involves a plot line: how you got into debt, what you did, said and thought while you were in there, and then — depending on whether the ending is to be happy or sad — how you got out of debt, or else how you got further and further into it until you became overwhelmed by it, and sank from view.”

The problem today is there is no “story” about the consequences of debt in the U.S. While there is a litany of other countries which have had their own “debt disaster” story, those issues have been dismissed under the excuse of “yes, but they aren’t the U.S.”

But this lack of a “story,” is what has led us to the very doorstep of “Modern Monetary Theory,” or “MMT.” As Michael Lebowitz previously explained:

“MMT theory essentially believes the government spending can be funded by printing money. Currently, government spending is funded by debt, and not the Fed’s printing press. MMT disciples tell us that when the shackles of debt and deficits are removed, government spending can promote economic growth, full employment and public handouts galore.

Free healthcare and higher education, jobs for everyone, living wages and all sorts of other promises are just a few of the benefits that MMT can provide. At least, that is how the theory is being sold.”

What’s not to love?

Oh yes, it’s that deficit thing.

Deficits Are Not Self-Financing

The premise of MMT is that government “deficit” spending is not a problem because the spending into “productive investments” pay for themselves over time.

But therein lies the problem – what exactly constitutes “productive investments?”

For government “deficit” spending to be effective, the “payback” from investments made must yield a higher rate of return than the interest rate on the debt used to fund it. 

Examples of such investments range from the Hoover Dam to the Tennessee River Valley Authority. Importantly, “infrastructure spending projects,” must have a long-term revenue stream tied to time. Building roads and bridges to “nowhere,” may create short-term jobs, but once the construction is complete, the economic benefit turns negative.

The problem for MMT is its focus on spending is NOT productive investments but rather social welfare which has a negative rate of return. 

Of course, the Government has been running a “Quasi-MMT” program since 1980.

According to the Center On Budget & Policy Priorities, roughly 75% of every current tax dollar goes to non-productive spending. (The same programs the Democrats are proposing.)

To make this clearer, in 2019, the Federal Government spent $4.8 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.6 Trillion was financed by Federal revenues, and $1.1 trillion was financed through debt.

In other words, if 75% of all expenditures go to social welfare and interest on the debt, those payments required $3.6 Trillion, or roughly 99% of the total revenue coming in. 

There is also clear evidence that increasing debts and deficits DO NOT lead to either stronger economic growth or increasing productivity. As Michael Lebowitz previously showed:

“Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found here.

The graph below plots a simple index we created based on total factor productivity (TFP) versus the ten-year average growth rate of TFP. The TFP index line is separated into green and red segments to highlight the change in the trend of productivity growth rate that occurred in the early 1970’s. The green dotted line extrapolates the trend of the pre-1972 era forward.”

“The plot of the 10-year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line) is telling.”

“This reinforces the message from the other debt-related graphs – over the last 30-years the economy has relied more upon debt growth and less on productivity to generate economic activity.

The larger the balance of debt has become, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.

Since 2008, the economy has been growing well below its long-term exponential trend. Such has been a consistent source of frustration for both Obama, Trump, and the Fed, who keep expecting higher rates of economic only to be disappointed.

The relevance of debt growth versus economic growth is all too evident. When debt issuance exploded under the Obama administration, and accelerated under President Trump, it has taken an ever-increasing amount of debt to generate $1 of economic growth.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has been no organic economic growth.

For the 30-years, from 1952 to 1982, the economic surplus fostered a rising economic growth rate, which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been higher. If you subtract the debt, there has not been any organic economic growth since 1990. 

What is indisputable is that running ongoing budget deficits that fund unproductive growth is not economically sustainable long-term.

The End Game Cometh

Over the last 40-years, the U.S. economy has engaged in increasing levels of deficit spending without the results promised by MMT.

There is also a cost to MMT we have yet to hear about from its proponents.

The value of the dollar, like any commodity, rises and falls as the supply of dollars change. If the government suddenly doubled the money supply, one dollar would still be worth one dollar but it would only buy half of what it would have bought prior to their action.

This is the flaw MMT supporters do not address.

MMT is not a free lunch.

MMT is paid for by reducing the value of the dollar and ergo your purchasing power. MMT is a hidden tax paid by everyone holding dollars. The problem, as Michael Lebowitz outlined in Two Percent for the One Percent, inflation tends to harm the poor and middle class while benefiting the wealthy.

This is why the wealth gap is more pervasive than ever. Currently, the Top 10% of income earners own nearly 87% of the stock market. The rest are just struggling to make ends meet.

As I stated above, the U.S. has been running MMT for the last three decades, and has resulted in social inequality, disappointment, frustration, and a rise in calls for increasing levels of socialism.

It is all just as you would expect from such a theory put into practice, and history is replete with countries that have attempted the same. Currently, the limits of profligate spending in Washington has not been reached, and the end of this particular debt story is yet to be written.

But, it eventually will be.

#FPC: Dave Ramsey Is Right & Very Wrong About Permanent Life Insurance (Pt. 1)

Let’s start with the basics, Dave Ramsey is great at a couple of things, budgeting, helping people get out of debt, prioritizing material things and/or putting things in perspective. 

BUT…

There are some things where good ole Dave isn’t so great. I know this is going to surprise many of you, but you need to hear this.

DAVE RAMSEY IS NOT GOOD AT FINANCIAL PLANNING OR INVESTMENT ADVICE.

Allow me to give you some additional context. Dave is good at helping people get out of debt and make better financial decisions, in fact he’s really good. His Financial Peace University has helped so many people get on track to a better life. I’m a really big fan of Dave for the work he does, but my clients and most of our readers have graduated beyond Dave’s philosophy’s to needing more sophisticated planning and advice.

Dave Ramsey believes you should buy term life insurance and invest the rest. In theory it sounds great. For example, if you were to spend $1,000 a month on a permanent life insurance policy- according to Dave you should buy a term policy and invest the rest.

And from a RISK MANAGEMENT mindset I love the idea.

In fact, this is where you should start. Buy a term policy to protect your family. There are many factors to consider when purchasing a term policy and how much you need here are a few:

  • Loss of Income
  • Debt
  • Expenses
  • Children
  • Lifestyle
  • Age
  • Do you have insurance through work? Is it portable if you leave?

The rule of thumb is 7 to 10 times your annual salary-BUT we believe each individual should go through a thorough analysis to help determine what’s right for their family.

Now that you have your bases covered to protecting your family what’s next?

I’m making an assumption that you already have an emergency fund, established a “financial vulnerability cushion” and are wondering where to put additional funds.

Here’s what I hear often-

  • I make too much to put into a Roth IRA
  • I make too much to put into a Roth 401(k)- (no you don’t there are no income limitations)
  • I can’t make tax deductible contributions to a Traditional IRA
  • Where do I put funds?
  • Savings aren’t earning much interest,
  • I’m missing out on returns in the markets (High Yield Savings) No FOMO.
  • Or alternatively, Markets are too high to put funds to work

The list goes on and on.

What has the Financial Industry beat into our brains year after year?

 Tax Deferred Savings, Tax Deferred Savings, Tax Deferred Savings!

Times are changing. With the new Secure Act we just saw the death of the Stretch IRA and are in one of the lowest tax brackets we’ve seen in years. Not to mention the TCJA (current tax code) sunsets in 2026 and there is also a political party dead set on raising taxes if elected.  In regard to debt and taxes neither Democrat or Republican party understands a budget or how to truly curtail deficit spending. U.S. Government let me introduce you to Dave. It’s a match made in Heaven-until it causes a massive recession, but that’s beside the point. I’d expect higher taxes, not austerity.

