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• Market Continues Euphoric Advance
• Portfolio Position Review
• MacroView: 2020 Market Outlook (Video)
• Financial Planning Corner: By The Numbers For 2020
• Sector & Market Analysis
• 401k Plan Manager

Follow Us On: Twitter, Facebook, Linked-In, Sound Cloud, Seeking Alpha

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Catch Up On What You Missed Last Week

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Market Continues Euphoric Advance

In last week’s missive, I discussed a couple of charts which suggested the markets are pushing limits which have previously resulted in fairly brutal reversions. This week, the market pushed those deviations even further as the S&P 500 has now pushed into 3-standard deviation territory above the 200-WEEK moving average.

There have only been a few points over the last 25-years where such deviations from the long-term mean were prevalent. In every case, the extensions were met by a decline, sometimes mild, sometimes much more extreme. 

The defining difference between whether those declines were mild, or more extreme, was dependent on the trend of financial conditions. In 1999, 2007, and 2015, as shown in the chart below, financial conditions were being tightened, which led to more brutal contractions as liquidity was removed from the financial system. 

Currently, the risk of a more “substantial decline,” is somewhat mitigated due to extremely easy financial conditions. However, such doesn’t mean a 5-10% correction is impossible, as such is well within market norms in any given year. 

This is particularly the case given how extreme positioning by both institutions and individual investors has become. With investor cash and bearish positions at extreme lows, with prices extremely extended, a reversion to the mean is likely and could lean toward to the 10% range.

One of the other big concerns remains the concentration of positions driving markets higher. Lawrence Fuller analyzed this particular extreme in the market. (H/T G. O’Brien)

“One similarity between the Four Horseman of 2000 and the mega-caps of 2020 is their tremendous influence on the overall market, as can be seen below by their cumulative weightings. The weighting of today’s top five names is now 17.3%. I’m not suggesting that history is going to repeat itself, but often it rhymes.

If you lived and invested through the 1990s, as I did, then you’ll understand what I am talking about when I say that the dot-com boom was a sentiment-driven rally. I’m starting to see the same explanation for the current rally, as there really haven’t been any concrete fundamental developments to explain or validate it. The momentum stocks are rising in price day after day on hopes and expectations, and Wall Street analysts are happy hop on board for the ride, as usual.”

Lawrence is correct. There has not been a fundamental improvement to support the rise in the market currently. As shown in the chart below, S&P just released its 2021 estimates for the S&P 500, which is estimated to come in at $171/share. 

What you should notice is that estimates for 2021 are now $3 LOWER than where estimates for the end of 2020 stood in April 2019. Importantly, between April 2019 and present, as earnings estimates were continually ratcheted lower, the S&P 500 index rose by 17.5%

While Apple, which we own, is the “cheapest” of the “4-horseman” currently, it is only “cheap” because of rather aggressive share repurchases. Here are some interesting stats:

In the 5-years from 2015:

• Earnings per share (EPS) grew by just $2.69 per share or $0.53 per share annually.
• Sales only grew by $26.45 billion or $5.29 billion/year.
• Shares outstanding, however, declined by 1.13 billion

However, during that same 5-year period, Apple’s share price has risen by 210%.  

The only reason Apple “appears” to be cheap is because of the massive infusion of capital used to reduce the number of shares outstanding. As a business, it is a great company, but it is a fully mature company, which is struggling to grow revenues. With a P/E of 27 and price-to-sales (P/S) ratio of 5.36, investors are grossly overpaying for the earnings growth and will likely be disappointed with future return prospects. 

So why do we still own Apple? Because “fundamentals don’t matter” currently as the momentum chase, fueled by the Fed’s ongoing liquidity interventions, has led to a “runaway train.” But, understanding that eventually fundamentals will matter, is why we have taken profits out of our position twice since January 2019.

Just remember, “price is what you pay, value is what you get.” 

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Next Stop, 3500

As noted last week, in July of 2019, we laid out our prognostication the S&P 500 could reach 3300 amid a market melt-up though the end of the year. On Friday, the S&P 500 closed at 3329, with the Dow pushing toward 29,350.

With the Federal Reserve continuing to pump liquidity into the market currently, we are raising our 2020 estimate for the S&P to 3500 as “the mania” goes mainstream. There is absolutely NO FUNDAMENTAL basis for raising the target; it is ONLY a function of the momentum chase.

This urgency to take on “risk,” as investors pile into “passive indexes” under a “no market risk” assumption, can be seen in the extreme lows of the put/call ratio.

With the Federal Reserve’s ongoing “Not QE,”  it is entirely possible the markets could continue their upward momentum towards S&P 3500, and Dow 30,000. Clearly, the “cat is out of the bag” if CNBC even realizes it’s the Fed:

“On Oct. 11, the central bank announced it would begin purchasing $60 billion of Treasury bills a month to keep control over short-term rates. The magnitude of the purchases resembles the quantitative easing program the Fed conducted during and after the financial crisis.”

