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Monthly Archives: November 2016

Michael Lebowitz and I have produced a number of charts that have generated a lot of questions, comments, and shares over the last year. We decided that each quarter we will begin producing a “chart book” of the “most important charts” from the last quarter for you to review.

We have provided the links in most cases back to the original articles as well for further clarification and context if needed. We hope you find them useful and insightful.

Time To Breakeven

While individuals are inundated with a plethora of opinions on why the index is moving up or down from one day to the next, a portfolio of dollars invested in the market is vastly different than the index itself. I have pointed out the problems of benchmarking previously stating:

  1. The index contains no cash
  2. It has no life expectancy requirements – but you do.
  3. It does not have to compensate for distributions to meet living requirements – but you do.
  4. It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
  5. It has no taxes, costs or other expenses associated with it – but you do.
  6. It has the ability to substitute at no penalty – but you don’t.
  7. It benefits from share buybacks – but you don’t.

Furthermore, it is also not representative what happens to real dollars invested in the financial markets which are impacted by changes in inflation. The chart below compares the breakeven times for the nominal index versus an inflation-adjusted index and $100,000 investment into the index.

You will notice in the $100,000 portfolio that investors, once the impact of inflation is added, just got back to even after 16-years of their investment time horizon was lost.

READ: The Big Lie Of Market Indexes

The Real Value Of Cash

As I discussed in the “Real Value Of Cash:” 

The chart below shows the inflation-adjusted return of $100 invested in the S&P 500 (capital appreciation only using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller’s CAPE ratio. However, I have capped the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets in the past. Lastly, I calculated a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves back to cash at a ratio of 23x.

I have adjusted the value of holding cash for the annual inflation rate which is why during the sharp rise in inflation in the 1970’s there is a downward slope in the value of cash. However, while the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset with respect to reinvestment may be different since asset prices are negatively impacted by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises.

READ: The 7-Myths Of Investing

Monetary Policy

Federal Reserve (Fed) stimulus comes in two forms as shown above. First in the form of targeting the Fed Funds interest rate at a rate below the nominal rate of economic growth (blue). Second, it stems from the large-scale asset purchases (Quantitative Easing -QE) by the Fed (orange). When these two metrics are quantified, it yields an estimate of the average amount of stimulus (red) applied during each post-recession period since 1980. It has been almost ten years since the 2008 financial crisis and the Fed has applied on average the equivalent of 5.25% of interest rate stimulus to the economy, dwarfing that of prior periods.

Valuations Matter

Yes, valuations matter, even for Millennials:

Over any 30-year period the beginning valuation levels, the price you pay for your investments has a spectacular impact on future returns. I have highlighted return levels at 7-12x earnings and 18-22x earnings. We will use the average of 10x and 20x earnings for our savings analysis.”

“As you will notice, 30-year forward returns are significantly higher on average when investing at 10x earnings as opposed to 20x earnings or where we are currently near 25x.

The point to be made here is simple and was precisely summed up by Warren Buffett:

‘Price is what you pay. Value is what you get.’” 

READ: Visualizing 10-Reasons For Caution

Demographic Trends Are A Problem

With respect to the demographic problem, it is a “one-two knock out punch” that will hit not only Social Security but also the country’s municipal and Federal pension systems. As I noted previously:

“One of the primary problems continues to be the decline in the ratio of workers per retiree as retirees are living longer (increasing the relative number of retirees), and lower birth rates (decreasing the relative number of workers.) However, this ‘support ratio’ is not only declining in the U.S. but also in much of the developed world. This is due to two demographic factors: increased life expectancy coupled with a fixed retirement age, and a decrease in the fertility rate.”

READ: The Insecurity Of Social Security

A Depression

Since the financial crisis of 2008, the annual increase in Federal debt has dwarfed the annual growth in GDP. Without the enormous increase in government borrowing and accompanying spending, averaging approximately $1 trillion a year since 2008, GDP would have been negative for the last nine years. The post-crisis trend marks a sharp departure from the years prior – an unprecedented “Great Depression.”

The Great Disconnect

Since Jan 1st of 2009, through the end of June, the stock market has risen by an astounding 130.51%. However, if we measure from the March 9, 2009 lows, the percentage gain explodes to more than 200%. With such a large gain in the financial markets we should see a commensurate indication of economic growth – right?

The reality is that after 3-massive Federal Reserve driven “Quantitative Easing” programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total more than $33 Trillion, the economy grew by just $2.64 Trillion, or a whopping 16.7% since the beginning of 2009. The ROI equates to $12.50 of interventions for every $1 of economic growth.

Not a very good bargain.

READ: The Great Disconnect: Markets & Economy

Can’t Afford It…Use Debt

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

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

READ: Consumer Credit & The American Conundrum

Fed Dependency

Equity market gains post-2008 have been highly correlated with QE. As the Fed embarks on balance sheet reduction, this correlation should be at the forefront of investors’ minds. The graph above plots the expected balance sheet reduction (gold) based on the Fed’s current plan as approved on September 2017. Will Trump tax cut “hopes” be enough to replace the dependency on the Fed?

Borrowing From The Future

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

READ: Everyone Is In The Pool

Who Pays Taxes

Given that roughly 2/3rds of income taxes are paid by the top 20%, the reality is that tax cuts will have their greatest impact in reducing the tax burden on those individuals.

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

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

READ: Bull Trap & The False Promise Of Tax Cuts

These are some of our favorite charts and we hope you find them useful and insightful. Please send us any comments, suggestions, or your favorite charts to us for consideration.

I was recently going through a new client’s portfolio and found it full of the likes of Coca-Cola, Kimberly-Clark and Campbell Soup — what I call (pseudo) bond substitutes. Each one is a stable and mature company. Your mother-in-law would be proud if you worked for any one of them. They have had a fabulous past; they’ve grown revenues and earnings for decades. They were in their glory days when most baby boomers were coming of age. But the days of growth are in the rearview mirror for these companies — their markets are mature, and the market share of competitors is high. They can innovate all day long, but consumers will not be drinking more fizzy liquids, wearing more diapers or eating more canned soup.

If you were to look at these companies’ financial statements, you’d be seriously under-impressed. They paint a stereotypical picture of corporate old age. Their revenues haven’t grown in years and in many cases have declined. Some of them were able to squeeze slightly higher earnings from stagnating revenue through cost-cutting, but that strategy has its limits — you can only squeeze so much water out of rocks (unless someone like 3G Capital takes the company, sells its fleet of corporate jets and starts mercilessly slashing expenses like the private equity firm did at Budweiser and Heinz). These businesses will be around ten years from now, but their profitability probably won’t be very different from its current level (not much higher, but probably not much lower either).

However, if you study the stock charts of these companies, you won’t see any signs of arthritis; not at all — you’ll have the impression that you’re looking at veritable spring chickens, as these stocks have gone vertical over the past few years. So this is what investors see — old roosters pretending to be spring chickens.

Let’s zoom in on Coke. Unlike the U.S. government, Coca-Cola doesn’t have a license to print money (nor does it have nuclear weapons). But it is a strong global brand, so investors are unconcerned about Coke’s financial viability and thus lend money to the company as though it were the U.S. government. (Coke pays a very small premium to Treasury bonds.) Investors ignore what they pay for Coke; they only focus on a singular, shiny object: its dividend yield, which at 3 percent looks like Gulliver in Lilliput (fixed-income) land.


Something Wicked This Way Comes: McDonalds – A Bear in a Bull Costume

And as investors do so, they are ignoring an inconvenient truth: They are paying a very pretty penny for this dividend. Coke is trading at 23 times earnings. This is not the first (nor will it be the last) time this has happened to Coke stock. Investors who bought Coke in 1998 were down 50 percent on their purchase ten years later and have not broken even for more than 15 years.

And this brings us to the problem with shiny objects: They don’t shine forever. Investors are paying 23 times earnings for a very mature business. Consumption of Coca-Cola’s iconic carbonated beverage is on the decline in health-conscious developed markets, and you can clearly see this in its income statement — sales and earnings have languished over the past decade.

Let’s say Coke does what it has not done over the previous decade and grows earnings 3 percent a year, despite the shift in consumer preferences away from sugar-powered and chemically engineered (diet) drinks. If at the end of this journey its price–earnings ratio settles to its more or less rightful place of 13 to 15 times, then jubilant Coke investors will have lost a few percentage points a year on Coke’s price decline. Thus the bulk of the dividend will have been wiped out by Coke’s P/E erosion.

Coca-Cola to some degree epitomizes the U.S. stock market. If over the next ten years, despite all the headwinds it faces, Coke is able to grow earnings at a faster pace than 3 percent and interest rates remain at current levels (so that the company’s P/E stays at the present “I want this 3 percent dividend at any cost” level), then its stock will provide a decent return. However, there is a lot of wishful thinking in this paragraph.

If interest rates rise and/or consumers’ tastes continue to shift from high-margin sugary drinks to low-margin (commodity) water, then Coke will be hit from both sides — its earnings will stall, and investors will take their eyes off its shiny dividend. Suddenly, they will see Coke for what it is: a 124-year-old arthritic American icon whose growth days are sadly behind it.

I am using Coke just to demonstrate the importance of differentiating between a good company (which Coke is) and a good stock (which it is not), and the danger of having an exclusive focus on a shiny object — dividends — when you are analyzing stocks.

At the end of his email blitz, which had loaded me up on data, Dougie sent me this summary:

At the root of my concern is that the Bull Market in Complacency has been stimulated by:

  • the excess liquidity provided by the world’s central bankers,
  • serving up a virtuous cycle of fund inflows into ever more popular ETFs (passive investors) that buy not when stocks are cheap but when inflows are readily flowing,
  • the dominance of risk parity and volatility trending, who worship at the altar of price momentum brought on by those ETFs (and are also agnostic to “value,” balance sheets,” income statements),
  • the reduced role of active investors like hedge funds – the slack is picked up by ETFs and Quant strategies,
  • creating an almost systemic “buy on the dip” mentality and conditioning.
  • When coupled with precarious positioning by speculators and market participants:
  • who have profited from shorting volatility and have gotten so one-sided (by shorting VIX and VXX futures) that any quick market sell off will likely be exacerbated, much like portfolio insurance’s role in a previous large drawdown,
  • which in turn will force leveraged risk parity portfolios to de-risk (and reducing the chance of fast turn back up in the markets),
  • and could lead to an end of the virtuous cycle – if ETFs start to sell, who is left to buy?” 

John Maudlin

The Bull Market in Complacency

The absence of market volatility and the rising probability that a flash crash may occur — a theme I steadfastly have endorsed in my Diary — were important elements of this weekend’s news flow. Indeed, these three articles are variations on the same theme:

For those who are of the view that potentially adverse market outcomes are unlikely when Barron’s or others like myself bring up the concerns, I have a message for you:

A small group of us vehemently expressed deep concerns over the risks of portfolio insurance in the summer of 1987 (which preceded a 21% market decline in October) and, more significantly, the possible contagion of packaging financial weapons of mass destruction (mortgage derivatives) in the summer of 2007 (which preceded The Great Recession of 2008-09).

Those threats were confidently ignored in 1987 and 2007 by the bullish cabal. After all, many had said, computers really can’t harm markets (1987) and home prices never can retreat (2007). Indeed, back then, market skeptics (like myself, Barry Ritholtz, Dr. Robert Shiller, Gary Shilling and Todd Harrison) were often laughed at publicly; they were called Cassandras, and worse.

Memories are short, and with the S&P 500 much higher many of these non-critical talking heads who dismissed the concerns of 30 years ago and 10 years ago are back self-confidently ushering in a new paradigm of uninterrupted economic growth with few accompanying market risks.

In A Flat, Networked and Interconnected World…

The only certainty is the lack of certainty, and the one thing I am certain of is that never in history have we faced so many potentially adverse political, geopolitical, economic, social and market outcomes.

From my pal, The Lindsey Group’s Peter Boockvar:

“There was also a new high in the net speculative short position in VIX futures for the week ended last Tuesday.”

Low-probability events do happen.

And risk is underpriced, perhaps materially so, in our interconnected world.

“If I have the cash should I pay my mortgage off early?”

That is a regular question we are asked.

While it might seem to be the simple answer of “yes,” such is not always the case. Like anything, when it comes to making decisions for an individual, or family, a plan and some sound advice is always beneficial when facing these tough decisions.

Since we can’t do a plan, here’s some advice.

Everyone’s scenario is different and I do mean everyone. You may be able to pay your mortgage off and still have millions in the bank. Maybe you have enough guaranteed income and additional savings that paying the house off earlier won’t cause you to skip a beat. Or maybe you need all additional liquidity, flexibility and income you can get.

Regardless of your scenario, I believe everyone can take something from these 7 considerations.

Let’s set the record straight. I’m not opposed to paying your home off early when given the right scenario. In fact, there are times that paying your home off early can provide great peace of mind. First, I would go through this exercise:

1) Have a sounding board- No, not your neighbor

This should be your advisor, CPA and/or attorney. If you were my client, I’d prefer it be me. We’d build a team of professionals or work with your existing accountants and attorneys. Your team should be constructed of a group of individuals that have your best interest at heart, a fiduciary is a good start.