So how will you prepare for higher taxes?

When helping clients prepare for retirement we look for not only the low hanging fruit or the obvious feel good propositions, but also some of the harder ones. Like paying taxes now.  

Right now we’re the bearers of bad news.

You don’t always retire in a lower tax bracket.

AND, most aren’t prepared for the additional stealth taxes Uncle Sam surprises you with.

Stay with me, I know I’m walking you through a dark tunnel. The light is near.

Envision yourself on a 3-legged stool. Each leg represents a different tax ramification.

  • Leg 1-Fully Taxable
  • Leg 2-Partially Taxable
  • Leg 3-Tax Free

If you could put all of your eggs in one leg where would they be?

Exactly, Leg 3-but why are so many stools so wobbly? I’ll go one step further.

  • Leg 1- 401(k)’s, 403(b)’s, Traditional IRA’s (the feel good’s)
  • Leg 2- Saving’s, Brokerage Accounts, After tax investment Vehicles
  • Leg 3- ROTH 401(k)’s, ROTH IRA’s, CASH VALUE FROM PERMANENT LIFE INSURANCE

We focus on so many other things first.  The typical sequence of savings is:

  • 401(k)
  • Savings
  • Investments

What do these all have in common? Taxes

What do we want to get away from? Taxes

Here’s how I want you to look at Leg 1- it’s not all yours. Treat these funds like a business, but you don’t own all of it Uncle Sam has some ownership in your business. However, this partnership is unlike any other-they can increase their ownership at any time therefore decreasing your probability of success in retirement.

Leg 2- the principal is yours (you’ve already paid the taxes,) but any realized growth, interest and dividends are taxable at either ordinary income levels or capital gains tax rates.

Leg 3- like leg 2 you’ve already paid the taxes, but the earning’s when all the rules are followed are tax free. For obvious reasons this is the more difficult leg to stabilize. It’s not easy, it takes some proper planning and it takes some work.

I believe everyone needs to strengthen leg 3. Most people will do it by utilizing a Roth 401k or a Roth IRA, but a few will use a permanent life insurance policy.

This is where Dave is right- for most people.

Buying term and investing the difference if you are diligent enough to do so is a great strategy for the majority of Americans living paycheck to paycheck or the saver who is doing all they can to make the sacrifices for their family, but they just can’t do much more. 

This is where Dave is wrong?

What about our typical client? These are the people who are doing all the right things, maxing out retirement contributions, maxing out their HSA’s, putting funds into their savings accounts regularly with little to no debt. Do they just keep plugging away putting additional funds into accounts that are taxable?

What about our clients who have a true estate tax problem? These are people who’ve built businesses, acquired land, built wealth with hard work, blood, sweat and tears. Do their heirs liquidate assets just to pay the tax bill?

No, no they don’t they use insurance properly.

Is permanent life insurance wrong for them, Dave?

No, they use insurance as one leg of their 3-legged stool. These are people who take a big picture holistic view, have a financial plan and have planned for these events.

Insurance is something that must be planned, not sold.

I know and hear of too many insurance agents who say everyone needs a Variable Universal Life Policy aka (VUL.) Unfortunately, many of these guys primarily sell property and casualty and are looking for a big-ticket item, the VUL. Which typically carry higher fee’s little or no guarantee’s and premiums that can change. The majority of the time a realistic plan wasn’t done, illustrations are done to show only the best case scenarios and many times the agents themselves are captive to one or two carriers and/or don’t quite know what to look for in an insurance policy or how to choose one that really fits your needs. This is the have hammer, everything is a nail syndrome.

Permanent Life Insurance when done right can play a vital role in a retiree’s financial plan, it can help provide tax free income, some provide guarantee’s to principal and offer low fee’s which help with accumulation of cash value when overfunding the contract.

Which is why we believe insurance should be planned, it’s a solution to a sophisticated problem. Insurance is also a sophisticated product, that deserves a better reputation than many give it.

  • Who doesn’t want some guarantee’s?
  • Who doesn’t want to pay 0% in taxes on distributions?
  • Who doesn’t want protection from the governments stealth taxes?
  • Who doesn’t want creditor protection?
  • Who doesn’t want to protect their family and their hard-earned funds?

I hope this post has opened your eyes to another potential avenue to explore in your plan.

Next week in Part 2, we’ll get into the nitty-gritty of different types of permanent life insurance, how to use them, what to look for in a policy and also what to stay away from.

#WhatYouMissed On RIA: Week Of 02-10-20

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

The Week In Blogs

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Our Latest Newsletter

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What You Missed At RIA Pro

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

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The Best Of “The Lance Roberts Show

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Video Of The Week

Conversation with Michael Lebowitz and Lance Roberts on whether, or not, the markets have built up an immunity to QE.

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Our Best Tweets Of The Week

See you next week!

Will The Corona Virus Trigger A Recession?

As if waking up to an economic nightmare, investors see headlines like these and many others flashing across their Bloomberg terminals:

  • Facebook says Oculus headphone production will be delayed due to virus
  • Apple extends country wide store closing for another week
  • Foxconn delays iPhone production
  • Qualcomm cuts production forecast due to virus uncertainty
  • Starbucks announces China store closures through Lunar New Year, uncertain when they may reopen
  • US Steel flashes a warning of a cut in demand
  • Nike shoe production halted
  • Under Armour missed on sales, and their outlook is weak. They partially blamed the Corona Virus outbreak.
  • IEA forecasts drop in oil demand this quarter- first time in a decade

The seemingly never ending list of delays, disruptions, and cuts rolls on from retail to high technology. Even services are impacted as flights and train trips are canceled within and to and from China.  While some technology-based services are provided over the Internet service, restaurants, training, and consulting, as examples, must be performed in person.  Manufacturing operations require workers to be at the factory to produce products. Thus, manufacturing is much more acutely affected by quarantines, shutdowns, transportation disruption, and other government actions.

It is as if an economic tsunami is rolling over the global economy. China’s economy was 18 % of world GDP in 2019.  For most S & P 100 corporations, the Asian giant is their fastest growing market at 20 – 30 % per year.  Even more critical, China has become the hub of world manufacturing after entering the World Trade Organization in 2000. Over the past two decades, U.S. corporations have relocated manufacturing to China to leverage an inexpensive labor force and modern business infrastructure.

Source: The Wall Street Journal – 2/7/20

Prior to the epidemic, world trade had begun to slow as a result of the China – U.S. trade war and other tariffs.  World trade for the first time since the last recession has turned negative.

Source: Haver Analytics, The Wall Street Journal, The Daily Shot – 1/19/20

Based on severity estimates, analysts have forecasted the impact on first-quarter China GDP growth. In the chart below from Fitch Ratings, growth for first quarter drops almost in half and for year growth drops to 5.2 % if containment is delayed:

Sources: The Wall Street Journal, The Daily Shot – 2/6/20

When news of the virus first was announced, the market sustained a quick modest decline. The next day, investors were reassured by official news from China and the World Health Organization that the virus could be contained. Market valuations bounced on optimism that the world economy would see little to no damage in the first quarter of 2020.  Yet, there is growing skepticism that the official tolls of the virus are short of reality. Doctors report that at the epicenter of Wuhan that officials are grossly underestimating the number of people infected and dead. The London School of Hygiene and Tropical Medicine has an epidemic model indicating there will be at least 500,000 infections at the peak in a few weeks far greater than the present 45,000 officially reported.