“The increase in the Fed’s balance sheet has been in near lockstep with the stock market’s climb. The balance sheet has expanded 10% since October, while the S&P 500 shot up 12%, including notching its best fourth quarter since 2013.”

With the Federal Reserve continuing to “ease” financial conditions, there is little to derail higher asset prices in the short-term. However, we continue to see cracks in the “economic armor,” like Friday’s plunge in “job openings,” continued deterioration in earnings estimates, weaker growth rates in employment, and negative revisions to data, like wages, which suggest the market is well ahead of the economy. (Last week, negative revisions wiped out all the wage growth for the bottom 80% of workers.)

But, as I said, “fundamentals” don’t matter currently. As CNBC noted:

“The problem front and center is how investors are looking past the continuous earnings rout, betting on a snapback as soon as the first quarter of 2020. S&P 500 earnings are expected to drop by 0.3% in the fourth quarter of 2019, marking the first back-to-back quarterly decline since 2016, according to Refinitiv.”

While “fundamentals” may not seem to matter much currently, eventually, they will.

Portfolio Positioning

After reducing exposure “slightly” to equities, as noted last week, we did not make any further changes to portfolios over the last few days. Given we have shortened our duration in our bond holdings, raised cash levels to roughly 10% of the portfolio, we can afford at the moment to allow our existing long positions to ride the market higher. 

In case you missed last week’s note, or are a new reader, here were the previous changes:

In the Equity Portfolios, we slightly reduced our weightings in some of our more extended holdings such as Apple (AAPL,) Microsoft (MSFT), United Healthcare (UNH), Johnson & Johnson (JNJ), and Micron (MU.)

In the ETF Sector Rotation Portfolio, we slightly reduced our overweight positions in Technology (XLK), Healthcare (XLV), Mortgage Real Estate (REM), Communications (XLC), Discretionary (XLY) back to portfolio weightings for now. 

The Dynamic Portfolio was allocated to a market neutral position by shorting the S&P index itself.

The reason we continue to derisk portfolios is that we have seen this “game” before. This was a point we made to our RIAPRO.NET Subcribers (Try RISK FREE for 30-Days) last week:

“The belief the markets can no longer have a correction is fueling an equity chase in companies with the poorest underlying fundamentals. The last time that we saw asset prices surge by 20%, or more, in a single month, particularly in companies with no revenue, negative valuations, and poor business models, was in 1999. The chart of Qualcom (QCOM) in late 1999 is a good example.”

“Unfortunately, for investors in QCOM, by the end of 2000, that 95% gain had been reversed to a 10% loss. But QCOM was not alone, the only difference is the vast majority of other companies like Global Crossing, Enron, Worldcom, Lucent Technologies, Sun Micro, and many others, no longer exist in their original forms, if at all. 

Another good example is Cisco Systems (CSCO). If you had bought it at the turn of the century, you would still be down 10% in your position 20-years later.”

“Today, we are seeing the same chase in companies which exhibit similar characteristics to what we saw in 1999:

• Poor business models with little, or no, ‘protective moat.’
• Little or no earnings
• Excessively high or negative valuations
• Prices are bid up on “hope” these companies will mature into valuations in the future.

Sure, companies from Tesla (TSLA) to Zoom Video (ZM) might just be the next Amazon (AMZN) of the “dot.com” mania to survive and prosper. However, the odds are highly stacked against that being the case.”

Being more conservative may “cost” you in the short-term. However, in the longer-term, where it matters for your money, it is highly likely we will eventually see some, most, or all of the gains of this past decade reversed. 

While that is hard to believe, just remember its happened twice before.

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The Macro View

Michael Lebowitz and I discuss our outlook and reasoning

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

See You Next Week

By Lance Roberts, CIO

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Financial Planning Corner

REGISTER NOW for our most popular workshop: THE RIGHT LANE RETIREMENT CLASS

• The Westin, Austin at the Domain- 11301 Domain Drive, Austin, TX 78758
• February 8th from 9-11am.

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

by Danny Ratliff, CFP®, ChFC®

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Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders

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S&P 500 Tear Sheet

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Performance Analysis

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

REGISTER NOW for our most popular workshop:

THE RIGHT LANE RETIREMENT CLASS

• The Westin Austin at the Domain- 11301 Domain Drive, Austin, TX 78758
• February 8th from 9-11am.

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Everyone has heard of having emergency funds, but how many have heard of a financial vulnerability cushion (FVC)? Common, old rule of thumb financial rules typically dictate savings rates, but in times like we currently face should we be doing something different?

I know, I know times are great. Markets are hitting all-time highs daily, unemployment is better than anything we have seen in 50 years, tax brackets are low, and the list goes on and on. These are just a few of the more common themes and I’m not here to argue any of them.

I am here to hopefully provide an ounce of clarity.

What happens after some of the best times? What happens when life can’t get you down? What happens after some of the worst times? Markets eb and flow and not just financial markets, but job markets as well.

They don’t say when it rains it pours for nothing.

We want you to be prepared.