The only reason it shouldn’t be your neighbor is they generally have a biased opinion based on what they did. For every one good piece of advice I’ve heard a client gleam from a neighbor there are 9 bad ones.

I’m sure your neighbor is a great guy, extremely smart and successful, but odds are they don’t know your full financial situation. It’s not that your neighbor isn’t smart or even that it’s bad advice, it’s just that it’s not good advice for you.

Gathering information from a number of people may be helpful for you to digest the magnitude of such a decision.  Remember to take that advice with a grain of salt and don’t get paralysis by analysis. Sometimes too many differing opinions can cause us to shut down or put decisions on the back burner.

Unfortunately, there are times we find out clients have paid their home off early after the fact.

For most, paying your home off early is more of an emotional decision than a planning decision. We need to reverse this aspect, just like when investing in markets we need to be as my partner Lance Roberts says “void of emotion.”

This is why it’s important to have someone on the outside looking in. Someone who has seen the triumphs, trials and tribulations of others, experiences that are sometimes priceless and can evaluate your scenario holistically.

2) How long do you plan to live in your home?

The amount of time you plan on living in your home could alter the decision to put your mortgage to bed.

Less than 5 years?

Keep your hard-earned cash on hand. Housing markets, like stock markets move in cycles. I’d hate to have to move and not have the necessary liquidity to put down on a new home or have to sell in a down or slow market.

5-15 years?

Maybe you pay it off? I end that last sentence with a question mark, because this time frame is a bit trickier.

If you find yourself in position to pay your home off early I would hope you could weather any recessionary period even after making that last home payment.

You must have enough in emergency funds and not pull from other assets that are designated to other goals. If you lost your job tomorrow could you still pay your bills and for how long?

This now becomes a best use of capital question. How much interest are you paying and how much can you earn in a relatively safe investment. In today’s environment taking advantage of lower borrowing rates doesn’t seem like such a bad idea.

This is your “forever home.”

Meaning you plan to stay there until you can no longer care for yourself. I really have a hard time with changing your liquid asset (cash) and turning it into a hard asset (your home.) As my partner, Richard Rosso calls it “turning water into ice” I think the analogy fits considering you’re taking your hard-earned cash and putting it into something that’s difficult to “chip” away at. Rule 6 can also play a role in this decision, sometimes when you need senior care you don’t have the luxury of funding it once your home sells.

There is always an exception to the rule, in this instance it’s if the money is going to burn a hole in your pocket. Pay it off, lower your expenses and at least you will have put the cash into something worthwhile, your home.

3) Tax Deductibility

Itemize your taxes? If you itemize many consider the interest tax deduction as the “end all be all” when considering paying off your home. The truth is the majority of people that are paying off their homes typically are in the last years of payments and have little interest to write off.

When considering the deduction of interest one must remember that it’s not 1 for 1. What do I mean by that? The deduction doesn’t reduce your tax burden 1 for 1, it reduces your adjusted gross income by the amount of deductible interest or overall deductions.

For example,

Your Adjusted Gross Income (AGI) is:      $100,000

Itemized Deductions are:    $15,000

Taxable Income:   $85,000

Yes, it does reduce your taxes. No, it’s not the reduction most think.

4) Best use of funds

What are the best use of funds? With current interest rates still near all-time lows, it would suit most to borrow money and use your cash in another way to get more bang for your buck. For most people leverage and credit is not your friend, however when used properly it’s a great tool.

Can you make more on your money investing semi conservatively? For instance, we can currently find investment grade bonds with a coupon of 5% with a 5-7 year duration, buying them at a bit of a premium you may see a 3-4% YTM return on your money.

The other argument is if you do pay your home off early and you’re in retirement the amount needed for expenses will decrease which will in turn decrease the amount you will need to pull from your investment accounts to live.

If you’re in the accumulation (working) mode paying off the home early would increase the amount you could put aside monthly.

Enter, the 5th consideration, liquidity.

5) Liquidity=Flexibility=Options

How much is liquidity worth to you? Having liquidity gives you options.

It’s likely you don’t fall into this category since you’re still reading and considering options. Congrats, you’re in an enviable situation to the majority of your peers. The liquidity you possess is powerful.

According to a Bankrate study 69% of Americans don’t have enough saved to meet 6 months of expenses.

When disaster strikes or opportunity knocks I don’t know about you, but I want cash in hand or liquid assets.

Natural disaster, take Hurricane Harvey and all the Houstonians (roughly 70-80%) without flood insurance.  There are some very tough decisions to be made by many, but in the end cash is certainly king.

Business opportunity or real estate deal you can’t pass up?

Need to move quickly, medical or family emergency or would just like to generate additional cash flow?

Cash flow is an important part of the equation. Can these funds generate some type of income for you and your family and you still retain a degree of flexibility? Go back to #4, best use of funds.

6) Do you have Disability or LTC Insurance?

While in your working years disability insurance is a must. If you use a substantial portion of your liquid assets to pay your home off it could be even more important.

How will you maintain the lifestyle your family is accustomed to if something were to happen such as a car accident or a health scare that kept you or your spouse from working for an extended period of time? A large part of financial planning is the risk management of protecting your family. Make sure you’re protecting your most precious asset.

Long term care insurance, do you, have it? Can you get it? Can you afford it without disrupting your cash flow? Do you need it? I could write a whole article on just these topics, but this should certainly be a consideration when paying off your home.

Remember, in your retirement years getting access to funds can be extremely important and when the funds are tied up in a home, access is limited and can take time.

If you do pay your home off early in retirement, having a home equity line of credit ready and available to use may mitigate some of that risk. I would also recommend having a Power of Attorney who can help in the event you’re incapacitated.

7) But my house has gone up so much in value!

For starters, if you have been in your home for any period of time I’d hope that to be the case. You’ve been socking money away in the form of your monthly payment year after year now add a little inflationary growth and I think you get my point.


Have you ever stopped to calculate how much you’ve actually put into your home in maintenance and improvements? And don’t forget to add those pesky property taxes and HOA fee’s.

Most find that after a similar exercise they come to realize that maybe their home isn’t the investment they thought it was.

The following two charts show prices in real terms and the percentage change.

Price in real terms indicate prices in $’000 at 2015 prices (deflated by CPI) and the percentage change shows the change in inflation adjusted prices between the two selected dates of 1980 to Q2 of 2016

These charts indicate that if you weren’t living in New York, San Francisco, Los Angeles, Miami, Boston or a handful of other offshoots the average American or Houstonian for that matter didn’t see substantial or real growth in their home valuations.

Unless you’re finding a home in foreclosure, at a heck of a discount or buying in one of the above valley’s I suspect that if we were as diligent about funding our other goals we may have a different outlook on what’s really our best investment.

Another consideration if you’re truly treating your home like an investment is you must actually sell it to realize any so called gains, after all you will always need someplace to live.

In conclusion:

Paying off your home early is a very personal decision. It’s a decision that’s best evaluated if you can take a step back and look at the big picture. Personally, I don’t like much debt, but debt can be a powerful tool when used correctly or a disastrous enabler.

There are so many sides to this coin, I feel like I could write for days, analyze every scenario and consideration, but then we’d have a book. This is only meant to be a template or guide for things to consider should you find yourself in this scenario.

Consider your circumstances, plan accordingly and make the right decision.  Find or use your resources to make decisions you feel confident in and don’t look back. Learn from your mistakes, don’t dwell on them.

There is no one size fits all.

As Halloween nears, kids are choosing costumes to transform themselves into witches, baseball players and anything else they can imagine. In the spirit of Halloween, we thought it might be an appropriate time to describe the most popular costume on Wall Street, one which many companies have been donning and fooling investors with terrific success.

Having gained over 65% in the last two years, the stock of McDonald’s Corporation (MCD) recently caught our attention. Given the sharp price increase for what is thought of as a low growth company, we assumed their new line of healthier menu items, mobile app ordering, and restaurant modernization must be having a positive effect on sales. Upon a deeper analysis of MCD’s financial data, we were quite stunned to learn that has not been the case. Utility-like in its economic growth, MCD is relying on stock buybacks and the popularity of passive investment styles to provide temporary costume as a high-flying growth company.

Stock Buybacks

We have written six articles on stock buybacks to date. While each discussed different themes including valuations, executive motivations, and corporate governance, they all arrived at the same conclusion; buybacks may boost the stock price in the short run but in the majority of cases they harm shareholder value in the long run. Data on MCD provides support for our conclusion.

Since 2012, MCD’s revenue has declined by nearly 12% while its earnings per share (EPS) rose 17%. This discrepancy might lead one to conclude that MCD’s management has greatly improved operating efficiency and introduced massive cost-cutting measures. Not so. Similar to revenue, GAAP net income has declined almost 8% over the same period, which rules out the possibilities mentioned above.

To understand how earnings-per-share (EPS) can increase at a double-digit rate, while revenue and net income similarly decline and profit margins remain relatively flat, one must consider the effect of share buybacks. Currently, MCD has about 20% fewer shares outstanding than they did five years ago. The reduction in shares accounts for the warped EPS. As noted earlier, EPS is up 17% since 2012. When adjusted for the decline in shares, EPS declined 7%. Given the 12% decline in revenue and 8% drop in net income, this adjusted 7% decline in EPS makes more sense. MCD currently trades at a trailing twelve-month price to earnings ratio (P/E) of 25. If we use the adjusted EPS figure instead of the stated EPS, the P/E rises to 30, which is simply breathtaking for a company that is shrinking. It must also be noted that, since 2012, shareholder equity, or the difference between assets and liabilities, has gone from positive $15.2 billion to negative $2 billion. A summary of key financial data is shown later in this article.

In addition to adjusting MCD’s earnings for buybacks, investors should also consider that to accomplish this financial wizardry, MCD relied on a 112% increase in their debt. Since 2012, MCD spent an estimated $23 billion on share buybacks. During the same period, debt increased by approximately $16 billion. Instead of repurchasing shares, MCD could have used debt and cash flow to expand into new markets, increase productivity and efficiency of its restaurants or purchase higher growth competitors. MCD executives instead manipulated EPS and ultimately the stock price. To their good fortune (quite literally), the Board of Directors and shareholders appear well-deceived by the costume of a healthy and profitable company. Over the last three years, as shown below, compensation for the top three executives has soared.

Source: MCD 2017 proxy statement (LINK)

The following table compares MCD’s fundamental data and buyback adjusted data from 2012 to their last reported earnings statement.

Data Source: Bloomberg and MCD Investor Relations

The graph below compares the sharp increase in the price of MCD to the decline in revenue over the last five years.

Data Courtesy: Bloomberg

Passive Influence

The share price of MCD has also benefited from the substantial increase in the use of passive investment strategies.

Active managers carefully evaluate fundamental trends and growth prospects of potential investments. They typically sell those investments which appear rich and overvalued while buying assets which they deem cheap or undervalued. When there is a proper balance among investing styles in a market, active investors act as a policeman of sorts, providing checks and balances on valuations and price discovery. Would an active investor buy into a fast food company with minimal growth prospects and rapidly rising debt, at a valuation well above that of the general market and long-term averages? Likely no, unless they knew of a greater fool willing to buy it at a higher price.

On the other hand, passive managers focus almost entirely on indexes and are typically less informed about the underlying stocks they are indirectly buying. They are indiscriminate in the deployment of capital allocating to match their index usually on the basis of market capitalization. Such a myopic style rewards those indexes exhibiting strong momentum. When investors buy indexes, the stocks comprising the index, good and bad, rise in unison. Would a passive investor buy into a fast food company with minimal growth prospects and rapidly rising debt at a valuation well above that of the general market and long-term averages? Yes, they have no choice because they manage to an index that includes that company.

When the marginal investors in a market are largely passive in nature, active managers are not able to effectively police valuations, and their influence is diminished. During such periods, indexes and their underlying stocks rise, regardless of the economic and earnings environment.  As the saying goes “a rising tide lifts all boats,” even those that are less seaworthy, such as MCD.


We warn investors that, when the day after Halloween occurs for MCD and other stocks trading well above fair value, investors might find a rotten apple in their portfolio and not the chocolatey goodness they imagined.

Buybacks will continue to occur as long as executives reap the short-term benefits, stock prices rise, money is cheap, and investors remain clueless about the long-term harm buybacks inflict on value. We suspect passive strategies will also garner a larger than normal percentage of investment dollars as long as these blind momentum strategies work. That said, valuations will reach a tipping point and the masking of fundamental weakness will be exposed.

Building wealth on faulty underpinnings is a strategy ultimately destined for failure. We urge investors to understand what they are buying and not be mesmerized by past gains or what the “market” is doing. Simply, when a stock rises above fair valuations, future returns are sacrificed.






“Taxi drivers told you what to buy. The shoeshine boy could give you a summary of the day’s financial news as he worked with rag and polish. An old beggar who regularly patrolled the street in front of my office now gave me tips and, I suppose, spent the money I and others gave him in the market. My cook had a brokerage account and followed the ticker closely. Her paper profits were quickly blown away in the gale of 1929.” – Bernard Baruch.