The reaction, and not statements, of major governments to the epidemic hint that the insider information they have received is far worse and uncertain.  U.S. global airlines have canceled flights to China until mid-March and 30 other carriers have suspended flights indefinitely – severely reducing business and tourist activities.  The U.S. government has urged U.S. citizens to leave the country, flown embassy staff and families back to the U.S., and elevated the alert status of China to ‘Do Not Travel’ on par with Syria and North Korea. All of these actions have angered the Chinese government. While protecting U.S. citizens from the illness it adds stress to an already tense trade relationship. To reduce trade tension, China announced a relaxation of import tariffs on $75 billion of U.S. goods, reducing tariffs by 5 to 10 %.  President Xi on a telephone call with President Trump committed to complete all purchases of U.S. goods on target by the end of the year while delaying shipments temporarily.  It remains to be seen if uncontrolled events will drive a deeper trade wage between the U.S. and China.

Inside China, chaos in the supply chain operations is creating great uncertainty. Workers are being told to work from home and stay away from factories for at least for another week beyond the Lunar New Year and now well into late-February.  Foxconn and Tesla announced plant openings on February 10th, yet ramping up output is still an issue. It will be a challenge to staff factories as many workers are in quarantined cities and train schedules have been curtailed or canceled.  Many factories are dependent on parts from other cities around the country that may have more severe restrictions on transportation and/or workers reporting to work. Thus, even when a plant is open, it is likely to be operating at limited capacity.

On February 7th, the Federal Reserve announced that while the trade war pause has improved the global economy, it cautioned that the coronavirus posed a ‘new threat to the world economy.’  The Fed is monitoring the situation. The central bank of China infused CNY 2 trillion in the last four weeks to provide fresh liquidity.  The liquidity will help financially stretched Chinese companies survive for a while, but they are unlikely to be able to continue operations unless production and sales return to pre epidemic levels quickly.

Will the Federal Reserve really be able to buffer the supply chain disruption and sales declines in the first quarter of 2020?  The Fed already seems overwhelmed, keeping a $1+ trillion yearly federal deficit under control and providing billions in repo financing to banks and hedge funds causing soaring prices in risk assets. While the Fed may be able to assist U.S. corporations with liquidity through a tough stretch of declining sales and supply chain disruptions, it cannot create sales or build products.

Prior to the virus crisis, CEO Confidence was at a ten year low.  Then, CEO confidence levels improved a little with the Phase One trade deal driving brighter business prospects for the coming year. Now, a possible black swan epidemic has entered the world economic stage creating extreme levels of sales and operational uncertainty.  Marc Benioff, CEO of Salesforce, expresses the anxiety many CEOs feel about trade:

 “Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”

Adding to the uncertainty is a deteriorating political environment in China.  During the first few weeks of December, local Wuhan officials denounced a doctor that was calling for recognition of the new virus. He later died of the disease, triggering a social media uproar over the circumstances of his treatment. Many Chinese people have posted on social media strident criticisms of the delayed government response.  Academics have posted petitions for freedom of speech, laying the blame on government censors for making the virus outbreak worse.  The wave of freedom calls is rising as Hong Kong protester’s messages seem to be spreading to the mainland. The calls for freedom of speech and democracy are posing a major challenge to President Xi.  Food prices skyrocketed by 20 % in January with pork prices rising 116 % adding to consumer concerns. Political observers see this challenge to government policies on par with the Tiananmen Square protests in 1989. The ensuing massacre of protestors is still in the minds of many mainland people. As seems to be true of many of these events that it is not the crisis itself, but the reaction and ensuing waves of social disorder which drive a major economic impact.

Oxford Economics has forecast a slowdown in US GDP growth in the first quarter of 2020 to just .6 %

Sources: Oxford Economics, The Wall Street Journal, The Daily Shot – 2/6/20

Will U.S. GDP growth really be shaved by just .4 %?  If we consider the compounding effect of the epidemic to disrupt both demand and supply, the social chaos in China challenging government authority (i.e., Hong Kong), and a lingering trade war – these factors all make a decline into a recession a real and growing possibility.  We hope the epidemic can be contained quickly and lives saved with a return to a more certain world economy.  Yet, 1930s historical records show rising world nationalism, trade wars, and the fracturing of the world order does not bode well for a positive outcome. Mohammed A. El-Arian. Chief Economic Advisor at Allianz in a recent Bloomberg opinion warns of a U shaped recession or worse an L :

I worry that many analysts do not fully appreciate the notable differences between financial and economic sudden stops. Rather than confidently declare a V, economic modelers need more time and evidence to assess the impact on the Chinese economy and the related spillovers – a consideration that is made even more important by two observations. First, the Chinese economy was already in an unusually fragile situation because of the impact of trade tensions with the U.S. Second, it has been navigating a tricky economic development transition that has snared many countries before China in the “middle income trap. All this suggests it is too early to treat the economic effects of the coronavirus on China and the global economy as easily containable, temporary and quickly reversible. Instead, analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”

Patrick Hill is the Editor of The Progressive Ensignhttps://theprogressiveensign.com/ writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

S&P 500 Technical Analysis Review 02-13-20

A technical review of the S&P 500 using daily, weekly and monthly charts to determine overbought, oversold, and risk/reward scenarios for carrying equity exposure.

We did this analysis at the end of January, but given the recent surge in the market, which is now pushing the S&P 500 back into extreme overbought territory, it is worth reviewing again to determine our next positioning moves.

We are currently looking at shorting the market in our models, given the right setup. We are close to that point currently.

Let’s take a look at the charts.

Daily

  • The S&P 500 had broken out to new highs which is bullish. However, the more extreme overbought condition of the market remains in terms of deviation from its 200-dma. At 3-standard deviations above the longer-term moving average, it suggests that 99.9% of all potential price movement is built into the advance.
  • On a very short term basis, the market is back to very overbought (top panel) which previously suggested the short-term correction.
  • However, the “buy signal” in the lower panel suggests that the current rally could have a bit more upside. But given the deviation to the 200-dma, I don’t suspect there is much “gas left in the tank.”
  • While we have added some exposure to portfolios recently, we have done so very cautiously with tight stops. That is a good plan to follow for now.

Daily Overbought/Sold

  • The chart above shows a variety of measures from the Volatility Index ($VIX) to momentum and deviation from intermediate term moving averages.
  • We noted back in September and early October that a rally into year-end was likely. At that time all of the indicators had pushed down into their respective “BUY” ranges.
  • Now that situation has reversed, with all indicators back into their respective “SELL” ranges.
  • The previous correction at the end of January did little to reverse those more extreme overbought conditions. This is not “bearish” or suggestive of a “crash” coming, but rather just suggesting that currently the risk/reward for adding additional equity risk is not optimal. A consolidation of price would also resolve the overbought conditions.
  • Be patient for a correction back to support that allows for a better entry point for trading positions.

Weekly

  • On a weekly basis, the market backdrop remains bullish with a weekly buy signal still intact.
  • However, that buy signal is extremely extended and has started to reverse with the market extremely overbought on a weekly basis.
  • This is an ideal setup for a bigger correction so some caution is advised.
  • With the market trading above 2-standard deviations, and testing the third, of the intermediate term moving average, some caution is suggested in adding additional exposure. A correction is likely over the next month which will provide a better opportunity. Remain patient for now.