I’m not talking about building a bunker, but I am talking about going above and beyond the typical 3-6 months of expenses held in a fully funded emergency fund.  In times like these it’s difficult to think about putting funds anywhere but in the market. After all, the market has been red hot. I visit with people daily who question their need for additional savings or any money in savings accounts while the market’s notching all-time highs weekly. FOMO or “Fear of missing out” is very real.

Have you ever wondered why Wall Street tells everyone that buy and hold is the only strategy, yet they don’t utilize it themselves?

Have you ever wondered how so many people end up in difficult financial positions? Many times, it’s because they choose the present over the future in terms of spending or believe the future will improve and things will only get better. I’ll get that raise or bonus this year, but unfortunately as many know sometimes things are as good as they get.  Don’t get me wrong I’m an eternal optimist, but when it comes to things I literally have no control over I know a little better.

We’d like for you to start thinking a little differently when it comes to where to put your funds and how much you should have saved that are easily accessible and low risk.

Emergency Funds

These funds should be in a savings account and accessible, but not so accessible you can go to the ATM and make a withdrawal. Emergency funds are for real emergencies, your A/C goes out, the car breaks down, your kid breaks their leg, the list goes on. (I’ve actually encountered all within the last 12 months) so don’t say it can’t happen!

We like online banks that are still FDIC insured or a brick and mortar that pays a higher interest rate. Don’t leave these funds in a bank that pays you very little or next to nothing. The banks are using your funds to make money, so should you. Every little bit helps.

A resource to find a credible bank could be www.bankrate.com or www.nerdwallet.com. Just type in High Yield Savings. Recently there have been many more banks popping up in the search que so do your research on each institution or give us a call if you have any questions.

Financial Vulnerability Cushion or (FVC)-

These are funds that you can think of a little differently, what if I lose my job/have a disability/illness AND the A/C goes out and the car breaks down.  Instead of putting funds in your savings account go ahead and structure these a bit different.

It’s ok to ladder CD’s to lock in higher or current rates. If using CD’s, you would ladder these in the event rates rise so a portion is always coming due. Example 3 months, 6 months, 9 months, 12 months. This may be difficult to stomach because these rates will be similar to what you will earn in a high yield savings account but will also provide a better rate should rates decrease. Short term bond funds or ETF’s could also be suitable for these funds. Safety and liquidity are key here.  We currently favor short term, high credit quality bonds or Treasury bond ETF’s. Remember, you’re not putting these funds here forever and these should be monitored like any other investment. While these are safer investment’s they are not cash and carry some risk and loss of principal.

While the main purpose of the Financial Vulnerability Cushion is to fortify your financial house, these funds can also be utilized for opportunities as well.

How many times have you thought to yourself if only I had the funds to invest or if you only did something differently? Well, congratulations you can now be one of the few investors with additional cash to buy low. This especially makes sense since Wall Street wants you to ride it out and you can’t time the markets, but they sure can. Wall Street will also tell you that cash is a terrible investment. Ever wonder why? How does Wall Street get paid on cash? Long term cash can be a terrible investment, but as our Director of Financial Planning Richard Rosso says you can fall on one of two swords in regards to having cash:

1. The inflation sword or
2. The loss of principal sword.

Our thoughts are this isn’t a forever holding. While I do think this strategy could be used indefinitely for all of the reasons above. This is a strategic investment to be used in late stage cycles. This is your chance to pounce when the market is on sale or that business opportunity falls in your lap. After all true financial freedom is earned not given in markets and often times it is taken away just as quickly.

Bet On Yourself.

Bet on yourself to make the right decision, to be prudent, to be wise. When everyone and I mean everyone is doing one thing does it make sense to be a bit of a contrarian, protect assets and give yourself an opportunity in the future?

This is a great time to review your financial plan and take a look at your assets. Where are you making your contributions? What impact will that make when you make withdrawals? What will give you the most opportunity for success. Most success isn’t given overnight and neither are investment returns.

No one knows what tomorrow brings, but we do know as Roman philosopher Seneca once said “Luck is what happens when preparation meets opportunity.”

Call your advisor, and ask them about your Financial Vulnerability Cushion.

Do you have one?

On Tuesday, Michael Lebowitz and I held private events with our high net worth clients to review our investment strategy and outlook for the rest of the year. The purpose of these events was to provide clarity on portfolio allocation, weightings,  and the risks that could potentially lead to large losses of capital.

As we noted in last weekend’s newsletter, we recently took profits in our various portfolio strategies to raise cash slightly, and reduce excess portfolio risk. Given our portfolios are already hedged with early exposures to value positioning, gold, and short-duration Treasuries, there currently isn’t a need to become overly defensive given the ongoing, liquidity fueled, momentum of the markets. 

Currently, the bullish exuberance, extreme complacency, and technical deviations are issuing warning signs which investors should NOT readily dismiss. These are the issues we cover in the following video presentation:

1. The “risks” to the current “bullish view,” 
2. Why we reduced risk in portfolios
3. The importance of valuations
4. The Fed’s ongoing liquidity programs.
5. Future expected returns, and more.

If you have any questions, please email us.

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

The Week In Blogs

MacroView: Has The Fed Trapped Itself?