I’m a hypocrite. I admit it.

We advise repeatedly at Real Investment Advice about how emotions mixed with investing is a toxic elixir. Research overwhelmingly proves the point.

Dalbar 2017: Investors Suck At Investing & Tips For Advisors

So, here I’m advising to listen to your gut?

Yeah, I am.

Hear me out:

There are hundreds of valid reasons to remain skeptical about committing cash to stocks right now. Then there’s double the commentary that makes the case that a new secular bull market began in 2013 and there’s no end in sight.

Hey, that’s what investors sign up for, how the game is played.

At Real Investment Advice we’ll stick with our analysis. We’re laborious with the math and charts that showcase how by almost every measure imaginable, stocks are priced somewhere between denial and fairy tale – think Goldilocks on porridge steroids.

Doesn’t seem to matter anymore, does it? At least until it does. My belief (and it’s only that), is it won’t take much to morph a correction or bout of volatility into something greater once “buy-the-dip” is no longer the popular Wall Street flavor of the day.

#FP: The Genesis Of The “Bubble’s Bubble”

Think of it this way: As corrections and bear markets fade away in the rear-view of market history, the greater the mileage between price discovery and price reality, the stronger the potential for panic.

Markets that respond negatively are emotional foreign territory for a generation of financial professionals and investors. As Minsky would lament “stability breeds instability.” I know my own emotional pitfalls, one of them being that I’m skeptical – “if it’s too calm, something is brewing under the surface.”

Currently, the positive ‘trend is your friend,’ is a challenge to swim against. Attempt to short and you’re probably going to hemorrhage capital longer than you’re willing to.  However, employing a sense of sanity when investing in stocks at this juncture to counterbalance an otherwise rosy (perfect) outlook, or at least, the popular narrative, is a rational step.

Reading blog posts from our daily contributors at Real Investment Advice should help you to minimize the pain that comes from egregious time erosion. You know – the vast wasteland, the fiscal purgatory of a valley that exists when money is invested and the years it takes to breakeven.

As I expound at workshops: “Congratulations. You’ve returned to even! Two more wrinkles on the forehead and a new bald spot!” My intention is never to be flippant, just to make the point that time is indeed a precious commodity that Wall Street prefers to ignore. Every tick higher is a permanent plateau; every move lower is a mere blip to overcome. Must be some form of passive pillow for a restful night’s sleep (and counting fees over sheep).

So, what about all this “dark ride,” stuff?

How does it tie in to this phase of markets?

Let me take you back… Back to when you experienced the thrill of first entering the labyrinthian of an enclosed thrill ride like a fun or horror house. Sitting anxiously, squirming from anticipation. High-backed compact rail cars with worn patent-leather seats, anxious legs secured by a crooked metal bar across the thighs.

Anyone who’s visited a theme park, especially a venue that has endured generations of visitors, is probably familiar with the nature of a dark ride, an indoor amusement attraction. One word describes most of them: Creepy. They’re the fodder for B horror-film plots replete with carnival barkers and mechanical, creaking laughing or screaming primitively painted creatures that laugh or scream at you.

What was the catalyst for the rise of a childhood nightmare?

It was the yacht life. Yes, “Yacht Life,” got me to relieve a couple of scary, personal moments.

You mean you haven’t caught E-Trade’s new television ad “Yacht Life,” yet?

Let me introduce you to a commercial that may irritate your internals.

Haven’t you heard? The dumbest guy in high school just got a boat. And the market is performing so great, that even you, yes you, can trade yourself right into an ostentatious lifestyle cruising on open water. I mean if the dumbest guy in high school can achieve massive wealth by trading, certainly you can. Right?

To continue the track of irresponsible advertisements produced (under the guise of humor) for financial big box retailers, in 1999, Stewart broke onto the scene for Ameritrade Holding Corp (now TD Ameritrade).

You don’t remember Stuart? Let me jog your memory.

Stuart, played by a then-unknown actor Michael Maronna became a pop-culture sensation with prolific one-liners like “let’s light this candle!”  before a finger hit a computer enter key and placed the electronic trade of a lifetime.

Quirky in motion, puckish in attitude, Stuart helped his middle-aged boss to purchase 100 shares of Kmart stock (KMRT). He proceeds to taunt his boss to go for 500, but the boss is steadfast on the trigger.

“100, Stuart.”

It’s a good thing the boss man stuck to his guns; he purchased 100 shares of the retail stock and ignored Stuart’s incessant squawking like a chicken, mocking him for not taking the plunge for 500.

I hope Stuart’s poor boss sold before Kmart declared bankruptcy in 2002. Two years after, Kmart merged with Sears. Sears Holding Corporation (symbol SHLD), a stock that has withered from $90 a share in 2010 to $6.77, today.

Ouch. This candle burn is painful.

Granted, these ads are clever; if you pay attention, they are representative of the last gasp of a market cycle. In this case, the final sprint of a bull.

Like Bernard Baruch, be observant of signs around you. Consider the clever ad agencies and financial as creators of electronic beacons of caution.

Yes, trust your gut, be an eavesdropper. More on this in a bit.

Oh yea, back to the dark ride. Much like an indoor amusement rail car, I took a wild turn and got spooked by a tech-bubble memory.

Stuck inside a dark ride isn’t fun.

Like a summer noon in West Texas. Hot like in the far-back of a tiny closet.

The smells. A combination of mold, worn plastics, the acrid odor of mechanization, body sweat, and a pungent hint of anxiety (mostly from me).

The carny potpourri was too much. Even after five minutes. It felt like hours of suffocation. The lack of even the tiniest pin stream of light made the sickness worse.

I put aside my fear of shadows. They lived outside the “safe” boundary of the ripped seat that brought me to this point. I knew it. They thrived where light couldn’t.

Peaked over the edge of the two-seat car that took me into amusement hell.

I vomited hard.

Into the warm, black shadows.

Within a Coney Island dark ride.

One of my scary favorites.

Until that Friday night in August. 1975.

When frolic reversed like a spook house car. Right to fright.

Stuck in Coney Island New York’s famous –


It took months to gather the courage to enter the black place. The desolation of winter falling on outdoor attractions would find me wandering outside this haunt. I was drawn to the dark. The shadows inside. Even when locked for the off-season, I was on. In. The ride.

It was that darn cyclops with the six pack.

I would stare up at that face. Shudder. My eyelids frozen open. Eyes behind them seduced to stare. I wanted to be there. Part of it.

The attraction to the attraction was unnatural.

A solo eye slid back and forth; a slow sweep to cajole Coney Island onlookers.

In winter. With the sky quiet and gray; cracked dirty urban streets were empty of banter, I swore I could hear the mechanized creak of that eye. That left arm. It moved up and down at a deliberate “look at what I can do” pace. Loud too. A creep hand that held a severed head by dark, long strands.

And I couldn’t get enough.

It was a mechanized witch with dangerous curves.

She tempted. Seduced me to enter.

Assured me it would be fine whatever “it” was. Perhaps my sanity, my sense of self, my ability to stay alive. Whatever fine was, I wanted it.

I shouldn’t be afraid.

To open up. Be myself. She promised not to scare me (too much).

Then. It happened.

Trapped in the dark.

Shadows all around me.

Too deep into the ride.

And the shadows surrounded me. I was breathing them in. Absorbing them through pores exchanging Satan for sweat.  I could feel a dark-line slither circle my heart.

My body tingled cold in a hot mess.

All I feared, hated. All that ate me inside. Swirled around me. And I couldn’t move.

In the sun haze of day that went to night behind swinging doors. Real fast.

Lost in the middle of a pitch-black horror house. Too far from the entrance, too scared to go near the exit as right before the daylight hit you in the face, 10 seconds before the rail car you were locked into would allow for release, there was a last breath of horror, a crescendo of mechanical howling, growling, jolting animated figures.

The final gasp. The spooky finale.

With volatility dead, like the reflection off a calm, glassy lake at sunset, the complacency in markets is at peak. Stocks move higher on bad news and rally on good. You’re witnessing the final run of the bull, the end of the ride before the doors open upon the light of a new cycle.

Now, I have no idea (neither does anybody else), know when the ride goes from thrill to horror; nobody has a clue how long it will take to get there, either.

However, you must trust your gut when committing new money to stocks now. And if I effectively, make my point, you will assuredly listen.

Here are several signs to get you started.

Pay attention to your surroundings. TV commercials like “Yacht Life,” conversations you overhear (yes, be an eavesdropper), about stocks (especially from friends and relatives), should raise a caution flag. Just like well-known traders Bernard Baruch, Joe Kennedy and Jesse Livermore, be observant.

Do not discount the qualitative, the messages (even from magazine covers), as in the short term, markets represent the greed or fear of crowds. Take note of what you’re seeing and reading. Is it positive or negative, how often do instances of bull or bear appear? How many Stuarts are you encountering? I maintain a notebook of observations from the tech crash and financial crisis. I’ve now begun taking notes on this cycle.

Now, this doesn’t mean you should act out on your portfolio. Frequently, I witness observations morph into all-or-none investment decisions where emotions lead to big mistakes. Investors either sell everything or throw caution to the wind when what’s required are a set of rules, consistently followed.

Use your gut to stay alert, ask questions to your financial professional, seek out information which conflicts with how you’re feeling and what you’re seeing. Set rules.

Here are some guidelines to follow. Created by Lance Roberts.

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to adjust.
  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 tend 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. (See this analysis for suggestions.)
  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.

 “People who look for easy money invariable pay for the privilege of proving conclusively that it cannot be found on this earth.” – Jesse Livermore.

Sell-side analysts are ‘giddy’ which means you shouldn’t be.  As markets move higher on hope rather than substance, the sell-side analysts, or those who are paid the big bucks to hawk stock investing for big-box financial retailers, are euphoric per Bank of America’s sell-side indicator of stock recommendations. As of June 30, the indicator is at a six-year high.

Savita Subramanian, the head of equity and quant strategy at Bank of America considers Wall Street’s consensus equity allocation a reliable contrarian indicator. In other words, it’s been a bullish signal when Wall Street has been bearish and vice versa.

Again, this information shouldn’t compel you to rush and sell all your equity positions. However, along with other signs, learning to adhere to rules of risk management seems to be a good start.

Individual investors are feeling good too. Perhaps a little too good.

Per Dr. Ed Yardeni of Yardeni Research, a provider of independent research for institutional investors, the Bull/Bear Ratio as of October 10, stands at 4. A level not seen in years.

On a percentage basis, bulls stand at a high of 60%, bears 15%. In other words, the market’s tenacious run since the presidential election, is beginning to make investors feel a bit too comfortable which should make savvy investors uneasy.

The tailwind for stocks can endure as long as on the surface, there appears no viable competition for investment dollars. Unfortunately, based on fundamental evaluation, stocks are accelerating on the expectation of fiscal policy changes that have yet to come to fruition, not on reality. Ostensibly, this means investors today are taking on increasingly greater risk for lower future stock returns.

American financier Bernard Baruch who amassed a fortune before his 30th birthday, understood when euphoria over stocks ostensibly had to be met with reality, especially when the masses grow confident in their skills and invest (speculate), sometimes on credit, to buy high and sell higher.

It’s acceptable to enjoy the crescendo of the market ride because closer to its conclusion the more exciting it gets.

I’ve personally learned that dark rides may not operate as expected; in what feels like moments, thrill has the potential to morph into fear and a subsequent rush for the exits.

Regardless of where you started to invest on this stock market journey, use the everlasting light of rules to form a market escape that suits your needs and minimize the time it will take to recover from portfolio losses.

The market is downright bullish. There is little reason to argue the point given the bullish trends of markets globally which are strongly trending, positively correlated, and simultaneously breaking out to all-time highs. Of course, such is not surprising given the massive levels of Central Bank interventions, suppressed interest rates, and global coordination between Government’s and major asset managers (banks) over the last eight years.

Importantly, as bullishness has reached historically high levels, the fear of a market crash, or another crisis, has faded into the abyss. As Mark DeCambre noted:

By at least one measure, the S&P 500 index is on pace to register its lengthiest period of quiescence in more than two decades—and perhaps ever.

The broad-market benchmark hasn’t experienced a decline of at least 3% since Nov. 7, 2016. That 236-day span registers as the second-longest period without a single-session drop of that magnitude since the 241 days from Jan. 26, 1995 to Jan. 9, 1996, according to Pension Partners’ Charles Bilello (see table below):

This lack of volatility, flood of liquidity from Central Banks, and a seemingly “bullet-proof” rise in the market has boosted investor confidence to exuberant levels. That consistent push higher, without a correctionary process along the way, has pushed the market into “extremely overbought, extended, and bullish territory.” As shown visually in last weekend’s newsletter:

When I discuss this, I am often asked exactly what is meant by such a statement. This week, I am going provide a basic course in technical analysis as the “overbought, bullish and extended” theme is likely to remain intact for several months to come.