Monthly

  • On a monthly basis we can see a pattern emerging as well as extremes.
  • First, from an investment standpoint, look at the previous two bull market advances compared to the current Central Bank fueled explosion. When the next mean reverting event occurs, make no mistake, it will be brutal for investors.
  • Secondly, the market is trading MORE THAN 2-standard deviations above the long-term mean and is still flirting with reversing the “buy signal” to a sell.
  • As noted in the red lines, the market continues to trade in a bullish trend from the 2009 lows, but with the market pushing back up into more extreme overbought conditions long-term, there is not likely a lot left to the current bull market.
  • Importantly, MONTHLY data is ONLY valid at the end of the month. Therefore, these indicators are VERY SLOW to turn. Use the Daily and Weekly charts to manage your risk. The monthly and quarterly chart (below) is to give you some idea about overall risk management.
  • However, the important takeaway is that the bull market is still largely intact but there is some deterioration around the edges. This suggests that investors should remain invested for now, but maintain risk controls accordingly.
  • All good things do eventually come to an end.

Quarterly

  • As noted above, this chart is not about short-term trading but long-term management of risks in portfolios. This is a quarterly chart of the market going back to 1920.
  • Note the market has, only on a few rare occasions, been as overbought as it is currently. The recent advance has pushed the market into 3-standard deviations above the 3-year moving average. In every single case the reversion was not kind to investors.
  • Secondly, in the bottom panel, the market has never been this overbought and extended in history.
  • As an investor it is important to keep some perspective about where we are in the current cycle, there is every bit of evidence that a major mean reverting event will occur. Timing is always the issue which is why use daily and weekly measures to manage risk.
  • Don’t get lost in the mainstream media. This is a very important chart.

S&P 500 vs Yield Curve (10yr-2yr)

  • The chart above compares the S&P 500 to the 10-2 year yield spread.
  • The relationship between stocks and bonds is the visualization of the “risk/reward” trade off.
  • When investors are exceedingly bullish, money flows out of “safe” assets, i.e. bonds, into “risk” assets, i.e. stocks.
  • What the chart shows is that when the yield-spread reverses, which is normally coincident with the onset of a recession, such tends to mark peaks of markets and ensuing corrections in stock prices.
  • While the recent spike of the ratio has not resulted in a correction just yet, it doesn’t mean it won’t.
  • Pay attention, all of the market indicators currently suggest risk outweighs rewards and patience will likely be rewarded with a better opportunity to add exposure.
  • As with the Monthly and Quarterly charts above, this is a “warning” sign to pay attention and manage risk accordingly. It does NOT mean sell everything and go to cash. Currently the Daily and Weekly charts suggest the bullish trend is intact, so we remain invested, but hedged.

Falling Oil Prices An Economic Warning Sign

On Tuesday morning, I got engaged in a debate on the recent decline in oil prices following my report on COT Positioning in the space. To wit:

“The inherent problem with this is that if crude oil breaks below $48/bbl, those long contracts will start to get liquidated which will likely push oil back into the low 40’s very quickly. The decline in oil is both deflationary and increases the risk of an economic recession.”

It didn’t take long before the debate started.

“Aren’t low oil prices good for the economy? They are a tax cut for the consumer?”

There is an old axiom which states that if you repeat a falsehood long enough, it will eventually be accepted as fact.

Low oil prices equating to stronger economic growth is one of those falsehoods.

Oil prices are indeed crucial to the overall economic equation, and there is a correlation between the oil prices, inflation, and interest rates.

Given that oil is consumed in virtually every aspect of our lives, from the food we eat to the products and services we buy, the demand side of the equation is a tell-tale sign of economic strength or weakness. We can see this clearly in the chart below which combines rates, inflation, and GDP into one composite indicator. One important note is that oil tends to trade along pretty defined trends (black trend lines) until it doesn’t. Importantly, since the oil industry is very manufacturing and production intensive, breaks of price trends tend to be liquidation events which has a negative impact on manufacturing and CapEx spending and feeds into the GDP calculation.

“It should not be surprising that sharp declines in oil prices have been coincident with downturns in economic activity, a drop in inflation, and a subsequent decline in interest rates.

We can also view the impact of oil prices on inflation by looking at breakeven inflation rates as well.

The short version is that oil prices are a reflection of supply and demand. Global demand has already been falling for the last several months, and oil prices are sending warnings that “market hopes” for a “global reflation” are likely not a reality. More importantly, falling oil prices are going to put the Fed in a very tough position in the next couple of months as deflationary pressures rise. The chart below shows breakeven 5-year and 10-year inflation rates versus oil prices.

Zero Sum

The argument that lower oil prices give consumers more money to spend certainly seems entirely logical. Since we know that roughly 80% of households in America effectively live paycheck-to-paycheck, they will spend, rather than save, any extra disposable income.

However, here is the most important part of the fallacy:

“Spending in the economy is a ZERO-SUM game.”

Falling oil prices are an excellent example since gasoline sales are part of the retail sales calculation.

Let’s take a look at the following example:

  • Oil Prices Decline By $10 Per Barrel
  • Gasoline Prices Fall By $1.00 Per Gallon
  • Consumer Fills Up A 16 Gallon Tank Saving $16 (+16)
  • Gas Station Revenue Falls By $16 For The Transaction (-16)
  • End Economic Result = $0

Now, the argument is that the $16 saved by the consumer will be spent elsewhere, which is true. However, this is the equivalent of “rearranging deck chairs on the Titanic.”

So, let’s now extend our example from above.

Oil and gasoline prices have dropped, so Elaine, who has budgeted $100 to spend each week on retail-related purchases, goes to the gas station to fill up.

  • Elaine fills up her car for $60, which previously cost $80. (Savings +$20)
  • Elaine then spends her normal $20 on lunch with her friends. 
  • She then spends her additional $20 (saved from her gas bill) on some flowers for the dining room.

————————————————-
Total Spending For The Week = $100

Now, economists quickly jump on the idea that because she spent $20 on flowers, there has been an additional boost to the economy.

However, this is not the case. Elaine may have spent her money differently this past week, but she still spent the same amount. Here is the net effect on the economy.

Gasoline Station Revenue = (-$20)
Flower Store Revenue = +$20
—————————————————-
Net Effect To Economy = $0

Graphically, we can show this by analyzing real (inflation-adjusted) gasoline prices compared to total Personal Consumption Expenditures (PCE). I am using “PCE” as it is the broadest measure of consumer spending and comprises almost 70% of the entire GDP calculation.

As shown, falling gasoline prices have historically equated to lower personal consumption expenditures, and not vice-versa. In fact higher oil and gasoline prices have actually been coincident with higher rates of PCE previously. The chart below show inflation-adjusted oil prices as compared to PCE.

While the argument that declines in energy and gasoline prices should lead to stronger consumption sounds logical, the data suggests this is not the case.

What we find is there is a parity between oil price and the economy. Like “Goldilocks,” prices which are too hot, or too cold, has a negative impact on consumption and economic growth.

Importantly, regardless of the level of oil prices, the only thing which increases consumer spending are increases in INCOME, not SAVINGS. Consumers only have a finite amount of money to spend. They can choose to “save more” which is a drag on economic growth in the short-term (called the “paradox of thrift”), or they can spend what they have. But they can’t spend more, unless they take on more debt. 

Which is what has been occurring as individuals struggle to fill the gap between the cost of living and incomes. (Read more on this chart)

A Bigger Drag Than The Savings

Importantly, falling oil prices are a bigger drag on economic growth than the incremental “savings” received by the consumer.

The obvious ramification of the plunge in oil prices is to the energy sector itself. As oil prices decline, the loss of revenue eventually leads to cuts in production, declines in capital expenditure plans (which comprises almost 1/4th of all CapEx expenditures in the S&P 500), freezes and/or reductions in employment, not to mention the declines in revenue and profitability.

Let’s walk through the impact of lower oil prices on the economy.