Comparison & The Role Your Advisor Should Play

Technically Speaking: This Is Nuts – Part Deux

Yeah…But

Rosso’s 2020 Reading List – Part II

The Fed Won’t Avert The Next “Crisis,” They Will Cause It.

The Best Of “The Lance Roberts Show

Video Of The Week

Lance Roberts & Michael Lebowitz discuss how the Federal Reserve has gotten itself trapped in its own liquidity program.

Our Best Tweets Of The Week

Yes. pic.twitter.com/kCeink3uIK

— Lance Roberts (@LanceRoberts) January 14, 2020

I keep hearing nonsense about how the Fed's actions are not responsible for the market going up. Instead they claim there is a shortage of assets. Why is there a shortage? Could it be the nearly $4 trillion in assets the Fed removed from the market?

— Michael Lebowitz, CFA (@michaellebowitz) January 16, 2020

Uhm…I have a question.
If #everyone is making money in the market AND we have the #greatesteconomyever then can anyone explain this.#ImBeingRhetorical pic.twitter.com/JlQ6eSun3J

— Lance Roberts (@LanceRoberts) January 13, 2020

How sad it is that financial/market writers spend so much ink on the Fed. Its like a sports reporter that writes about refs instead of the game. #pathetic

— Michael Lebowitz, CFA (@michaellebowitz) January 13, 2020

What could possibly go wrong? pic.twitter.com/75jcXayyUR

— Lance Roberts (@LanceRoberts) January 14, 2020

Market performance is defying fundamentals and, it would seem, gravity itself. Why we think that's just…nuts. The latest #ThreeMinutesOnMarketsAndMoney podcast is on our YouTube channel now:https://t.co/AjSDMegWOH#Markets #Money #Investing pic.twitter.com/EohFMWfyPu

— Lance Roberts (@LanceRoberts) January 14, 2020

"The market is currently fairly valued." – Jeremy Siegel
Long-term view of price versus 10x (cheap), 15x (fair) and 20x (expensive) valuations. Most important takeaway is that when price has pushed will above 20x, subsequent outcomes have been bad. $SPY $TLT pic.twitter.com/Zp79j4br4B

— Lance Roberts (@LanceRoberts) January 15, 2020

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Gimme Shelter

See you next week!

We have written rather extensively lately about the extreme extension we are seeing in the markets as the Fed’s ongoing “repo” operations and QE are directly fueling a sharp rise in asset prices. The problem is prices are surging at a time when both corporate profits and earnings growth remain weak. 

Importantly, the ongoing Fed policies have lured investors into an extreme sense of complacency as witnessed by the sharp drop in “short-interest” in the S&P 500. This belief the markets can no longer have a correction is fueling an equity chase in companies with the poorest underlying fundamentals.

The last time that we saw asset prices surge by 20%, or more, in month, particularly in companies which have no revenue, negative valuations, and poor business models, was in 1999. The chart of Qualcom (QCOM) in late 1999 is a good example.

Unfortunately, for investors in QCOM, by the end of 2000, that 95% gain had been completely reversed into a 10% loss. But QCOM was not alone, the only difference is that the vast majority of the other companies like Global Crossing, Enron, Worldcom, Lucent Technologies, Sun Micro, and many others no longer exist in the original forms today, if at all. 

Here is another good example, if you had bought CSCO at the turn of the century, you would still be down by 10% on your position 20-years later.

Today, we are seeing the same chase in companies which exhibit similar characteristics to what we saw in 1999:

• Poor business models with little, or no, “protective moat.” 
• Little or no earnings
• Excessively high or negative valuations
• Prices are bid up on “hope” these companies will mature into valuations in the future.

Sure, companies from Tesla (TSLA) to Zoom Video (ZM) might just be the next Amazon (AMZN) of the “dot.com” mania to survive and prosper. However, the odds are highly stacked against that being the case. 

Here are a few examples of why it looks like investors are once again “Partying Like It’s 1999.” 

Zoom Video

10x Genomics

Twilo, Inc.

Tesla, Inc.

Shake Shack, Inc.

Pope Resource Partners

Pinterest, Inc.

NIO, Inc.

iRhythm Technologies, Inc.

CrowdStrike Holdings, Inc.

Beyond Meat, Inc.

Alteryx, Inc.

While we are not saying the markets are going to “crash” tomorrow, there is mounting evidence that “irrational exuberance” and “extreme complacency,” due to the ongoing Federal Reserve interventions, has begun to manifest itself in equity prices of companies with the poorest fundamentals. 

Historically, this has not worked out well for investors. 

“History doesn’t always repeat itself, but it often rhymes.” – Samuel Clemens

John Mauldin recently penned an interesting piece:

“Ignoring problems rarely solves them. You need to deal with them—not just the effects, but the underlying causes, or else they usually get worse. In the developed world, and especially the US, and even in China, our economic challenges are rapidly approaching that point. Things that would have been easily fixed a decade ago, or even five years ago, will soon be unsolvable by conventional means.