Clarifying Over Bought, Extended & Bullish

What exactly is meant by the markets being overbought, overextended and overly bullish? These are concepts, which once understood, will hopefully lead you to managing your money more successfully over the long term.

What Do You Mean By Overbought?

I am often asked that since there is “always a buyer for every seller,” then how can a market become overbought?

Before we get into the raw technical analysis of showing the “overbought” condition let’s rationalize what one is and how it occurs.

First, while it is true that there is always a buyer and seller in every transaction it is the “supply and demand” of those buyers and sellers at a particular price point that affects the overall price. Let me explain.

Imagine two rooms of 100 individuals each that want to buy shares of ABC stock. Room A has 100 individuals that currently own ABC stock and Room B has 100 individuals with cash wanting to buy shares of ABC. The table below shows a very simplified model of this process.

At $10 a share, there are numerous buyers but sellers are few. The demand for the shares drives the price higher which entices more sellers. As long as the demand for shares outpaces the supply of sellers – the price is pushed higher. However, at some point, the price reaches a level that exhausts the supply of buyers.  The next price decline occurs as sellers have to begin lowering prices to find buyers.

So, while there is always a buyer and seller for every transaction it is the relative supply and demand for those shares at current prices that determine the “overbought” and “oversold” conditions.

The chart below shows several methods I look at to try and determine if buyers are potentially reaching a point of “exhaustion” which might lead to a price reversal in the short-term. The top of the chart looks at the historic deviation between the price of the market as compared to the 200-dma. The bottom 4-indicators are measures of price movement and participation (The bottom two panels are the number of stocks above the 50 and 200-dma.)

Don’t get too hung-up on trying to understand all the nuances of the chart. The important point, from a money management standpoint, is the determination of the potential risk/reward opportunity for allocating capital to the markets at any given time.

As a portfolio manager, clients tend “not to like” having their capital invested in the markets only to almost immediately suffer a principal loss. By using some measures to determine the current risk/reward outcome, the deployment of capital can be more effectively timed.

While the chart is suggesting the market has reached levels where buyers have typically been turned into sellers, it is important to understand that just because the indicator has reached an extreme level – the market will not necessarily fall apart immediately. It is a warning sign that suggests further upside in the market is relatively limited compared to the downside risk that currently exists.

The average correction that resolved the overbought condition, since the end of the last financial crisis, has been as little as -3% but as much as -19%. It is for this reason that I continue to suggest NOT chasing the markets at the current time. There will be a correction of some magnitude in the near future that will allow for a safer entry of new capital into the markets. Patience, however, will likely be tested before that opportunity presents itself.

How Can A Market Get Over Extended?

Now that we have defined what overbought means – I can explain what I mean by overextended. As I discussed in “Visualizing Bob Farrell’s 10 Investing Rules”:

“Like a rubber band that has been stretched too far – it must be relaxed in order to be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.

The chart below shows the S&P 500 with a 52-week simple moving average. The bottom chart shows the percentage deviation of the current price of the market from the 52-week moving average.  During bullish trending markets, there are regular reversions to the mean that create buying opportunities.  However, what is often not stated is that in order to take advantage of such buying opportunities profits should have been taken out of portfolios as deviations from the mean reached historical extremes.  Conversely, in bearish trending markets, such reversions from extreme deviations should be used to sell stocks, raise cash and reduce portfolio risk rather than ‘panic sell’ at market bottoms.”

The dashed blue lines denoted when the markets changed trends from positive to negative. This is the very essence of portfolio “risk” management.

The idea of “stretching the rubber band” can be measured in several ways, but I will limit our discussion this week to two: Standard Deviation and Distance.

As I noted in this past weekend’s newsletter, “Standard Deviation” is defined as:

“A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of the variance.”

In plain English this means, and as shown in the chart below, is that the further away from the average that an event occurs the more unlikely it becomes. As shown below, out of 1000 occurrences, only three will fall outside of the area of 3 standard deviations. 95.4% of the time events will occur within two standard deviations.

For the stock market, and as shown in both charts above, the standard deviation is measured is with Bollinger Bands.  John Bollinger, a famous technical trader, applied the theory of standard deviation to the financial markets.

Because standard deviation is a measure of volatility, Bollinger created a set of bands that would adjust themselves to the current market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average).

The closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market.

The dashed purple line is the 50-week moving average (or mean) with shaded area representing 2-standard deviations. As shown in the chart above, 2-standard deviations encompass 95.4% of all probable price movement.Even during the 2012-15, QE3 driven, stock advance, there were several corrections back to the 50-week moving average which allowed for increases in equity risk.

The chart on the next page shows this more clearly. The blue colored vertical bars represent when the price of the index has risen 5%, or more, above the 50-week moving average. The orange-ish bars represent a move of 5%, or more, below the moving average.

Currently, with the index more than 7% above its 50-week moving average, there is little questioning that the markets are extended to the upside. From this point, there are two things that could occur. If this is only an intermediate-term top, and the markets are going to remain in a bullish trend, then any correction should remain confined to a retracement back to the 50-week moving average.

However, if the markets are building a longer term top then a reversion past the 50-week moving average will denote a possible change into a bear market. Bull and bear markets are denoted below by how they trade either above or below the 50-week moving average.

Measuring Extreme Optimism

“It is a bad sign for the market when all the bears give up. If no-one is left to be converted, it usually means no-one is left to buy.” – Pater Tenebrarum

That quote got me thinking about the dearth of bearish views that are currently prevalent in the market. The chart below shows the monthly level of bullish outlooks according to our composite indicator of both individual and professional investors.

The extraordinarily low level of “bearish” outlooks combined with extreme levels of complacency within the financial markets has historically been a “poor cocktail” for future investment success.

Much like measuring overbought and overextended conditions – overly bullish optimism, or a “lack of fear” of a market correction, are historically seen at intermediate and longer-term market peaks. This is also the case with consumer “sentiment” which also just registered the highest level on record of individuals expecting the markets to rise over the next 12-months.

As I wrote previously, “records are records for a reason.” 

With bullish sentiment and complacency at extreme levels, it only further supports the idea that the current risk of investing new capital in the markets outweighs the potential reward. It is very likely that sometime within the next couple of weeks, to a couple of months, the markets will experience at least an intermediate-term correction.

Could it turn into a more serious correction? Sure. However, we won’t know that until we get there.

I hope this helps clarify things.

For now, holding a little extra cash certainly won’t detract significantly from portfolio performance but will provide an opportunity to take advantage of panicked sellers later. It’s not a question of “if, only of “when.”

I was recently watching a movie about the FBI trying to bring down a terrorist cell in the U.S. During their investigation, their evidence board became more and more cluttered with people, evidence, and locations as they attempted to track down the “cell.” At first, the clues were disparate, and they didn’t provide a clear path to the end goal. But as more clues were obtained, the bigger picture emerged eventually leading to the successful ending of the terrorist threat.

It got me to thinking about what is currently happening in the markets. As stocks rang new highs last week, there were several disparate stories that caught my attention. Individually, each story is nothing to be overly concerned about, and are regularly dismissed by investors. However, when you begin linking these stories, a picture is beginning to emerge that suggests investors may be ignoring the evidence at their own peril.

Story 1: CPI Remains Weak

Despite three hurricanes and wildfires over the last couple of months, core CPI (ex-aircraft) failed to register much inflationary pressure. One would have expected given the surge in demand for goods and services needed to rebuild destroyed communities.

However, despite the Fed’s hopes for a surge in inflationary pressures to justify further hikes in interest rates, inflationary pressures have been on the decline for the last several months.

Story 2: Real Wage Growth Slumps Along With Employment

Of course, the lack of inflation leads through to a decline in inflation-adjusted wages. While the chart below only goes back to 2008, wage growth has been non-existent since 1998. (For more detail read this.)

But as I discussed previously, even those wage numbers are skewed by the top 20% of income earners versus the bottom 80% which continue to see wages decline.

Story 3: Auto Originations Crash

As Wells Fargo announced this past week, the decline in auto loan originations continued tumbling 47% Y/Y to only $4.3 billion, the lowest print since the bank started disclosing this item back in 2013.

The problem is that it is not just Wells having this problem, but all banks. As shown in the chart below the number of banks reporting strong auto loan demand has been in decline for quite some time.

Story 4: Retail Sales Continue To Lag

It isn’t just auto either. Retail sales account for roughly 40% of personal consumption expenditures which makes up 70% of the economy. With wages stagnant, and the real cost of living on the rise, it is not surprising that with roughly 80% of Americans living paycheck-to-paycheck that retail sales continue to wane. 

The chart below is the annual percent change in the 12-month average of “control purchases.” These are the items that consumers buy with regularity and shows why retail struggles aren’t just related to the “Amazon effect.” 

Story 5: Pay-Tv Customers Decline 

While “cutting the cord” may be a “thing,” this is much more a story about consumers being faced with a choice between making their mortgage payment or paying for cable. With budgets strained, consumers are actively seeking choices where they can get access to programming at much cheaper costs. From Bloomberg last week:

Barring a major fourth-quarter comeback, 2017 is on course to be the worst year for conventional pay-TV subscriber losses in history, surpassing last year’s 1.7 million, according to Bloomberg Intelligence. That figure doesn’t include online services like DirecTV Now. Even including those digital plans, the five biggest TV providers are projected to have lost 469,000 customers in the third quarter.”


At least all the “low budget” films are getting a shot at a whole new audience. So sit back, grab some popcorn and take in “Galaxina” or “Cannibal Women From The Avocado Jungle.” 

Story 6: Banks Ramp Up Loan Loss Reserves

In another interesting note this week, Citi, JP Morgan and BofA all boosted their “loan loss reserves” by the most in 4-years. Banks don’t boost reserves unless there is a rising risk of defaults on the horizon. From Zerohedge:

“Four months ago, when looking at the latest S&P/Experian data, we first reported that credit card defaults had surged the most since June 2013, a troubling development which ran fully counter to the narrative that the economy was recovering and the US consumer’s balance sheet was improving.

The troubling deterioration prompted Moody’s to pen its own report titled ‘Spike in Charge-off Rates Indicates a Slide in Underwriting Standards’ and as Moody’s analyst Warren Kornfelf wrote, the steep increase in credit card charge-off rates in 1Q’17 and 4Q’16 was the largest since 2009, and indicates that ‘strong underwriting standards in place since the financial crisis have deteriorated, potentially rapidly.'”

Of course, the following chart might just suggest why they are doing that.

Story 7: Millennials Are Delaying Marriage Because Men Aren’t Earning Enough

As reported by The Hill this past week, more Americans are living alone today has risen sharply.

“The number of Americans living with a spouse or partner has fallen notably in the last decade, driven in part by decisions to delay marriage in the wake of a recession that hit new entrants into the workforce especially hard.

Forty-two percent of Americans live without a spouse or partner, up from 39 percent in 2007, according to the Pew Research Center’s analysis of U.S. Census Bureau figures. For those under the age of 35 years old, 61 percent live without a spouse or partner, up 5 percentage points from a decade ago.”

With more multi-generational families living together, the aging of the baby-boomer generation and a significant fall-off in birth rates, the huge demographic headwind is gaining momentum. The economic ramifications, as well as for the financial markets, is going to be extremely problematic. (Read this.)

Tying It All Together

As more clues become available, the risk to the financial markets becomes clearer.

All of these stories have a common thread – the consumer. While stocks continue to ratchet to all-time highs on expectations of tax cuts and reforms leading to stronger economic growth, the stories here all suggest something much more telling is happening beneath the surface.

Yes, household net worth has recently reached historically high levels. However, The majority of the increase over the last several years has come from increasing real estate values and the rise in various stock-market linked financial assets like corporate equities, mutual and pension funds.

But, once again, the headlines are deceiving even if we just slightly scratch the surface. Given the breakdown of wealth across America we once again find that virtually all of the net worth, and the associated increase thereof, has only benefited a handful of the wealthiest Americans. 

As the Federal Reserve just recently reported, while the mainstream media continues to tout that the economy is on the mend, real (inflation-adjusted) median net worth suggests this is not the case overall. As stated, the recovery in net worth has been heavily skewed to the top 10% of income earners.

Of course, this explains why the largest number of the population over the age of 65 is still employed as they simply can’t afford to retire. The multi-generational households are on the rise, not by choice but by necessity. These are long-term headwinds that suggest economic growth will remain weak, and the rise in delinquencies, slow-down in auto demand, and weak retail sales all suggest consumers may have reached the limits of the debt-driven consumption cycle for now.

In other words, individuals are ratcheting up debt, not to buy more stuff, but just to maintain their current “standard of living.” 

The disconnect between the stock market and real economic growth can certainly continue for now. Exuberance and confidence are at the highest levels on record, but the underlying stories are beginning to weave a tale of an economy that is very late in the current cycle.

Importantly, these are not short-term stories either. The long-term picture for the economy and the markets from the three biggest factors (Debt, Deflation, and Demographics) continues to build. These factors will continue to weigh on economic growth, and market returns, during the next generation as the massive wave a baby-boomers shift from supporters to dependents of the financial and welfare system. 