Declining oil prices lead to declining revenue for oil and gas companies. Given that drilling for oil is a very capital intensive process requiring a lot of manufactured goods, equipment, supplies, transportation, and support, the decrease in prices leads to a reduction in activity as represented by Capital Expenditures (CapEx.) The chart below shows the 6-month average of the 6-month rate of change in oil prices as compared to CapEx spending in the economy.

Of course, once CapEx is reduced the need for employment declines. However, since drilling for oil is a very intensive process, losses in employment may start with the energy companies, but eventually, all of the downstream suppliers are impacted by slower activity. As job losses rise, and incomes decline, it filters into the economy.

Importantly, when it comes to employment, the majority of the jobs “created” since the financial crisis has been lower wage-paying jobs in retail, healthcare and other service sectors of the economy. Conversely, the jobs created within the energy space are some of the highest wage paying opportunities available in engineering, technology, accounting, legal, etc.

In fact, each job created in energy-related areas has had a “ripple effect” of creating 2.8 jobs elsewhere in the economy from piping to coatings, trucking and transportation, restaurants and retail.

Given that oil prices are a reflection of global economic demand, falling oil prices have a negative feedback loop in the economy as a whole. The longer oil prices remain suppressed, the negative impacts of loss of employment, reductions in capital expenditures, and declines in corporate profitability will begin to outstrip any small economic benefit gained through consumption.

Simply put, lower oil and gasoline prices may actually have a bigger detraction on the economy than the “savings” provided to consumers.

Newton’s third law of motion states:

“For every action, there is an equal and opposite reaction.”

In any economy, nothing works in isolation. For every dollar increase that occurs in one part of the economy, there is a dollars’ worth of reduction somewhere else.

Selected Portfolio Position Review: 02-12-2020

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

With this basic tutorial, we will now review some of positions in our Equity Portfolio which are either a concern, an opportunity, or are doing something interesting.

ABT – Abbott Laboratories

  • We bought ABT in early 2019, and have taken profits twice along the way.
  • ABT has been on a deep “sell signal” for a while and has now reversed that signal maintaining a fairly tight consolidation range over the last 7-months.
  • We are maintaining our current stop level, and will look to add to our holding on a pullback to 82.50.
  • Stop is set at $77.50

JNJ – Johnson & Johnson

  • We bought JNJ when it was out of favor with the market over their “talc” lawsuit issues.
  • With the bulk of the those issues behind them, the stock has rebounded sharply. We took profits in the position as it is now EXTREMELY overbought and more than 2-standard deviations above the 200-dma.
  • We are moving our stop up to $135

AGNC – Agency Mortgage REIT

  • We bought 2 positions to benefit from a steepening of the 10-2 yield curve which came to pass and has now begun to invert again. However, our “steepner play” continues to rise.
  • Since we were at full weight in AGNC, and only 1/2 weight in NLY, we took profits in AGNC and reduced the position as it remains grossly extended and deviated from its long-term mean.
  • The buy signal is also extremely extended as well.
  • We are moving our stop up to $15.25

AMZN – Amazon.com, Inc.

  • We bought AMZN in 2019 heading into the winter shopping season. It did nothing for quite some time but in just the last couple of weeks, it has exploded higher.
  • The buy signal is now getting extended and AMZN is now 4-standard deviations above the long-term mean. This is not sustainable. We will likely take profits out of this position if we see weakness in the broader market begin to exert itself.
  • Stop is moved up to $1800.

AEP – American Electric Power Co.

  • AEP has remained a strong performer for us, and we like Utilities into 2020.
  • AEP has triggered a buy signal which got extremely extended very quickly with the sharp spurt higher over the last few weeks.
  • At 3-standard deviations above the longer-term mean we will have to wait for a correction or consolidation to add further exposure.
  • Stop is set at $90

IAU – Gold

  • We sold 1/2 of IAU near the peak in gold prices (as it was 2-standard deviations above the 200-dma) to bring in profits and protect our position. When then added back to IAU in early December.
  • IAU has broken out to new highs and while overbought on a short-term basis it has now registered a buy signal.
  • If we get some more consolidation or a bit of correction that holds support, we will look to overweight our position.
  • Stop is moved up to $14.

DOV – Dover Corp.

  • DOV has been a great performer for the portfolio particularly as the “trade war” has gotten resolved.
  • DOV is exceedingly overbought and the buy signal extremely extended. A correction is inevitable.
  • We have taken profits previously, but we are monitoring the position for an opportunity to reweight the position in the portfolio.
  • Stop loss moved up to $102.50

MU – Micron Technology

  • MU was an add for us in 2019. We had owned it previously but got stopped out, however, our second entry has performed much better.
  • MU is now exceedingly overbought with an extended buy signal
  • We took some profits and rebalanced our risk in the position. We will look for a pullback in the next month or two to add back to our exposure if needed.
  • Stop-loss moved up to $46

UNH – United Healthcare

  • UNH has surged higher in recent months after struggling with “Medicare for all” from Democratic candidates last year.
  • We love this position and will continue to hold it, however, the position is SO extremely extended we reduced our overweight holding to portfolio weight.
  • We did add UNH to our Dynamic model and will look to increase our weight in the Equity model on a bit more consolidation.
  • Stop loss moved up to $250

UTX – United Technology

  • UTX shot higher as conflict rose with Iran.
  • UTX, like many other of our positions, is now extremely overbought and extended above the 200-dma.
  • We reduced our position slightly and took in some profits but are looking to add back to UTX at a lower price.
  • Stop loss is moved up to 137.50

Why “Not-QE” is QE: Deciphering Gibberish

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

Imagine if Federal Reserve (Fed) Chairman Jerome Powell told the American people they must pay more for the goods and services they consume.

How long would it take for mobs with pitchforks to surround the Mariner Eccles building?  However, Jerome Powell and every other member of the Fed routinely and consistently convey pro-inflationary ideals, and there is nary a protest, which seems odd. The reason for the American public’s complacency is that the Fed is not that direct and relies on carefully crafted language and euphemisms to describe the desire for higher inflation.

To wit, the following statements from past and present Fed officials make it all but clear they want more inflation:  

  • That is why it is essential that we at the Fed use our tools to make sure that we do not permit an unhealthy downward drift in inflation expectations and inflation,” – Jerome Powell November 2019
  • In order to move rates up, I would want to see inflation that’s persistent and that’s significant,” -Jerome Powell December 2019
  • Been very challenging to get inflation back to 2% target” -Jerome Powell December 2019
  • Ms. Yellen also said that continuing low inflation, regarded as a boon by many, could be “dangerous” – FT – November 2017
  • One way to increase the scope for monetary policy is to retain the Fed’s current focus on hitting a targeted value of inflation, but to raise the target to, say, 3 or 4 percent.” –Ben Bernanke October 2017
  • Further weakness in inflation could prompt the U.S. Federal Reserve to cut interest rates, even if economic growth maintains its momentum”  -James Bullard, President of the Federal Reserve Bank of St. Louis  May 2019
  • Fed Evans Says Low Inflation Readings Elevating His Concerns” -Bloomberg May 2019
  • “I believe an aggressive policy action such as this is required to re-anchor inflation expectations at our target.”  Neel Kashkari, President Minneapolis Fed June 2019

As an aside, it cannot be overemphasized the policies touted in the quotes above actually result in deflation, an outcome the Fed desperately fears.

The Fed, and all central banks for that matter, have a long history of using confusing economic terminology. Economics is not as complicated as the Fed makes it seem. What does make economics hard to grasp is the technical language and numerous contradictions the Fed uses to explain economics and justify unorthodox monetary policy. It is made even more difficult when the Fed’s supporting cast – the media, Wall Street and other Fed apologists – regurgitate the Fed’s gibberish.   