Yes, we did indeed need the Federal Reserve to provide liquidity during the initial crisis. But after that, the Fed kept rates too low for too long, reinforcing the wealth and income disparities and creating new bubbles we will have to deal with in the not-too-distant future.

This wasn’t a ‘beautiful deleveraging’ as you call it. It was the ugly creation of bubbles and misallocation of capital. The Fed shouldn’t have blown these bubbles in the first place.”

John is correct. The problem with low interest rates for so long is they have encouraged the misallocation of capital. We see it everywhere throughout the entirety of the financial system from consumer debt, to subprime auto-loans, to corporate leverage, and speculative greed.

Misallocation Of Capital – Everywhere

Debt, if used for productive purposes, can be beneficial. However, as discussed in The Economy Should Grow Faster Than Debt:

“Since the bulk of the debt issued by the U.S. has been squandered on increases in social welfare programs and debt service, there is a negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.”

Currently, throughout the entire monetary ecosystem, there is a rising consensus that “debt doesn’t matter” as long as interest rates and inflation remain low. Of course, the ultra-low interest rate policy administered by the Federal Reserve is responsible for the “yield chase,” and the massive surge in debt since the “financial crisis.” 

Yes, current economic growth is good, but not great. Inflation, and interest rates, remain low, which creates an “illusion” that using debt remains opportunistic. However, as stated, rising levels of non-productive debt has negative long-term economic consequences.

Before the deregulation of the financial industry under President Reagan, which led to an explosion in consumer credit issuance, it required just $1.00 of total system-wide debt to create $1.00 of economic growth. Today, it requires $3.97 to create the same $1 of economic growth. This shouldn’t be surprising, given that “debt” detracts from economic growth as the “debt service” diverts income from productive investments and leads to a “diminishing rate of return” for each new dollar of debt.

The irony is that while it appears the economy is growing, akin to the analogy of “boiling a frog,” we accept 2% economic growth as “strong,” whereas such growth rates were previously considered near recessionary.

Another conundrum is that corporations, and financial institutions, appear to be healthier, not to mention wealthier than ever. If such is indeed the case, then why is the Federal Reserve still needing to engage in “emergency monetary measures” to support the financial markets and economy after more than a decade?

As John stated above, the Fed’s actions are only “ignoring the problems” which, combined, is a problem too large for the Federal Reserve to fix.

The Dark Side Of Stock Buybacks

While many argue that “share buybacks” are just a method by which corporations can return cash to shareholders, there is a dark side. In moderation, repurchases can be a beneficial method for a company to deploy capital when no better options are available. (It’s the least best use of cash.)

But, as with everything in life, when taken to “excess” the beneficial effects, can become detrimental.

“The rules now reward management, not for generating revenue, but to drive up the price of the share price, thus making their options and stock grants more valuable.” – John Mauldin

The problem for the Fed was, despite the best of intentions, lowering interest rates to zero did not spark a “bank lending spree” throughout the economy. Instead, the excess liquidity flowed directly back into the financial system, creating a global wealth gap, rather than supporting stronger economic growth.

The most vivid example of this “closed loop” was in corporate share repurchases. Corporations, able to borrow cheaply due to low rates, used debt and cash to repurchase shares to increase earnings per share. This was the easiest route to create “executive wealth,” rather than deploying capital in more risky endeavors. As the Financial Times penned:

“Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.”

Importantly, as noted by the Securities & Exchange Commission:

“SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks.”

Again, buybacks may not be an issue, but when taken to excess such can have the negative side effects of inflating asset bubbles. As John Authers pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

“Stock buybacks” are only a short-term benefit. With liquid cash, or worse debt, used for a one-time benefit, there is a long-term negative return on uses of capital for non-productive investments.

All Levered Up

Currently, total corporate debt has surged to $10.1 trillion – its highest level relative to U.S. GDP (47%) since the financial crisis. In just the last two years, corporations have issued another $1.2 trillion of new debt NOT for expansion, but primarily used for share buybacks.

For the last 10-years, the Fed’s “zero interest rate policy” has left investors chasing yield, and corporations were glad to oblige. The end result is the risk premium for owning corporate bonds over U.S. Treasuries is at historic lows, and debt has allowed many “zombie companies” to remain alive.

During the next market reversion, the 10-year rate will fall towards “zero” as money seeks the stability and safety of the U.S Treasury bond. However, corporate bonds will be decimated. When “high yield,” or “junk bonds,” begin to default in large numbers, as they always do in a recession, which is why they are called “junk bonds,” investors will face sharp losses on the one side of their portfolio they “thought” was safe. 

As the credit market falls into crisis, the Fed will have to ramp up additional stimulus to bail out the financial institutions caught long with an exceeding amount of poor-quality debt. As shown below, Treasuries will gain a bid as yields fall to zero, while corporate bonds lose value.

“In just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high. To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder.

And there’s a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis.” –  John Mauldin:

As noted previously, there is a large tranche of BBB bonds on the verge of being downgraded to “junk.” When this occurs, there will be an avalanche of selling as pension, mutual, and hedge fund managers dump bonds simultaneously into what will be an illiquid market.