As an investor, it is important to pay attention to the clues and the weight of the evidence. The success, or failure, of catching the end of the current bull market and economic cycle will have important implications to your long-term financial goals.

As the stock market continues to press new highs, the level of optimism climbs with it. I discussed yesterday Richard Thaler’s, a recent recipient of the Nobel Price in Economics, comments about not understanding the current “irrationality of investors relating to their investing behavior.”

What is interesting is that Thaler’s received his Nobel Prize for his pioneering work in establishing that people are predictably irrational — that they consistently behave in ways that defy economic theory. For example, people will refuse to pay more for an umbrella during a rainstorm; they will use the savings from lower gas prices to buy premium gasoline; they will offer to buy a coffee mug for $3 and refuse to sell it for $6.

The fact that a man who studies the “irrationality of individuals” is stumped by current investor behavior should be alarming at the least.

But as earnings season gets underway we once again return to quarterly Wall Street “beat the estimate game,” in which companies are rewarded by beating continually lowered estimates. Of course, the primary catalyst used to beat those estimates was not a rise in actual revenue, or even reported earnings, but rather ongoing accounting gimmickry and stock buybacks. As shown below, through the second quarter of this year, reported EPS, which includes “all the bad stuff,” actually declined in the latest quarter and has remained virtually unchanged since 2014. (But, even that is an illusion as shares have been aggressively bought back in order to sustain that same level of EPS.)

The difference between reported earnings with and without the benefit of share repurchases is substantial. The chart below shows the net difference between gross reported earnings with and without the buyback impact. Importantly, the net effect of buybacks is having less impact which, as was the case in 2007, was a precursor to the crash. 

Ralph Nader just recently did an in-depth expose on the problems with share repurchases. To wit:

The monster of economic waste—over $7 trillion of dictated stock buybacks since 2003 by the self-enriching CEOs of large corporations—started with a little-noticed change in 1982 by the Securities and Exchange Commission (SEC) under President Ronald Reagan. That was when SEC Chairman John Shad, a former Wall Street CEO, redefined unlawful ‘stock manipulation’ to exclude stock buybacks.”

Yep, stock buybacks used to be considered stock manipulation, yet today, it is widely accepted by investors as “just the right measure to boost earnings in the ongoing “beat the estimate” game.

As Ralph Nader points out – there is a problem.

“The stock buyback mania was unleashed. Its core was not to benefit shareholders (other than perhaps hedge fund speculators) by improving the earnings per share ratio. Its real motivation was to increase CEO pay no matter how badly such burning out of shareholder dollars hurt the company, its workers and the overall pace of economic growth.

The bottom line is that while companies take trillions of dollars and buyback shares, it only benefits the executives of the company at the expense of both workers and, ultimately, shareholders as companies with excessive stock buybacks experience a declining market value.

The interview is worth watching, and read the article, and think about it.

Here’s your reading list to for the weekend.

Trump, Economy & Fed


Research / Interesting Reads

“Making it, and keeping it, are two different things.Anonymous

Questions, comments, suggestions – please email me.

Dear reader, if you are overcome with fear of missing out on the next stock market move; if you feel like you have to own stocks no matter the cost; if you tell yourself, “Stocks are expensive, but I am a long-term investor”; then consider this article a public service announcement written just for you.

Before we jump into the stock discussion, let’s quickly scan the global economic environment. The health of the European Union did not improve in 2016, and Brexit only increased the possibility of other “exits” as the structural issues that render this union dysfunctional went unfixed.

Japan’s population has not gotten any younger since the last time I wrote about it — it is still the oldest in the world. Japan’s debt pile got bigger, and it remains the most indebted developed nation (though, in all fairness, other countries are desperately trying to take that title away from it). Despite the growing debt, Japanese five-year government bonds are “paying” an interest rate of –0.10 percent. Imagine what will happen to its government’s budget when Japan has to start actually paying to borrow money commensurate with its debtor profile.

Regarding China, there is little I can say that I have not said before. The bulk of Chinese growth is coming from debt, which is growing at a much faster pace than the economy. This camel has consumed a tremendous quantity of steroids over the years, which have weakened its back — we just don’t know which straw will break it.

S&P 500 earnings have stagnated since 2013, but this has not stopped analysts from launching their forecasts every year with expectations of 10–20 percent earnings growth . . . before they gradually take them down to near zero as the year progresses. The explanation for the stagnation is surprisingly simple: Corporate profitability overall has been stretched to an extreme and is unlikely to improve much, as profit margins are close to all-time highs (corporations have squeezed about as much juice out of their operations as they can). And interest rates are still low, while corporate and government indebtedness is very high — a recipe for higher interest rates and significant inflation down the road, which will pressure corporate margins even further.

I am acutely aware that all of the above sounds like a broken record. It absolutely does, but that doesn’t make it any less true; it just makes me sound boring and repetitive. We are in one of the last innings (if only I knew more about baseball) of the eight-year-old bull market, which in the past few years has been fueled not by great fundamentals but by a lack of good investment alternatives.

Starved for yield, investors are forced to pick investments by matching current yields with income needs, while ignoring riskiness and overvaluation. Why wouldn’t they? After all, over the past eight years we have observed only steady if unimpressive returns and very little realized risk. However, just as in dating, decisions that are made due to a “lack of alternatives” are rarely good decisions, as new alternatives will eventually emerge — it’s just a matter of time.

The average stock out there (that is, the market) is very, very expensive. At this point it almost doesn’t matter which valuation metric you use: price to ten-year trailing earnings; stock market capitalization (market value of all stocks) as a percentage of GDP (sales of the whole economy); enterprise value (market value of stocks less cash plus debt) to EBITDA (earnings before interest, taxes, depreciation, and amortization) — they all point to this: Stocks were more expensive than they are today only once in the past century, that is, during the dot-com bubble.

In reference to this fact, my friend and brilliant short-seller Jim Chanos said with a chuckle,

“I am buying stocks here, because once they went higher . . . for a year.”

Investors who are stampeding into expensive stocks through passive index funds are buying what has worked — and is likely to stop working. But mutual funds are not much better. When I meet new clients, I get a chance to look at their mutual fund holdings. Even value mutual funds, which in theory are supposed to be scraping equities from the bottom of the stock market barrel, are full of pricey companies. Cash (which is another way of saying, “I’m not buying overvalued stocks”) is not a viable option for most equity mutual fund managers. Thus this market has turned professional investors into buyers not of what they like but of what they hate the least (which reminds me of our political climate).

In 2016, less than 10 percent of actively managed funds outperformed their benchmarks (their respective index funds) on a five-year trailing basis. Unfortunately, the last time this happened was 1999, during the dot-com bubble, and we know how that story ended.

To summarize the requirements for investing in an environment where decisions are made not based on fundamentals but due to a lack of alternatives, we are going to paraphrase Mark Twain:

“All you need in this life [read: lack-of-alternatives stock market] is ignorance and confidence, and then success is sure.”

To succeed in the market that lies ahead of us, one will need to have a lot of confidence in his ignorance and exercise caution and prudence, which will often mean taking the path that is far less traveled.

There is a wide disconnect between the current market’s focus on short-term influences and the long-term and worrisome trends in pension obligations, spiraling debt, the wealth/income gap and the Fed’s ability to extricate itself from its large balance sheet.

“I’d say get it while you can, yeah
Honey, get it while you can, yeah
Hey hey, get it while you can
Don’t you turn your back on love, no, no

Don’t you know when you’re loving anybody, baby
You’re taking a gamble on a little sorrow
But then who cares, baby
‘Cause we may not be here tomorrow, no.”

–Janis Joplin, “Get It While You Can

We live in a not-so-brave world in which time frames have been increasingly compressed, owing in part to the impact of technology on human behavior. It is as if almost everyone these days has ADHD, or attention-deficit hyperactivity disorder.

This short-term behavior permeates our society as physical human interaction is diminished in a world of Twitter, Instagram and Snapchat.

Even politics is subverted to the short term. For example, politicians are elected and almost the next day they have begun to campaign and raise money for their next election. Another example of the short-term orientation and subversion of longer-term thinking is seen in President Trump’s impulsive, possibly dangerous and seat-of-the-pants tweeting, which is now being “normalized,” as an expression of delivering policy that in the past has been conducted in a far more contemplative way. Or even in Anthony Weiner’s sexting!

Nowhere is the compression of time frames more apparent than in the investment business, where it seems that everyone has become a day trader.

As it is said, market opinions are like noses — everyone has one!

The business media spends most of their time asking the talking heads questions that are likely to be responded to without much rigor because it’s easier looking at a price chart or monitoring “unusual call activity” in making short-term trading decisions than employing fundamental analysis that is time-consumptive and laborious.

Among the usual questions:

  • Where are interest rates going by year-end?
  • What is the next 50-handle move in the S&P Index?
  • How will XYZ Co.’s shares respond to this afternoon’s earnings report?
  • What is the next move in the U.S. dollar, the price of oil, in soybeans or in the emerging market space?

The limited discussion and consideration of intermediate to longer-term prospects — such as whether we are pulling investment returns forward — may be a technologically influenced event or may be the desire, as Janis Joplin reminded us all, of “getting it while we can.”

Or it might be the byproduct of the continuing eight-year bull market in which dips are ever bought.

Regardless, current prices always must be measured and judged not only by the next near-term variable (such as interest rates, earnings and the price of oil), but also by the assessment of the intermediate to longer term.

And it is the longer term that to me and to some others is where the greatest concerns lie for investors today.

These longer-term concerns seem to have been ignored by most market participants and by the machines, algorithms and ETFs, which have been fueled by large inflows that have translated into the virtuous market cycle I recently wrote about in “Active vs. Passive Conflict, and Why All Dips Are Bought.”

Stated simply, passive investing is agnostic to long-term fundamentals such as private market value and secular earnings growth projections. One can spend weeks discussing these profound headwinds and challenges, and I will follow up on them in the time ahead by expanding on my non short-term concerns. However, here are the four leading issues as seen in my eyes with a big, big assist from my friend, Outside the Box’s rigorous John Mauldin (the first two issues):

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

* Pension Storm Warning 

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

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

Bottom Line

“A bull market is like sex. It feels best just before it ends.” Warren Buffett

We live in a world of instant gratification.

Basing investments on short-term influences and worshiping at the altar of price momentum can be profitable, but it obscures our attention from long-term trends, many of which are potentially quite adverse.

The long term can be seen as a collection of short terms; the long term is little discussed as the investment debate principally is governed by questions regarding near-term market and price movements, in which market participants try to “get it while they can.”

There is a wide disconnect between the current market’s high valuations and focus on short-term influences and the long-term and worrisome trends in pension obligations, spiraling debt, the wealth/income gap and the Fed’s ability to extricate itself from its large balance sheet.

During my morning reading, I ran across a couple of very interesting articles that tied a common theme relating to the current risks in the financial markets.

Via Zerohedge:

88-year-old investing icon John “Jack” Bogle, founder of the Vanguard Group, said:

“The valuations of stocks are, by my standards, rather high, but my standards, however, are high.

When considering stock valuations, Bogle’s method differs from Wall Street’s. For his price-to-earnings multiple, Bogle uses the past 12 months of reported earnings by corporations, GAAP earnings, which include ‘all of the bad stuff,’ to get a multiple of about 25 or 26 times earnings.

‘Wall Street will have none of that. They look ahead to the earnings for the next 12 months and we don’t really know what they are so it’s a little gamble.’

He also noted that Wall Street analysts look at operating earnings, ‘earnings without all that bad stuff,’ and come up with a price-to-earnings multiple of something in the range of 17 or 18.

‘If you believe the way we look at it, much more realistically I think, the P/E is relatively high,’

‘I believe strongly that [investors] should be realizing valuations are fairly full, and if they are nervous they could easily sell off a portion of their stocks.'”

This, of course, from the father of “buy and hold” investing with whom millions of Americans have pumped roughly $4.7 Trillion into a whole smörgåsbord of indexed based ETF’s provided by Vanguard to meet investor appetites.

Think about that for a moment while you read the following snippet from Bloomberg:

“A buoyant and complacent stock market is worrying Richard H. Thaler, the University of Chicago professor who this week won the Nobel Prize in economics.

‘We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.

I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked. Nothing seems to spook the market, and if the gains are based on tax-reform expectations, surely investors should have lost confidence that tax reform is going to happen.'”

These two points drive to the heart of the recent concerns I have expressed in both how companies continue to use accounting gimmickry to win the beat the estimate game” each quarter and the risk of disappointment surrounding tax reform legislation.

But since markets have continued to advance due to the ongoing flood of liquidity from global Central Banks, no one is really paying attention to such “silly” things. However, while market analysts continue to come up with a variety of rationalizations to justify high valuations, none of them hold up under real scrutiny. The problem is the Central Bank interventions boost asset prices in the short-term, in the long-term, there is an inherently negative impact on economic growth. As such, it leads to the repetitive cycle of monetary policy.