The Fed’s fourth installment of quantitative easing (“QE4”, also known as “Not-QE QE”) is vehemently denied as QE by the Fed and Fed apologists. These denials, specifically a recent article in the Financial Times (FT), provide us yet another opportunity to show how the Fed and its minions so blatantly deceive the public.

What is QE?

QE is a transaction in which the Fed purchases assets, mainly U.S. Treasury securities and mortgage-backed-securities, via their network of primary dealers. In exchange for the assets, the Fed credits the participating dealers’ reserve account at the Fed, which is a fancy word for a place for dormant money. In this transaction, each dealer receives payment for the assets sold to the Fed in an account that is essentially the equivalent of a depository account with the Fed. Via QE, the Fed has created reserves that sit in accounts maintained by it.

Reserves are the amount of funds required by the Fed to be held by banks (which we are using interchangeably with “primary dealer” for the remainder of this discussion) in their Fed account or in vault cash to back up a percentage of specified deposit liabilities. While QE is not directly money printing, it enables banks to create loans at a multiple of approximately ten times the reserves available, if they so choose.

Notice that “Quantitative Easing” is the preferred terminology for the operations that create additional reserves, not something easier to understand and more direct like money/reserve printing, Fed bond buying program, or liquidity injections. Consider the two words used to describe this policy – Quantitative and Easing. Easing is an accurate descriptor of the Fed’s actions as it refers to an action that makes financial conditions easier, e.g., lower interest rates and more money/liquidity. However, what does quantitative mean? From the Oxford Dictionary, “quantitative” is “relating to, measuring, or measured by the quantity of something rather than its quality.”   

So, QE is a measure of the amount of easing in the economy. Does that make sense to you? Would the public be so complacent if QE were called BBMPO (bond buying and money printing operations)? Of course not. The public’s acceptance of QE without much thought is a victory for the Fed marketing and public relations departments.

Is “Not-QE” QE?

The Fed and media are vehemently defending the latest round of repurchase market (“repo”) operations and T-bill purchases as “not QE.” Before the Fed even implemented these new measures, Jerome Powell was quick to qualify their actions accordingly: “My colleagues and I will soon announce measures to add to the supply of reserves over time,” “This is not QE.”

This new round of easing is QE, QE4, to be specific. We dissect a recent article from the FT to debunk the nonsense commonly used to differentiate these recent actions from QE.  

On February 5th, 2020, Dominic White, an economist with a research firm in London, wrote an article published by the FT entitled The Fed is not doing QE. Here’s why that matters.

The article presents three factors that must be present for an action to qualify as QE, and then it rationalizes why recent Fed operations are something else. Here are the requirements, per the article:

  1. “increasing the volume of reserves in the banking system”
  2. “altering the mix of assets held by investors”
  3. “influence investors’ expectations about monetary policy”

Simply:

  1.  providing banks the ability to make more money
  2.  forcing investors to take more risk and thereby push asset prices higher
  3.  steer expectations about future Fed policy. 

Point 1

In the article, White argues “that the US banking system has not multiplied up the Fed’s injection of reserves.”

That is an objectively false statement. Since September 2019, when repo and Treasury bill purchase operations started, the assets on the Fed’s balance sheet have increased by approximately $397 billion. Since they didn’t pay for those assets with cash, wampum, bitcoin, or physical currency, we know that $397 billion in additional reserves have been created. We also know that excess reserves, those reserves held above the minimum and therefore not required to backstop specified deposit liabilities, have increased by only $124 billion since September 2019. That means $273 billion (397-124) in reserves were employed (“multiplied up”) by banks to support loan growth.

Regardless of whether these reserves were used to back loans to individuals, corporations, hedge funds, or the U.S. government, banks increased the amount of debt outstanding and therefore the supply of money. In the first half of 2019, the M2 money supply rose at a 4.0% to 4.5% annualized rate. Since September, M2 has grown at a 7% annualized rate.  

Point 2

White’s second argument against the recent Fed action’s qualifying as QE is that, because the Fed is buying Treasury Bills and offering short term repo for this round of operations, they are not removing riskier assets like longer term Treasury notes and mortgage-backed securities from the market. As such, they are not causing investors to replace safe investments with riskier ones.  Ergo, not QE.

This too is false. Although by purchasing T-bills and offering repo the Fed has focused on the part of the bond market with little to no price risk, the Fed has removed a vast amount of assets in a short period. Out of necessity, investors need to replace those assets with other assets. There are now fewer non-risky assets available due to the Fed’s actions, thus replacement assets in aggregate must be riskier than those they replace.

Additionally, the Fed is offering repo funding to the market.  Repo is largely used by banks, hedge funds, and other investors to deploy leverage when buying financial assets. By cheapening the cost of this funding source and making it more readily available, institutional investors are incented to expand their use of leverage. As we know, this alters the pricing of all assets, be they stocks, bonds, or commodities.

By way of example, we know that two large mortgage REITs, AGNC and NLY, have dramatically increased the leverage they utilize to acquire mortgage related assets over the last few months. They fund and lever their portfolios in part with repo.

Point 3

White’s third point states, “the Fed is not using its balance sheet to guide expectations for interest rates.”

Again, patently false. One would have to be dangerously naïve to subscribe to White’s logic. As described below, recent measures by the Fed are gargantuan relative to steps they had taken over the prior 50 years. Are we to believe that more money, more leverage, and fewer assets in the fixed income universe is anything other than a signal that the Fed wants lower interest rates? Is the Fed taking these steps for more altruistic reasons?

Bad Advice

After pulling the wool over his reader’s eyes, the author of the FT article ends with a little advice to investors: Rather than obsessing about fluctuations in the size of the Fed’s balance sheet, then, investors might be better off focusing on those things that have changed more fundamentally in recent months.”

After a riddled and generally incoherent explanation about why QE is not QE, White has the chutzpah to follow up with advice to disregard the actions of the world’s largest central bank and the crisis-type operations they are conducting. QE 4 and repo operations were a sudden and major reversal of policy. On a relative basis using a 6-month rate of change, it was the third largest liquidity injection to the U.S. financial system, exceeded only by actions taken following the 9/11 terror attacks and the 2008 financial crisis. As shown below, using a 12-month rate of change, recent Fed actions constitute the single biggest liquidity injection in 50 years of data.

Are we to believe that the latest round of Fed policy is not worth following? In what is the biggest “tell” that White is not qualified on this topic, every investment manager knows that money moves the markets and changes in liquidity, especially those driven by the central banks, are critically important to follow.

The graph below compares prior balance sheet actions to the latest round.

Data Courtesy St. Louis Federal Reserve

This next graph is a not so subtle reminder that the current use of repo is simply unprecedented.

Data Courtesy St. Louis Federal Reserve

Summary

This is a rebuttal to the FT article and comments from the Fed, others on Wall Street and those employed by the financial media. The wrong-headed views in the FT article largely parrot those of Ben Bernanke. This past January he stated the following:

“Quantitative easing works through two principal channels: by reducing the net supply of longer-term assets, which increases their prices and lower their yields; and by signaling policymakers’ intention to keep short rates low for an extended period. Both channels helped ease financial conditions in the post-crisis era.”   -LINK

Bourbon, tequila, and beer offer drinkers’ very different flavors of alcohol, but they all have the same effect. This round of QE may be a slightly different cocktail of policy action, but it is just as potent as QE 1, 2, and 3 and will equally intoxicate the market as much, if not more.

Keep in mind that QE 1, 2, and 3 were described as emergency policy actions designed to foster recovery from an economic crisis. Might that fact be the rationale for claiming this round of liquidity is far different from prior ones? Altering words to describe clear emergency policy actions is a calculated effort to normalize those actions. Normalizing them gives the Fed greater latitude to use them at will, which appears to be the true objective. Pathetic though it may be, it is the only rationale that helps us understand their obfuscation.