Pensions Are Broke

But it is NOT just “share buybacks” and debt, which are problems hiding in plain sight.

“Moody’s Investor Service estimated last year that the total pension funding gap in the U.S. is $4.4 trillion. A few months ago, the American Legislative Exchange Council estimated it at nearly $6 trillion.”

With pension funds already wrestling with largely underfunded liabilities, the aging demographics are further complicating funding problems.

The $6 Trillion “Pension Crisis” is just one sharp market downturn away from imploding. As I wrote in “The Next Financial Crisis Will Be The Last:”

“The real crisis comes when there is a ‘run on pensions.’ With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the ‘fear’ that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are declining, will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.”

This $6 trillion hit is going to come at a time where the Federal Reserve will already be at “full tilt” monetizing debt to stabilize declining financial markets to keep a “debt crisis” from spreading.

Strike Three, You’re Out

While investors have become extremely complacent over the last decade that Central Banks have gained control of the financial markets, this is likely an illusion. There are numerous catalysts which could pressure a downturn in the equity markets:

• An exogenous geopolitical event
• A credit-related event
• Failure of a major financial institution
• Recession
• Falling profits and earnings
• A loss of confidence by corporations which contacts share buybacks

Whatever the event is, which is currently unexpected and unanticipated, the decline in asset prices will initiate a “chain reaction.”

• Investors will begin to panic as asset prices drop, curtailing economic activity, and further pressuring economic growth.
• The pressure on asset prices and weaker economic growth, which impairs corporate earnings, shifts corporate views from “share repurchases” to “liquidity preservation.” This removes a major support of asset prices.
• As asset prices decline further, and economic growth deteriorates, credit defaults begin triggering a near $5 Trillion corporate bond market problem.
• The bond market decline will pressure asset prices lower, which triggers an aging demographic who fears the loss of pension benefits, sparks the $6 trillion pension problem. 
• As the market continues to cascade lower at this point, the Fed is monetizing nearly 100% of all debt issuance, and has to resort to even more drastic measures to stem selling and defaults. 
• Those actions lead to a further loss of confidence and pressures markets even further. 

The Federal Reserve can not fix this problem, and the next “bear market” will NOT be like that last.

It will be worse.

As John concluded:

Coordinated monetary policy is the problem, not the solution. And while I have little hope for change in that regard, I have no hope that monetary policy will rescue us from the next crisis.

Let me amplify that last line: Not only is there no hope monetary policy will save us from the next crisis, it will help cause the next crisis. The process has already begun.” – John Mauldin

“A reader lives a thousand lives before he dies… The man who never reads lives only one.” – George R.R. Martin.

I’m not sure what I would do without books. On weekends, I can be found in antique stores searching out volumes written in many instances, over 100 years ago from authors most of us never knew existed. These treasures don’t cost much. The words are priceless.

I find that absorbing fiction and self-improvement as well as financial or economic titles, fosters an ability to think creatively.  As much as you’ll hear that money is about numbers, it’s equally about emotions and intuition.

After all, what are investments but stories?

The next 5 tomes for 2020 are mostly tied to emotional and physical health. The health + wealth connection is one of the most important equations of our lifetimes.  Although, one of my favored authors on economics, Robert Shiller also appears.

Narrative Economics: How Stories Go Viral and Drive Major Economic Events – Robert J. Shiller.

Professor Shiller’s latest is off the beaten path when compared to  previous writings. In this book, he explores how stories go viral and have the force to fuel major economic events. It’s a very human analysis for a man usually immersed in math, which many Shiller zealots find disconcerting.  I find it refreshing. As I lament often – Economics is a social science and as humans, we live and breathe the subject every day  The world is one big Petri dish; investors cannot discount emotions or ‘animal spirits’ to shift economic winds. The professor shares plenty of historical references to make his case; he studies how  words spread throughout society. Think about how specific narratives have sparked economic tinderboxes on Main Street – Houses always go up in value,  we’re in a stock market bubble (or not),  robots are stealing jobs. What are stocks but stories spread by biased sell-side analysts and investors, overall? What Shiller doesn’t adequately cover is why certain phrases infiltrate the lingo of the masses while others die in transit.  Regardless, this book is a fascinating read into the economic wildfire of emotions.

Love Yourself Like Your Life Depends On It – Kamal Ravikant.

My friend Kamal revisits, refreshes his work on torturous personal growth. Kamal is a modern-day Stoic; he objectively examines his life as a successful CEO who fell apart emotionally after his company failed. Kamal documents his trials of ‘getting in his own way.’ How many of us do the same? The urge to self-sabotage must be exposed, brought to the light, and cleansed. Kamal examines how living in the past can destroy the present. His methods to emerge from a dark place will provide profound sense of encouragement for those who feel lost. We all play, re-play patterns in our heads. They in turn, trigger feelings.  The loops that roll in our minds, our thoughts, can free or imprison. Once caught in a negative-feedback loop, how do you break it? Kamal shares what he’s done to free and love himself because his life depended on it.  This book never leaves my nightstand.