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

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

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

It is critical to remember the stock market is NOT the economy. The stock market should be reflective of underlying economic growth which drives actual revenue growth. Furthermore, GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40).

However, in the meantime, the promise of a continued bull market is very enticing as the “fear of missing out” overrides the “fear of loss.”

Valuations Are Expensive

This brings us back to Jack Bogle and the importance of valuations which are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are HORRIBLE predictors of 12-month returns should not be used in any strategy that has such a focus. However, in the longer term, valuations are strong predictors of expected returns.

I have adjusted Bogle’s measure of valuations to a 24-month, versus 12-month, measure to smooth out the enormous spike in valuations due to the earnings collapse in 2008. The end valuation result is the same but peaks, and troughs, in valuations are more clearly shown.

At 26.81, Bogle is clearly correct that valuations have reached expensive levels. More importantly, outside of the peak in 1999, stocks are more highly valued today than at any other point in history. (The two points during bear market troughs are excluded as those valuations were due to earnings collapsing faster than prices due to recessionary conditions.)

Bogle’s view is also confirmed by other measures as well. The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-ratio. Again, valuations only appear cheap when compared to the peak in 2000. Outside of that exception, the financial markets are now more expensive than at any other single point in history.

I have also previously modified Shiller’s CAPE to make it more sensitive to current market dynamics.

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

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

To get a better understanding of where valuations are currently relative to past history, we can look at the deviation between current valuation levels and the long-term average going back to 1900.

With a 63.62% deviation from the long-term mean, a reversion will be quite damaging to investors when it occurs. As you will notice, reversions have NEVER resulted in a “sideways” consolidation but rather much more serious, and sharp, declines. These rapid “maulings” of investors is why declines are aptly named “bear markets.” 

Lastly, even Warren Buffett’s favorite valuation measure is screaming valuation issues. The following measure is the price of the Wilshire 5000 market capitalization level divided by GDP. Again, as noted above, asset prices should be reflective of underlying economic growth rather than the “irrational exuberance” of investors.

Of course, it’s Buffett’s own axiom that best sums up all of the famous valuation measures noted above.

“Price is what you pay, valuation is what you get.” 

Maybe Not Today

Bogle, Buffett, Shiller, and Tobin are right about valuations.

Maybe not today.

Next month.

Or even next year.

But as Vitaliy Katsenelson just recently penned:

Our goal is to win a war, and to do that we may need to lose a few battles in the interim.

Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions.

We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.”

With that point, I clearly agree.

The most fundamental basis for economics is human decision-making. Satisfying needs and wants creates demand. Engaging in a vocation to provide a good or service of value to others generates supply. The intersection of the two is a market.

This week we introduce the unique insight of Mark McElroy. Mark is a friend of 720Global who often provides valuable input on our article concepts, their structure and occasionally challenges their validity. Now, with some minor arm-twisting, he challenges the status quo of economics – the profession, the pedigrees and their intentions. 

In Saying It Slowly Doesn’t Help, he doesn’t challenge the PhD economists so much as he takes the rest of us to task. If human decisions are the basis for economics then aren’t we all obligated to be economists at some level? His casual but intentional arms-length observer status poses the question: why is economics so difficult?

Saying It Slowly Doesn’t Help

“The quality of ideas seems to play a minor role in mass movement leadership. What counts is the arrogant gesture, the complete disregard of the opinion of others, the singlehanded defiance of the world.”Eric Hoffer, The True Believer

To communicate about economics is to describe the mirror as if it were a commodity. Economics is a tricky subject. It schemes and dodges—just try to sneak up on a mirror. For all the numbers, parentheses, red and black, boxes and columns, economics is mostly narrative. The digits and bytes of the trade are stand-ins for our resources or assets that are stand-ins for our fears, hopes, memories, hungers and regrets.  Economics is the overly eager attempt to hold at arms-length what we don’t want to see up close. Quantifying the narrative is like measuring a joke. But, it must be done.  It should be done.  Honestly, it needs to be done because no one is alone.

If such twaddle seems impractical, you’re in large company. I get it. That doesn’t necessarily mean you should be off the hook for thinking practically (critically) regarding how we talk about ourselves, our resources, and our guiding principles–economics.  Our collective want for information about economics is huge. Really huge. Cable, Twitter, whatever offers a 24/7 stream of info about economics to more and more people.  Evidently being in a flood doesn’t make one a hydrologist (that was weak, I apologize).  For all the volume of economic info/data available, one would expect we could be fairly proficient in discussing/communicating the basics of economics. Given the rise of six year financing plans for Toyota Corollas, I’m gonna go out on a limb and call BS on the notion that we know how to talk about it effectively. Clearly. Honestly.

If you fancy yourself an economist (and everyone should), it may be of comfort to realize economists are not the only ones in this “we have much to say and struggle to be understood” syndrome.  Scientists find themselves there, too. Scientists are studying themselves and the scientific assumptions regarding how to communicate about science. Tired of being picked last for kickball in the public square, scientists are aiming their magnified gaze upon themselves and are coming around to a counter-intuitive notion.  The more scientists try to correct and inform the public discourse, the less impact they have.  Saying it (you know, smart stuff) with more detail and credentials not only doesn’t work, it makes things worse. Tim Requarth in Slate wrote it like this:

[T]he way most scientists think about science communication—that just explaining the real science better will help—is plain wrong. In fact, it’s so wrong that it may have the opposite effect of what they’re trying to achieve.

I think he meant this:

[T]he way most scientists economists think about science economic communication—that just explaining the real science economics better will help—is plain wrong. In fact, it’s so wrong that it may have the opposite effect of what they’re trying to achieve.

Okay, he clearly did not mean that, but it would have been great if he did. Go read his article in full and play this parlor game. Every time you see “science” or some version of it, replace it with “economics” or some version of it.  It pretty much holds up.

Economics should be natural for us to communicate, but it isn’t. Who doesn’t know what a mirror looks like?  Economics is discussed ad nauseam as if it were an elusive concept that only a few have glimpsed (yep, just like Bigfoot) when it should be as natural as falling off a bike. Why is that?

I have a guess. Something as simple and natural as discussing the priorities and principles around which we value and exchange our assets has been made complex, confusing, and somehow has justified cable news panels with snooty people using phrases I can’t spell (of which there are many)—all this is the handiwork of a cottage industry (institution) committed to sustaining the confusion for profit, prestige, or because they miss satisfaction of taking names in third grade.

SIDEBAR: I am in a sustained lover’s quarrel with an institution that now spans 30+ years. Institutions of all flavors are the same in that their original spark, purpose or mission always becomes overwhelmed by its desire for self-perpetuation. To be clear, when I refer to the cottage industry proliferating the confusion regarding economics as an “institution,” it is meant as no compliment. If you have finished watching the paint dry and are intrigued by the whole institution thing, check out the work of Eric Hoffer, The True Believer: Thoughts on the Nature of Mass Movements.  SIDEBAR CLOSED

If economics remains confusing for me (as is religion and healthcare), I am less likely to experience contentment (or faith or health). Admittedly, though, the institutions that keep economics (and other matters) an ivory tower topic have a willing accomplice in me.  It is a co-dependence. Somewhere deep down I need as a way coping for that topic to be at arms-length.  At arms-length, I can see economics as a collection of digits, theories, and fractional transactions en masse. I am then spared the need to contemplate the basics of economics: stewardship, community, contentment, and charity.

Honestly, it needs to be done because no one is alone.

Mark McElroy, PhD @B40MKM is a writer, farmer, and management consultant with leadership roles in nonprofit and technology/information companies.





 “I think we’re doing the right things with money, but we feel sub-optimized.”

Twenty-eight years guiding others through financial challenges, thousands of words, and oddly I experienced personal angst over this one – “sub-optimized.”

It’s rare the word arises, if at all. There was something about it that captured my ear and mind. I wondered about the obstacles that create what I call “dollar drag,” whereby the highest and best use of our money is overlooked or ignored.

Sub-optimization is an equal opportunity offender. We all are afflicted, even if our track record of handling money is better than average. There can be great intentions, even respectable core money habits and yet sub-optimization thrives because we’re human.

As in the case of this forty-something couple: Six-figure wage earners, ambitious savers who set aside 20% of income for retirement, well-funded 529 plans for young children and saddled with dangerous credit card debt levels due to a failed real estate venture.

Overall, I give them high marks when it comes to handing their money however a simple solution to reduce the high-interest debt was clearly in front of them and they couldn’t see it. They couldn’t wrap their minds around their financial condition in its entirety.

There was a mental barrier between the personal and business debt even though they were the business. In other words, the burdensome interest charges affected their household net worth.

As a financial professional I realize nobody can avoid some degree of sub-optimization or dollar drag. Much of it stems from a failure in our logic called mental accounting.

See, we like to compartmentalize money: We create mental walls that prevent us from considering how each dollar may flow freely through and across various goals to the final and best destinations on our household balance sheets.

Dan Ariely, professor of behavioral economics at Duke University and New York Times best-selling author helped me understand how to position “highest and best use” in my mind. He said

“Every financial decision has an opportunity cost. You cannot make the best money choices in a vacuum.”

You must revolve around each decision and control where your money lands.

So, how can you make better financial choices and think full circle?

6-Steps To Optimization

1) Break it down and look around.

Don’t perceive every financial challenge as a straight edge with a beginning and conclusion. It leads to narrow thinking and sub-optimization at the point of action.

Round out your thought process. Go where you never been before. When presented with a financial decision, break down the walls, goals, compartments and picture how all your dollars can flow free from their different types of accounts and work together to achieve the greatest impact to your bottom line.

When performing this exercise with my fiscally responsible couple, we concluded that utilizing an existing home equity line of credit at less than 4% interest, to pay off the credit card with 21% interest rate, was an optimum conclusion.

It was a major improvement never considered because the mental barriers were thick between business and personal accounts. Once those barriers were removed, a solution was obvious.

2) Grab every opportunity to assess the opportunity (cost).

I’ve gone overboard with this one. I take lessons seriously from influences like Dan Ariely and share them with anyone who will listen. I now examine the “full circle” of every money choice. I’m obsessed with dollar drag.

During a recent evening out, before ordering at an iconic Texas barbecue place, I stepped back and thought of what else I could do with the money.  Was this the “highest and best use” for my $28 bucks?

I took away the walls and permitted the money to flow through other options including eating at home. I had to weigh the opportunity cost until I either returned full circle to the current choice, or stopped on a better solution. Better doesn’t always mean cheaper, either. When it comes to opportunity cost you need to input much into the calculation including what your time is worth and qualitative factors.

If anything, this type of exercise will allow you to pause before making a purchase and create awareness about other options that may bring greater satisfaction and value.

And yes, I went for the pork ribs and fixings.

3) Think rooftop, not basement.

When you bust down the walls between dollars, you begin to think bigger (and smarter). You’re up on the roof looking out and over the landscape of your finances. You begin to see how fungible money is.

Most of the time, we rummage in the basement where it’s dark and narrow because of the laser-focus on the problem.  Unfortunately, the longer we concentrate, the less we observe lucrative options hiding in plain sight. That’s why financial decisions should begin from a holistic perspective (roof) and then narrowed down to the basement or specific issues at hand.

For example, when gasoline prices were shy of 4 dollars a gallon, I was inundated with inquiries about trading in paid-off automobiles for new gas-efficient options. In other words, I was being asked whether spending $32,000 was worth the saving of $600 a year at the gas pump.

The numbers didn’t work out advantageously. Once you consider the opportunity cost of spending five figures, well, you’re on the roof and seeing things from a clearer perspective. From there, dollars may flow to higher uses or in these cases, not flow inefficiently to paying additional debt from automobile loans.

4) Hire a navigator.

The navigators are out there. The best financial advisers are sensitive to their own emotional biases and can help others navigate through theirs. There’s a synergy and greater satisfaction when a financial partner can help reduce barriers and encourage breakthrough or “a-ha” moments.

You always appreciate the highest and best use of a navigator. Ostensibly, your net worth should be affected positively, too.

5) Live your retirement plan optimization. Most people I encounter have a retirement strategy. Unfortunately, it exists in their heads, but not in writing.

Those who have a formal, written plan tend to weigh opportunity costs or are at the least, sensitive to the implications of their financial choices.  Since plans take into account your entire financial picture they re-direct focus on the big picture. Hey, the portfolio is important, but it isn’t everything.

Eventually, emotional walls crumble; you can easily think full circle and assess how every decision made today affects your retirement start date.

6) How sub-optimized are your relationships? As you grow as an individual, a force, you must consistently optimize your relationships to determine who is worthy of your inner circle. All the others must be cast away. They’re weights tied to your spirit and they will hold you down.  Surround yourself with those who are smarter than you (not just book smart, but also will expose you to learning experiences outside your comfort zones). Also, people who make you laugh inspire optimization.


Now that you’re in the mood to bust boundaries around money, keep in mind that any account can be a retirement account. Just because it’s not held with your employer or doesn’t have “IRA” in the title, doesn’t mean the dollars you save aren’t applicable to retirement. Society, to a degree, has encouraged mental accounting by sanctioning retirement vs. non-retirement accounts.