Sector Buy/Sell Review: 02-11-20

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

Basic Materials

  • XLB rallied back into resistance on Friday and failed on Monday once again. There is the beginning of downtrend channel forming which needs to be reversed if Materials are going to rally further. However, the risk of the virus to the global supply chain makes Materials tricky.
  • The sector has gotten back to short-term overbought, but a sell signal is close to being triggered.
  • We currently hold 1/2 a position and until we get a better handle on the “coronavirus” impact we are going to maintain a reduced exposure for now.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions with a tighter stop-loss.
    • This Week: Hold current positions with a tighter stop-loss.
    • Stop-loss moved back to $57 to allow for entry.
  • Long-Term Positioning: Neutral

Communications

  • We previously reduced our allocations slightly to the sector due to the rather extreme extension. The recent correction, and reversal, were not enough to allow us a decent entry point to add back to our holdings.
  • With a “buy signal” in place, but extended, there is more correction likely. This is particularly the case since XLC has not reversed its extreme overbought condition as of yet. XLC must hold support at $50.
  • XLC is currently 2/3rds weight in our portfolios.
  • Short-Term Positioning: Bullish
    • Last Week: Reduced weighting in portfolio.
    • This Week: Hold positions.
    • Stop adjusted to $50
  • Long-Term Positioning: Neutral

Energy

  • Energy has failed at all levels.
  • We have been trying to add XLE to our portfolios but XLE broke back below the 200-dma, the downtrend line, and now sits at the last level of support and the stop level.
  • With the buy signal close to reversing, but with the sector very oversold. a short-term bounce is likely. Use that bounce to sell into for now.
  • We had noted previously, we were remaining cautious as rallies had repeatedly failed in the past. And, as expected, it happened again.
  • Short-Term Positioning: Bearish
    • Last week: Hold positions
    • This week: Sell into rally.
    • No position currently
  • Long-Term Positioning: Bearish

Financials

  • As noted previously, XLF was extremely extended above the 200-dma which put the sector at risk of a more severe correction.
  • The buy signal is correcting but remains a bit extended along but the sector is now approaching oversold.
  • XLF succesfully tested the bullish trend line, which give us an opportunity to add 1/2 position to our portfolio.
  • Short-Term Positioning: Bullish
    • Last week: Hold for now.
    • This week: Added 1/2 Position.
    • Stop-loss adjusted to $28
  • Long-Term Positioning: Neutral

Industrials

  • XLI remains exceedingly overbought short-term and the “buy signal” remains very extended as well. No rush chasing the sector currently. Also, there is a good risk the “coronavirus” will have a direct impact on the global supply chains of industrial companies.
  • We are holding reduced position weightings until we can assess the impact of the virus on the sector.
  • We have adjusted our stop-loss for the remaining position.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position.
    • Stop-loss adjusted to $77
  • Long-Term Positioning: Neutral

Technology

  • XLK had only a SLIGHT correction and rocketed off to nearly 4-standard deviations above the 200-dma. Currently, just 5-stocks make up 20% of the index which is what is driving the index higher.
  • We reduced our position in XLK from overweight to target portfolio weight due to the extreme extension and noted a correction is coming. That is still the case currently.
  • The bullish trend line is the first level of support XLK needs to hold while reversing the overbought condition. A failure at that support is going to bring the 200-dma into focus.
  • Be careful chasing the sector currently. Take profits and rebalance risks accordingly.
  • Short-Term Positioning: Bullish
    • Last week: Reduce Overweight to Target Weight
    • This week: Rebalance To Target Weights
    • Stop-loss adjusted to $80
    • Long-Term Positioning: Neutral

Staples

  • Defensive sectors continue to perform as interest rates have fallen as money is rotating to risk-off positioning despite the drive of the market higher.
  • XLP continues to hold its very strong uptrend and remains close to all-time highs.
  • XLP is back to more extreme overbought and extended above the 200-dma, however, the “buy signal” has been registered. Look for pullbacks to support to add weight to portfolios. Maintain a stop at the 200-dma.
  • We previously took profits in XLP and reduced our weighting from overweight.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $59
    • Long-Term Positioning: Bullish

Real Estate

  • Last week we noted that XLRE had broken out back to new highs. We took profits recently, and reduced our risk a bit in the position as interest rates are extremely overbought.
  • With XLRE very extended short-term, we previously suggested looking for a short-term reversal in interest rates to create an entry point. That has not occurred as of yet, so patience is needed to add exposure accordingly.
  • We had previously noted that while we are holding our long-position, trading positions could be added to portfolios. Hold off adding any new positions currently and wait for this correction to complete.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Took profits and reduced weighting slightly.
    • Stop-loss adjusted to $37.00 for profits.
  • Long-Term Positioning: Bullish

Utilities

  • XLU, like XLRE, is benefiting from the decline in interest rates. XLU is extremely extended above the 200-dma, and the “buy signal” is now extremely extended as well.
  • We took profits in our holdings and will wait for a correction back to support to bring our holdings back to overweight. Such will give us a much better risk/reward entry.
  • The long-term trend line remains intact.
  • We are currently at 2/3rds weight.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Took profits and reduced weight slightly.
    • Stop-loss adjusted to support at $64.00
  • Long-Term Positioning: Bullish

Health Care

  • XLV has remained intact and has rallied after a brief correction which we used to add to our current holdings.
  • The move in Healthcare has started to consolidate and the overextended buy signal has begun to correct. We will look to add to our holdings if support holds and more of the overbought condition is reduced.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions
    • This week: Brought holdings back to target weightings.
    • Stop-loss adjusted to $94
  • Long-Term Positioning: Bullish

Discretionary

  • XLY, due to the impact of AMZN, has pushed into rather extreme extensions from the 200-dma.
  • We took profits last week and reduced the position slightly.
  • Hold current positions for now, New positions can be added on a pullback to the breakout level that holds and works off the overbought condition.
  • A “buy signal” has been triggered which gives the sector support.
  • Short-Term Positioning: Neutral
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $120.
  • Long-Term Positioning: Neutral

Transportation

  • XTN held its previous breakout level and is consolidating at recent levels.
  • We remain out of the economically sensitive sector currently particularly due to the impact of the “coronavirus” which will likely have global supply chain impacts.
  • The sector is moving back towards overbought territory short-term but is working off the extended buy signal. Hold adding new positions for the moment, we will likely see another pullback shortly to buy into if needed.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: COT Positioning – Risk Of Correction Still High (Q1-2020)

As discussed in this past weekend’s newsletter, the market remains overly extended as the recent correction sharply reversed on expectations for more Fed liquidity. However, with the market extremely deviated from the long-term moving average, a correction is once again a high probability event. 

“Previously, we discussed that we had taken profits out of portfolios as we were expecting between a 3-5% correction to allow for a better entry point to add equity exposure. While the “virus correction” did encompass a correction of 3%, it was too shallow to reverse the rather extreme extension of the market. The rally this past week has reversed the corrective process, and returned the markets to 3-standard deviations above the 200-dma. Furthermore, all daily, weekly, and monthly conditions have returned to more extreme overbought levels as well.”

But it isn’t just the more extreme advance of the market over the past 5-weeks which has us a bit concerned in the short-term, but a series of other indications which typically suggest short- to intermediate-terms corrections in the market.