Super Human: The Bulletproof Plan to Age Backward and Maybe Even Live Forever –  Dave Asprey.

Ok, so Dave’s goal to live to 180 is indeed, lofty. However, as the ultimate human bio-hacker, in book 5 of his “Bulletproof” series, he does provide worthwhile tips on how to gain and maintain health. As a child, he was classified as “premature aging.” His body was its own worst enemy. Dave improved his health dramatically based on aggressive diet, lifestyle, supplementation and specific biohacking methods outlined in the book. There are several unconventional tactics that require further homework. However, Dave is also solid about reminding us about the basics of better sleep and intermittent fasting. Last, readers are provided with specific ideas on the proper supplements and strategies to not only live a longer life, but a robust healthier one. I see his methods as a pathway to lowering healthcare costs. Keep in mind, a couple may incur anywhere from $280,000 to $387,000 in total healthcare expenses throughout retirement. Good habits employed to become aggressively preventative will ostensibly lead to lower expenses and an increasingly active lifestyle.

The Simple Life Guide to Financial Freedom – Gary Collins, MS.

Gary has been a guest on our  700AM KSEV radio show on numerous occasions. He’s a minimalist, ‘ruralist’ and many other ‘ists’ that pertain to financial independence through small yet enriched living. He employs simple math – addition, subtraction, division (unlike the mainstream financial industry which wields obfuscation like a Japanese sword), to make clear the reasons as to why the vast majority of Americans live one paycheck away from disaster, why the health=wealth connection is most important, how primary residence can be your greatest American nightmare, and presents a primer on basic consumer debt. Gary is my brother from another mother; he walks the talk of  financial independence. His philosophy is almost in perfect alignment with RIA’s Financial and Debt Guardrails. Want the financial truth such as what you read in our RIA blog? Here’s the book. My copy is highlighted, dog-eared and resides on a bookshelf in my office.

Blood – Allison Moorer.

In 1986, Allison Moorer awoke to a gunshot. Her father shot and killed her mother then turned the gun on himself.  Blues, folk, country singer/songwriter Allison Moorer and recording artist sister Shelby Lynne,  live in this shadow every day.  This work is Allison’s story of recovery written in a form only a songwriter can pen. The words, her perceptions, are poetic, biting and flow like a  dark song which transforms into a melody of warmth and sunlight. For those who have suffered a family trauma and carry it daily, Allison’s writing style is overwhelmingly healing and loving. I’ve already recommended her tome to friends who bear similar burdens. Candidly,  a topic such as this is a departure from my usual reading material. However,  I’m personally fond of Allison and her award-winning older sister Shelby Lynne, a songwriter and actress in her own right.  The sentiments shared in this book will stick with me. I bet they will with you, too.

I consider the written word a tap dance for the synapses. With each step, new visions are born and new thoughts forged.

Through a tumultuous childhood, books were one of my greatest escapes; a salvation of sanity and calm. During summer break as a boy I’d grab a stack of paperback books, depart our apartment early and head to the interior of a local funeral parlor (a friend’s dad was the director), where I’d sit in the corner nearest the largest plate-glass window I’ve ever seen. The morning sun at maximum light was all I needed. I loved the feel of the luxurious wall-to-wall deep red carpet of that place. Quiet floated on the faint aroma of flowers. The time made my reading that much more rewarding and memorable. Today, that large window is replaced with concrete. However, the memories of my reading time can never be sealed away.

This spring, I’ll provide my next five for your summer reading pleasure.  I read, study, highlight, 40-50 books a year and happily share my top selections.  Currently, I’m re-reading several classics including – Jack London’s White Fang, Shelley’s Frankenstein and Stoker’s Dracula.

If you read any of these selections, please let me know what you learned!

Have you heard? There’s trouble in the repo markets. Even casual investment market participants probably know that something’s amiss. While only a handful of investors participate in repo, this obscure corner of the investment markets rests at the epicenter of the financial system—hence all the attention. The turmoil caught many by surprise, prompting the Federal Reserve (Fed) into emergency action. However, the real surprise is, in my opinion, why this took any of us by surprise to begin with?

What is Repo

Repo is financial jargon for a repurchase agreement. While it sounds complex, repo is simply a form of short-term, secured lending. The borrower sells collateral (typically a high quality bond) to a lender. At the same time, it agrees to repurchase the same collateral back at a later date for a predetermined and higher price; hence the moniker repurchase agreement. The borrower receives the use of currency for this short period. The lender receives interest in the form of the price difference.

If this sounds overly complicated, it’s because it is. The details, however, are unimportant for our discussion. One need only grasp that repo sits at the bottom of the financial system pyramid. It’s a primary funding source for many large institutions that comprise the plumbing of financial markets. Due to leverage, small disturbances in the repo (and other money) markets can ripple through the entire system. This is what some fear.