As part of your change in thinking, consider all money in one pool. You decide how it flows to its most honorable (and hopefully lucrative) conclusion.

Sub-optimization optimized my thinking; I hope it’s sparked a new perspective for you.

This past weekend, I discussed what appears to be the markets ongoing melt-up toward its inevitable conclusion. Of course, that move is supported by the last of the “holdouts” that finally capitulate and take the plunge back into a market that “can seemingly never go down.” But therein lies the danger. To wit:

“However, it should be noted that despite the ‘hope’ of fiscal support for the markets, longer-term conditions are currently present that have led to rather sharp market reversions in the past.”

“Regardless, the market is currently ignoring such realities as the belief ‘this time is different’ has become overwhelming pervasive.”

The other problem on a short-term basis is the market is pushing very elevated levels currently. As shown below, with RSI (14) now above 70, the market 3-standard deviations above the 50-dma, and the MACD over 13, in both previous cases over the last year a short-term reversal followed.

A similar outcome would not be surprising this time either, so some caution is advised.

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. With the exception of the 10-Year Treasury which I have compared to interest rates, the others have been compared to the S&P 500.

Volatility Extreme

The extreme net-short positioning on the volatility index suggests there will be a rapid unwinding of positions given the right catalyst. As you will note, reversals of net-short VIX positioning has previously resulted in short to intermediate-term declines. With the largest short-positioning in volatility on record, the rush to unwind that positioning could lead to a much sharper pickup in volatility than most investors can currently imagine.

Crude Oil Extreme

The recent attempt by crude oil to get back to $50/bbl coincided with a “mad rush” by traders to be long the commodity. For investors, it is also worth noting that crude oil positioning is also highly correlated to overall movements of the S&P 500 index. With crude traders currently extremely “long,” a reversal will likely coincide with both a reversal in the S&P 500 and oil prices being pushed back towards $40/bbl. 

While oil prices could certainly fall below $40/bbl for a variety of reasons, the recent bottoming of oil prices around that level will provide some support. Given the extreme long positioning on oil, a reversion of that trade will likely coincide with a “risk off” move in the energy sector specifically. If you are overweighted energy currently, the data suggests a rebalancing of the risk is likely advisable.

US Dollar Extreme

Recent weakness in the dollar has been used as a rallying call for the bulls. However, a reversal of US Dollar positioning has been extremely sharp and has led to a net-short position.

As shown above, and below, such negative net-short positions have generally marked both a short to intermediate-term low for the dollar as well as struggles for the S&P 500 as a stronger dollar begins to weigh on exports and earnings estimates.

It is also worth watching the net-short positioning the Euro-dollar as well which has also begun to reverse in recent weeks. Historically, the reversal of the net-short to net-long positioning on the Eurodollar has often been reflected in struggling financial markets.

Interest Rate Extreme

One of the biggest conundrums for the financial market “experts” is why interest rates fail to rise. Apparently, traders in the bond market failed to get the “memo.” With the net positioning in bonds at some of the highest levels since the financial crisis, there is little reason to believe the “bond bull” market is over. Look for a reversal of the current positioning to push bond yields lower over the next few months.

Smart Vs. Dumb Money Extreme

While we have been looking at solely the large non-commercial traders above, they are not the only ones playing in the future markets. We can also dig down into the overall net exposure of retail investors (considered the “dumb money”) versus that of the major institutional players (“smart money”)

The first chart below shows the 3-month moving average of both smart and dumb-money players as compared to the S&P 500 index. With dumb-money running close to the highest levels on record, it has generally led to outcomes that have not been favorable in the short-term.

We can simplify the index above by taking the net-difference between the two measures. Not surprisingly, the message remains the same. With the confidence of retail investors running near historic peaks, outcomes have been less favorable.

None of this analysis suggests that a market “crash” is about to occur tomorrow. However, with complacency high, and investors scrambling to find excuses why markets can only go higher, suggests that extremes in positioning have likely been reached. 

This was a point made by Macquarie’s Viktor Shvetz, the bank’s head of global equity strategy, yesterday:

Investors seem to be residing in a world without any notable perceived risks. It is an extraordinary and unprecedented situation, particularly given unresolved issues of over-leveraging and associated over-capacity as well as profound disruption of business and economic models, which are not just depressing inflation but also causing extreme political and electoral outcomes while feeding Maslowian-type disappointments across labor markets.

What can explain such lack of concern regarding potential risks?

In our view, the only answer is one of investors’ perception that, as we discussed in our preview of 2H’17, ‘slaves must remain slaves’ and hence, neither Central Banks nor other public institutions can afford to step aside but need to continue to guarantee asset price inflation. In its turn, this can only be achieved by ensuring that volatilities are contained (as they are the deadliest enemy of an ongoing leveraging) and liquidity is expanding at a sufficient pace to accommodate nominal demand.

We remain constructive on financial assets (both equities and bonds), not because we expect a return to self-sustaining private sector-led recovery and growth but because we believe that an ongoing financialization is the only politically and socially acceptable answer.

In our view, therefore, the greatest risk is one of policy.”

The complete disregard for “risk” has never worked out well for investors in the past and is unlikely to be different this time either. But remember, in the short-term, the markets can remain irrational longer than logic would predict and they always “feel” their best at the peak.

The rise in the market has seemed unstoppable. Despite the Federal Reserve continuing to hike interest rates and tightening monetary policy, geopolitical risks from North Korea to Iran, mass shootings, failure of legislative agenda and weak economic growth – the market’s rise has continued unabated.

Much of the recent rise, as discussed last week, has been based upon faulty assumptions about the effect of tax cuts and reforms. However, in the short-term, it is always the exuberance of market participants chasing returns as the “fear of missing out,” or FOMO, overrides the logic of fundamentals.

The problem for investors is that since fundamentals take an exceedingly long time to play out, as prices become detached “reality,” it becomes believed that somehow “this time is different.” 

Unfortunately, it never is.

Our chart of the day is a long-term view of price measures of the market. The S&P 500 is derived from Dr. Robert Shiller’s inflation adjusted price data and is plotted on a QUARTERLY basis. From that quarterly data I have calculated:

  • The 12-period (3-year) Relative Strength Index (RSI),
  • Bollinger Bands (2 and 3 standard deviations of the 3-year average),
  • CAPE Ratio, and;
  • The percentage deviation above and below the 3-year moving average. 
  • The vertical RED lines denote points where all measures have aligned

Over the next several weeks, or even months, the markets can certainly extend the current deviations from long-term mean even further. But that is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market “holdouts” back into the markets.

As Vitaliy Katsenelson penned last week:

Our goal is to win a war, and to do that we may need to lose a few battles in the interim. Yes, we want to make money, but it is even more important not to lose it. 

We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.”

I wholeheartedly agree with that statement which is why we remain invested, but hedged, within our portfolios currently. Unfortunately, for most investors, they are currently playing with a losing hand.

As the chart clearly shows, “prices are bound by the laws of physics.” While prices can certainly seem to defy the law of gravity in the short-term, the subsequent reversion from extremes has repeatedly led to catastrophic losses for investors who disregard the risk.

With sentiment currently at very high levels, combined with low volatility and excess margin debt, all the ingredients necessary for a sharp market reversion are currently present. Am I sounding an “alarm bell” and calling for the end of the known world? Should you be buying ammo and food? Of course, not.

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desired end result you have been promised.

As I stated above, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered “bearish” to point out the potential “risks” that could lead to rapid capital destruction; then I guess you can call me a “bear.” However, just make sure you understand that I am an “almost fully invested bear”…for now.

But such can, and will, rapidly as the market dictates.

(Follow up read on how to approach the market: The 80/20 Rule Of Investing)

Just remember, in the market there really isn’t such a thing as “bulls” or “bears.” There are only those that “succeed” in reaching their investing goals and those that “fail.” 

With the market recently breaking above 2500, there seems to be nothing to dampen the bullish exuberance. The recent run, which has largely been focused on areas in the market with the most sensitivity to tax cuts, has exploded over the last two weeks to record highs. That explosion has also lead to a surge in the Market Greed/Fear Gauge which comprises different measures of market complacency and bullishness.

But the rush to chase performance can be clearly seen in the chart below of the S&P 600 index (small cap) which is now 4-standard deviations above the 6-month moving average.

Then there is the widely viewed CNN Fear/Greed Index.

Of course, not surprisingly, with investors as optimistic and bullish as they can be equity to money market ratios are at extremes.

And “Dumb Money” is continuing to pile into markets as “Smart Money” is willing to sell positions to them.

After 9-years of a bull market, and pushing a 270% gain from the lows, investors have now decided it is now time to get back into the market. But that is the nature of a bull market, and particularly one that has entered into the final stages of long-term cyclical advance, where the last of the “holdouts” are sucked back into the game.

As we enter into earnings season, we once again enter into the “beat the estimates game,” where analysts act surprised that companies “beat” lowered estimates. In the short-term, these “beat rates” will provide support for the bullish case, but in the long-term, it is valuations and actual revenue growth that matters.

I agree with Doug’s sentiment yesterday:

  •  Massive injections of liquidity from the world’s central bankers
  • Passive investing (quants and ETFs) are now dominating markets (at nearly 40%) at the margin
  • Machines and algorithms, as well as many individual investors, are behaving differently as they are now programmed and conditioned to buy the dips.
  • 17% of the listed shares outstanding have been retired in corporate stock repurchases since the Generational Low in March, 2009.
  • More than half of the listed companies on the exchanges have disappeared over the last eight years

“We have a Bull Market in Complacency.” – Doug Kass


Here’s your reading list to for the weekend.

Trump Tax Cuts…


Research / Interesting Reads

“In a bear market all stocks go down and in a bull market they go up.Jesse Livermore

Questions, comments, suggestions – please email me.

“At this time 85 years ago, Yale economist Irving Fisher was jubilant. ‘Stock prices have reached what looks like a permanently high plateau,’ he rejoiced in the pages of The New York Times. That dry pronunciation would go on to be one of his most frequently quoted predictions — but only because history would record his declaration as one of the wrongest market readings of all time.” -Time Magazine, “The Worst Stock Tip In History

In Jim “El Capitan” Cramer’s opening missive today he analytically addresses the active vs. passive conflict, which helps explain the market’s steady bullish action. As Jim writes:

“The answer is that there are two kinds of sellers in this market: hedge fund sellers, who react off of research, and portfolio shufflers, who buy and sell ETFs and index funds.

The former jump on anything, right or wrong, as long as it is actionable. Sure, if PepsiCo (PEP) has an organic growth shortfall, as we said could happen in our Action Alerts PLUS bulletins last week about PEP, it could get hammered. That’s a change in the margin of a bad group. But most of the  ‘valuation’ calls analysts make, shy of catalysts, only produce hedge fund jumps.

The latter, the index funds and ETF traders, rarely jump although they may press down harder on a bedraggled ETF, like one that includes the consumer products group.

But there are two kinds of buyers. The opportunistic buyers and the index buyers. The opportunists think that the downgrades are noise and give them a chance to buy high quality stocks with the money that comes in over the transom.

The index and ETF buyers? Well, they just buy.

The dichotomy explains a lot of the bullish action, and isn’t talked about enough. You see the sellers off those research calls? They were either shorts, or people who hadn’t done their homework, because nothing really happened to justify their actions.

But the buyers?

They lurk and wait and pounce.”

I am in basic agreement with Jim but would differ a bit in my interpretation of why dips are bought and how sustainable that buying is.

ETFs and index funds, when faced with a constant and large inflow of funds, are always rebalancing and buying, which is why all dips are purchased. But sizable net inflows may not be seen over time as a constant state, because at some point there will be outflows and that steady dip buying and demand for stocks could disappear almost immediately. To be sure, attempts to give reasons why investor sentiment, now buoyant (see the latest CNN Fear & Greed Index), may erode have fallen on deaf ears this year. But ebbs and flows are a more natural condition of the markets, and as sure as night follows day, the outflows at some point will return. And if ETFs sell, who will be left to buy?

Second, another source of dip buying, as mentioned below (and not covered by Jimmy), are the quant funds that are influenced by a conditioning in the algorithms to buy weakness. That buying has nothing to do with fundamentals, as machines are agnostic to the value — or lack of value — inherent in the income statement, balance sheets and replacement values of the constituent stocks. And, of course, traders who worship at the altar of price momentum are now following the dip buying of quant funds.

Third, money is coming out of active managers in favor of passive investing (i.e., ETFs and quants). Many high-profile and successful managers have closed. Hedge funds — the catalyst for fundamental-based selling that Jim describes — no longer hold the sort of influence that they have in the past.

The Virtuous Circle

The dominance and impact of these three constituents — inflows into ETFs, an expansion in quants’ influence and the contraction taking place in hedge funds — explain a lot about the dip buying that has existed over the last year and the current virtuous circle of demand versus supply.

I recently added up some other reasons for the dip buying.