Furthermore, the markets are completely entirely the impact the “coronavirus” will have on the supply-chain globally. As David Rosenberg noted Monday:

“The impact of this virus is lasting longer and the effects, relative to SARS, are larger at a time when the Chinese economy is far softer. The follow-on effects on other markets has yet to be fully appreciated.”

Had the markets completed a correction that reduced the extreme overbought and extended conditions of the market, such would have offset the risk of the “viral impact” to the economy. However, without that correction, the eventual slowdown will likely have a great impact than is currently anticipated. 

However, even if we set aside investor sentiment and positioning for a moment, the rapid reversion is price has sent our technical composite overbought/oversold gauge back towards more extreme levels of overbought conditions. (Get this chart every week at RIAPRO.NET)

What we know is that markets move based on sentiment and positioning. This makes sense considering that prices are affected by the actions of both buyers and sellers at any given time. Most importantly, when prices, or positioning, becomes too “one-sided,” a reversion always occurs. As Bob Farrell’s Rule #9 states:

“When all experts agree, something else is bound to happen.” 

So, how are traders positioning themselves currently? 

Positioning Review

The COT (Commitment Of Traders) data, which is exceptionally important, is the sole source of the actual holdings of the three key commodity-trading groups, namely:

  • Commercial Traders: this group consists of traders that use futures contracts for hedging purposes and whose positions exceed the reporting levels of the CFTC. These traders are usually involved with the production and/or processing of the underlying commodity.
  • Non-Commercial Traders: this group consists of traders that don’t use futures contracts for hedging and whose positions exceed the CFTC reporting levels. They are typically large traders such as clearinghouses, futures commission merchants, foreign brokers, etc.
  • Small Traders: the positions of these traders do not exceed the CFTC reporting levels, and as the name implies, these are usually small traders.

The data we are interested in is the second group of Non-Commercial Traders.

This is the group that speculates on where they believe the market is headed. While you would expect these individuals to be “smarter” than retail investors, we find they are just as subject to “human fallacy” and “herd mentality” as everyone else.

Therefore, as shown in the series of charts below, we can take a look at their current net positioning (long contracts minus short contracts) to gauge excessive bullishness or bearishness. 

Volatility 

The extreme net-short positioning on the volatility before to the correction last week, had suggested the correction was coming. However, while the correction reduced the net-short positioning somewhat, it remains at historical extremes. What the more extreme positioning tells us is there is plenty of “fuel” to drive a correction when one occurs.

Investors have gotten used to extremely low levels of volatility, which is unique to this market cycle. This complacency, due to low volatility, has encouraged investors to take on greater levels of risk than they currently realize. When volatility eventually makes it return, the consequences to investors will not be kind.

Crude Oil Extreme

The recent attempt by crude oil to get back above the 200-dma coincided with the Fed’s initiation of QE-4. Historically, these liquidity programs tend to benefit highly speculative positions like commodities, as liquidity seeks the highest rate of return. 

However, beginning in December, that support for oil prices gave way, and prices have collapsed along with expectations for global economic recovery. We have been warning our RIAPro Subcribers (30-Day Risk Free Trial) for the last couple of months about the potential for this decline.

  • As noted previously, “Oil completely broke down last week, and collapsed below all of the important levels. Oil is now testing critical support at $51. A failure there and a break into the low $40’s is probable.”
  • The support is barely holding and oil looks extremely weak. However, oil is extremely oversold so a counter-trend rally is highly likely and can be used to “sell” into.
  • Stops Triggered for any direct crude oil positions.
  • Long-Term Positioning: Bearish

Despite the decline in oil prices over the last year, it is worth noting that crude oil positioning is still on the bullish side with 397,000 net long contracts. 

The inherent problem with this is that if crude oil breaks below $48/bbl, those long contracts will start to get liquidated which will likely push oil back into the low 40’s very quickly. The decline in oil is both deflationary and increases the risk of an economic recession.

U.S. Dollar Extreme

Another index we track each week at RIAPRO.NET is the U.S. Dollar.

  • As noted previously: “The dollar has rallied back to that all-important previous support line. IF the dollar can break back above that level, and hold, then commodities, and oil, will likely struggle.
  • That is exactly what happened over the last two weeks. The dollar has strengthened that rally as concerns over the “coronavirus” persist. With the dollar close to testing previous highs, a break above that resistance could result in a sharp move higher for the dollar.
  • The rising dollar is not bullish for Oil, commodities or international exposures.
  • The “sell” signal has began to reverse. Pay attention.

Much of the bulls rallying cry has been based on the dollar weakening with the onset of QE, but as shown above, that has yet to be the case. However, it is worth noting that positioning in the US Dollar has been weakening. Historically, these reversals are markets of more important peaks in the market and subsequent corrections. 

It is also worth watching the net-short positioning the Euro-dollar as well. Historically, when positioning in the Eurodollar becomes NET-LONG, as it is currently, such has been associated with short- to intermediate corrections in the markets, including outright bear markets.

Net-long Eurodollar positioning has recently started to reverse from an all-time record. While the market hasn’t corrected as of yet, if foreign banks begin to extract dollar-denominated assets to a large degree, the risk to the market rises sharply. 

Interest Rate Extreme

One of the biggest conundrums for the financial market “experts” is why interest rates fail to rise. In March of last year, I wrote “The Bond Bull Market” which was a follow up to our earlier call for a sharp drop in rates as the economy slowed. That call was based on the extreme “net-short positioning” in bonds which suggested a counter-trend rally was likely.

Since then, rates fell back to some of the lowest levels in 10-years as economic growth continues to slow, both domestically and globally. Importantly, while the Federal Reserve turned back on the “liquidity pumps” last October, juicing markets to all-time highs, bonds have continued to attract money for “safety” over “risk.” 

Not surprisingly, despite much commentary to the contrary, the number of contracts “net-short” the 10-year Treasury remains at some of the highest historical readings.

Importantly, even while the “net-short” positioning on bonds has been reversed, rates have failed to rise correspondingly. The reason for this is due to the near-record levels of Eurodollar positioning, as noted above.

This suggests a high probability rates will fall further in the months ahead. This will most likely occur in concert with further deterioration in economic growth as the impact of the “coronavirus” is realized. 

Amazingly, investors seem to be residing in a world without any perceived risks and a strong belief that financial markets can only rise further. The arguments supporting those beliefs are based on comparisons to previous peak market cycles. Unfortunately, investors tend to be wrong at market peaks and bottoms.

The inherent problem with much of the mainstream analysis is that it assumes everything remains status quo. However, such never tends to be the case for long.  

“Oil prices down 20% is not a good thing, even if it means lower gasoline prices. This is swamped by the negative implications for capital spending and employment in the key oil-producing regions of the U.S. Copper prices have dropped 11% in just the past two weeks and just above a three-year low, and this is a global macro barometer. Money flowing into bond funds, the lagging performance in the high-yield market, the slump in commodity markets and the weakness, both relative and absolute, in the Russell 2000 small-cap index, surely cannot be making the economic growth bulls feeling too comfortable right now..” – David Rosenberg

We agree.

With retail positioning very long-biased, the implementation of QE4 has once again removed all “fears” of a correction, a recession, and a bear market, which existed just this past summer. Historically, such sentiment excesses form around short-term market peaks.

This is a excellent time to remind you of the other famous “Bob Farrell Rule” to remember: 

“#5 – The public buys the most at the top and the least at the bottom.”

What investors miss is that while a warning doesn’t immediately translate into a negative consequence, such doesn’t mean you should not pay attention to it.

It is akin to constantly running red lights and never getting into an accident. We begin to think we are skilled at running red lights, rather than just being lucky.

Eventually, your luck will run out.

Pay attention, have a plan, and act accordingly.