From my perch, stocks continue to be buoyed by some of the following conditions:

* Massive injections of liquidity from the world’s central bankers

* Passive investing (quants and ETFs) are now dominating markets (at nearly 40%) at the margin

* Machines and algorithms, as well as many individual investors, are behaving differently as they are now programmed and conditioned to buy the dips

* 17% of the listed shares outstanding have been retired in corporate stock repurchases since the Generational Low in March, 2009.

* More than half of the listed companies on the exchanges have disappeared over the last eight years

* We have a Bull Market in Complacency

–Kass Diary, “A Bull Market in Complacency”

We are having a hard time finding high-quality companies at attractive valuations.

For us, this is not an academic frustration. We are constantly looking for new stocks by running stock screens, endlessly reading (blogs, research, magazines, newspapers), looking at holdings of investors we respect, talking to our large network of professional investors, attending conferences, scouring through ideas published on value investor networks, and finally, looking with frustration at our large (and growing) watch list of companies we’d like to buy at a significant margin of safety. The median stock on our watch list has to decline by about 35-40% to be an attractive buy.

But maybe we’re too subjective. Instead of just asking you to take our word for it, in this letter we’ll show you a few charts that not only demonstrate our point but also show the magnitude of the stock market’s overvaluation and, more importantly, put it into historical context.

Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: the average stock is overvalued somewhere between tremendously and enormously. If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry, we don’t know either. But this is our point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.

Let’s demonstrate this point by looking at a few charts.

The first chart shows price-to-earnings of the S&P 500 in relation to its historical average. The average stock today is trading at 73% above its historical average valuation. There are only two other times in history that stocks were more expensive than they are today: just before the Great Depression hit and in the1999 run-up to the dotcom bubble burst.

We know how the history played in both cases – consequently stocks declined, a lot. Based on over a century of history, we are fairly sure that, this time too, stock valuations will at some point mean revert and stock markets will decline. After all, price-to-earnings behaves like a pendulum that swings around the mean, and today that pendulum has swung far above the mean.

What we don’t know is how this journey will look in the interim. Before the inevitable decline, will price-to-earnings revisit the pre-Great Depression level of 95% above average, or will it maybe say hello to the pre-dotcom crash level of 164% above average? Or will another injection of QE steroids send stocks valuations to new, never-before-seen highs? Nobody knows.

One chart is not enough. Let’s take a look at another one, called the Buffett Indicator. Apparently, Warren Buffett likes to use it to take the temperature of market valuations. Think of this chart as a price-to-sales ratio for the whole economy, that is, the market value of all equities divided by GDP. The higher the price-to-sales ratio, the more expensive stocks are.

This chart tells a similar story to the first one. Though neither Mike nor Vitaliy were around in 1929, we can imagine there were a lot of bulls celebrating and cheerleading every day as the market marched higher in 1927, 1928, and the first eleven months of 1929. The cheerleaders probably made a lot of intelligent, well-reasoned arguments, which could be put into two buckets: first, “This time is different” (it never is), and second, “Yes, stocks are overvalued, but we are still in the bull market.” (And they were right about this until they lost their shirts.)

Both Mike and Vitaliy were investing during the 1999 bubble. (Mike has lived through a lot of more bubbles, but a gentleman never tells). We both vividly remember the “This time is different” argument of 1999. It was the new vs. the old economy; the internet was supposed to change or at least modify the rules of economic gravity – the economy was now supposed to grow at a new, much faster rate. But economic growth over the last twenty years has not been any different than in the previous twenty years – no, let us take this back: it has actually been lower. From 1980 to 2000 real economic growth was about 3% a year, while from 2000 to today it has been about 2% a year.

Finally, let’s look at a Tobin’s Q chart. Don’t let the name intimidate you – this chart simply shows the market value of equities in relation to their replacement cost. If you are a dentist, and dental practices are sold for a million dollars while the cost of opening a new practice (phone system, chairs, drills, x-ray equipment, etc.) is $500,000, then Tobin’s Q is 2. The higher the ratio the more expensive stocks are. Again, this one tells the same story as the other two charts: Stocks are very expensive and were more expensive only twice in the last hundred-plus years.

What will make the market roll over? It’s hard to say, though we promise you the answer will be obvious in hindsight. Expensive markets collapse by their own weight, pricked by an exogenous event. What made the dotcom bubble burst in 1999? Valuations got too high; P/Es stopped expanding. As stock prices started their decline, dotcoms that were losing money couldn’t finance their losses by issuing new stock. Did the stock market decline cause the recession, or did the recession cause the stock market decline? We are not sure of the answer, and in the practical sense the answer is not that important, because we cannot predict either a recession or a stock market decline.

In December 2007, Vitaliy was one of the speakers at the Colorado CFA Society Forecast Dinner. A large event, with a few hundred attendees. One of the questions posed was “When are we going into a recession?” Vitaliy gave his usual, unimpressive “I don’t know” answer. The rest of the panel, who were well-respected, seasoned investment professionals with impressive pedigrees, offered their well-reasoned views that foresaw a recession in anywhere from six months to eighteen months. Ironically, as we discovered a year later through revised economic data, at the time of our discussion the US economy was already in a recession.

We spend little time trying to predict the next recession, and we don’t try to figure out what prick will cause this market to roll over. Our ability to forecast is very poor and is thus not worth the effort.

An argument can be made that stocks, even at high valuations, are not expensive in context of the current incredibly low interest rates. This argument sounds so true and logical, but – and this is a huge “but” – there is a crucial embedded assumption that interest rates will stay at these levels for a decade or two.

Hopefully by this point you are convinced of our ignorance, at least when it comes to predicting the future. As you can imagine, we don’t know when interest rates will go up or by how much (nobody does). When interest rates rise, then stocks’ appearance of cheapness will dissipate as mist on the breeze.

And there is another twist: If interest rates remain where they are today, or even decline, this will be a sign that the economy has big, deflationary (Japan-like) problems. A zero interest rate did not protect the valuations of Japanese stocks from the horrors of deflation – Japanese P/Es contracted despite the decline in rates. America maybe an exceptional nation, but the laws of economic gravity work here just as effectively as in any other country.

Finally, buying overvalued stocks because bonds are even more overvalued has the feel of choosing a less painful poison. How about being patient and not taking the poison at all?

You may ask, how do we invest in an environment when the stock market is very expensive? The key word is invest. Merely buying expensive stocks hoping that they’ll go even higher is not investing, it’s gambling. We don’t do that and won’t do that.

Not to get too dramatic here, but here’s how we look at it: Our goal is to win a war, and to do that we may need to lose a few battles in the interim.

Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions.

We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.

However, valuing companies is not random. In the long run stocks revert to their fair value. If we assemble a portfolio of high-quality companies that are significantly undervalued, then we should do well in the long run. However, in the short run we have very little control over how the market will price our stocks.

Our focus in 2016 was to improve the overall quality of the portfolio – and we did. We will stubbornly continue to build a portfolio of high-quality companies that are undervalued.

The market doesn’t need to collapse for us to buy new stocks. The market falls in love and out of love with specific sectors and stocks all the time. In 2014 and 2015 healthcare stocks were in vogue, but in 2016 that love was replaced by a raging hatred. We bought a lot of healthcare stocks in 2016. In the first quarter, REITs as a group were decimated and we bought Medical Properties Trust (MPW) at less than 10 times earnings and a near 8% dividend yield – more on that later. We also spend a lot of time looking for stocks outside the US, in countries that have a free market system and the rule of law.

The point we want to stress is this: We don’t own the market. Though the market may be overvalued, our portfolio is not.

Last week, I did a fairly extensive analysis on the release of the 9-page “Trump Tax Cut” plan. 

The most important aspect of that discussion was the difference between 1982, the last time there was permanent tax reform, as compared to today.

Comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem that bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today.  Consider the following table:‘”


The differences between today’s economic and market environment could not be starker. The tailwinds provided by initial deregulation, consumer leveraging and declining interest rates and inflation provided huge tailwinds for corporate profitability growth.

Most importantly, when tax cuts were implemented in the mid-80’s, the U.S. economy was just coming out of back-to-back recession versus being in the third longest economic expansion on record to date.

However, besides the fact the economic backdrop is diametrically opposed to what is was during the “Reagan years,” we also need to look at the backdrop of who actually pays taxes to begin with.

Who Pays Taxes

While the current tax plan has not defined actual income levels as of yet, we can make some assumptions from previous iterations of proposals. The entire premise behind the tax cuts is that it will unleash economic growth, generate millions of jobs, bring back manufacturing to America and lead to higher wage growth.

However, given that roughly 70% of economy is driven by personal consumption, the tax cuts will need to increase the amount of disposable incomes available to individuals to expand consumption further, thereby increasing overall economic growth.

So, here is the issue of tax cuts for the middle class. The chart below shows “who pays what in Federal taxes.”

Look at that chart closely.

  • 50% of ALL taxes are paid by the top 10% of income earners.
  • The other 50% of ALL taxes are paid by remaining 90%.
  • The BOTTOM 80% only pay 36% of ALL taxes.

But it is even more glaring when we look at the taxes paid by just the top 20% of income earners.

Given that roughly 2/3rds of income taxes are paid by the top 20%, the reality is that tax cuts will have their greatest impact in reducing the tax burden of those individuals.

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

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

The problem, as I have detailed previously, is that the vast majority of Americans are living paycheck to paycheck. According to CNN, almost six out of every ten Americans do not have enough money saved to even cover a $500 emergency expense. That lack of savings can be directly contributed to the lack of income growth as noted recently by Bloomberg:

“Newly released income and wealth data from the Federal Reserve Board’s triennial Survey of Consumer Finances show that America’s richest families enjoyed gains in income and net worth over the last decade. Not part of the top 10 percent? Then your income probably fell. The data show that families ranked in the highest percentile saw an income gain of $16,300 from 2007 to 2016. Those below are still making less money.”

So, with 80% of Americans living paycheck-to-paycheck, the need to supplant debt to maintain the standard of living has led to interest payments consuming a bulk of actual disposable income. The chart below shows that debt has exceeded personal consumption expenditures. Therefore, any tax relief will most likely evaporate into the maintaining the current cost of living and debt service which will have an extremely limited, if any, impact on fostering a higher level of consumption in the economy.

But again, there is a vast difference between the level of indebtedness (per household) for those in the bottom 80% versus those in the top 20%.

But Corporate Tax Cuts Are The Key, Right?

Yes, corporate tax cuts will immediately drop to the bottom lines of corporate income statements. When that earnings boost is combined with any repatriated dollars to buy back shares, there will be an earnings expansion for the first year. (You didn’t REALLY think they would use repatriated dollars to expand production and hire workers did you?)

Importantly, while there is a boost to bottom line earnings, there was NO increase in top-line revenues.

However, from an economic perspective, tax cuts for corporations will have only a minor impact in reality. The first chart below shows total federal tax revenue by source.

As you can see, corporate taxes are less than 10% of the total taxes collected by the Government.

But more importantly, it is the promise of cutting the corporate tax rate from 35% to 20% that has gotten the financial markets all excited.

There’s just one problem. Roughly 80% of all corporations already pay rates far lower than 20% and any reduction in deductions for corporations will actually lead to higher taxes being paid. As shown below, 90% of all corporations currently have a tax rate below 10%.

It is a myth that the U.S. has the highest corporate tax rate in the world. We simply don’t.

This was also an observation made by Dr. John Hussman this week:

“I’ll add that another feature of Wall Street’s blissful delusion is the notion that ‘U.S. corporate taxes are the highest in the world.’ It’s striking how disingenuous this claim is. The fact is that among all OECD countries, the U.S. is also the only country that does not levy any tax at all on corporate value-added in the production of goods and services.”

“The main point is this. The argument that U.S. taxes on corporate profits are somehow oppressive relative to other countries is an apples-to-oranges comparison. It wholly ignores that the U.S. levies no value-added tax on corporations at all, whereas the value-added tax is the principal revenue source for most other countries. The rhetoric on corporate taxes here is unfiltered effluvium.

The chart below presents a clearer picture of U.S. corporate profits taxation. Actual taxes paid by U.S. companies, as a share of pre-tax profits, have never been lower, outside of the depths of the global financial crisis.”

Again, as with individual taxes, today ain’t 1982 or 1986.

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

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

This issue of whether tax cuts lead to economic growth was examined in a 2014 study by William Gale and Andrew Samwick:

“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

Again, the timing is not advantageous, the economic dynamics are not supportive and the structure of the tax cut itself is not self-supporting.

As Hussman concludes:

“The potential effect of even a substantial percentage reduction in statutory rates for several years is quite small when the present value of the tax reduction is compared with existing equity market capitalization. The likely cumulative impact comes to just a few percent of stock market value.

Against that, consider that the most reliable market valuation measures we identify (as measured by their correlation with actual subsequent S&P 500 total returns in market cycles across history) are currently between 2.5 and 2.7 times their historical norms (that is, 150% to 170% above those norms).

Put simply, it seems misguided to imagine that ‘tax reform’ will somehow make the most obscene speculative bubble in U.S. history something other than the most obscene speculative bubble in U.S. history.”

Put simply, you can’t solve a debt-problem with tax cuts.