What Went Wrong

Repo rates dramatically spiked on September 17, 2019, more than doubling the previous day’s (using SOFR as a proxy). This is highly unusual for the most illiquid of all markets, let alone one of the most trafficked. Arbitrage should render this behavior anomalous as the rise in repo rates represented a highly profitable opportunity. Why weren’t the big banks picking up all this free money? With the Great Financial Crisis (GFC) still fresh in the minds of many, the rumor mill kicked into overdrive surmising why.

Repo rates (estimated with SOFR) unexpectedly spiked on September 17, 2019.

The cause of this unexpected rate spike is still a matter of speculation. The financial system is highly complex with innumerable inputs and outputs making it difficult to establish direct, behavioral links. However, it’s likely that routine balance sheet mismanagement by the Fed was the culprit (as discussed by George Selgin here and Zoltan Pozar of Credit Suisse here).

The Fed’s responsibilities expanded as a result of the GFC. These, and other regulatory changes, might have created some idiosyncrasies that underpinned the unexpected rise in repo rates. One is that the Fed now banks the U.S. Treasury. The Treasury used to have bank accounts with private institutions. It now keeps its money at the Fed in an account called the Treasury General Account (TGA). Another important development is the increased size of the foreign repo pool. The Fed avails its balance sheet to “about 250 central banks, governments and international official institutions.” While not new, the aptly named foreign repo pool usage is up nearly 3-fold since 2014.

The significant growth in the TGA (blue) and foreign repo pool (red) after the GFC creates new balance sheet volatility for the Fed to manage.

The chart above illustrates that both the TGA and foreign repo pool are large and volatile. They are also relatively new in their importance to the Fed from an operational perspective. Let’s not forget that while the Fed is a central bank, it’s nonetheless just a bank. Unpredictable and violent swings in account balances are difficult to manage—community, commercial, and central bank alike. Too be sure, we may later discover different reasons for the repo rate spike … but not until later.

Centralization Breeds Instability

It’s easy to get bogged down in the details when analyzing the financial system. After all, it may be the most complex one we’ve built. Thus, applying some more macroscopic principles can help in understanding the system as a whole.

Generally speaking, decentralized systems are more stable than centralized ones. We intuitively get this and can witness its widespread application throughout the man-made and natural worlds. We diversify our investment portfolios, manufacturers source from multiple suppliers, organisms spawn many offspring, and successful animals eat varied diets. Decentralization is a primary thesis for Bitcoin, breeds a fear of monopolies, and is why I find capitalism so attractive (among other reasons).

Imagine if you kept your entire net worth in a single account at a single bank and it failed (ignoring FDIC insurance, which protect against just this). Your wealth would disappear overnight. What if your investment portfolio comprised of a single stock and it went bankrupt? Such reckless behaviors are rightfully condemned. Yet, we expect differently from our financial system; why?

For some reason we believe that centralizing our monetary system reduces volatility and increases stability. Thus, the financial system is either a complete outlier or the premise is false. Modern day economies are built on the belief of the former, yet the evidence is underwhelming.

Merely a Matter of Time

I find no reason to believe that centralizing our financial system holds unique benefits. It’s just another type system. From a stability perspective, all benefit from decentralization. It follows that our financial one should too. Thus, I believe it was (is) only a matter of time until the monetary system broke (breaks) again. It happened in 2008—which I see as a run on banking collateral rather than a housing market collapse (ask me to explain in the comment section if you’re interested in my view)—and it will inevitably happen again. It has to because the future is unknowable and risks are concentrated.

It’s not that decentralization breed omniscience. No, omniscience doesn’t exist. Rather, it allows for discovery. Decentralized systems have more actors striving towards the same goals. However, all will not proceed in the same way. Inevitably, some will fail and some will succeed and to varying degrees. Diversity ensures that the failures are inconsequential to the system as a whole. Yet, we all benefit from the knowledge that those who succeed discover. Hence, human prosperity advances.

Following the GFC we changed a bunch of rules and allegedly strengthened regulations. Despite the best of intentions, these actions further homogenized behavior ensuring that the system breaks again! Remember, centralized systems are most fragile. Further centralization—which is what laws and regulations actually do—limits diversity by raising the barriers to entry (compliance costs money) and conforms incentive schemes (to comply with regulatory demands). Thus, we got fewer actors behaving in more similar fashions. The financial system became more fragile as a result, not stronger. Here we are, a decade later, and low and behold trouble’s a brewin’ in financial markets again, and in new and unforeseen ways.

Principles Bring Clarity

In the end, the presence of a central bank and the myriad of rules and regulations are counterproductive. They work to limit competition, stymie diversity, and ultimately increase frailty. Progress requires failure and centralized systems are not flexible enough to allow for this. If a centralized actor goes down, so goes the whole. “Too big to fail” is only a feature of centralized systems.

While unexpected, the breakdown of repo markets should come as no surprise. Further centralization of the financial system increased its fragility qua system. Of course, predicting how and when it might fail ex ante is nearly impossible. If the current problems were obvious they wouldn’t have escalated to this point.

That said, the inevitability of a system failure doesn’t make it an investible theme, especially for casual observers. In fact, waiting for a repeat of the GFC may be expensive in opportunity cost terms and cause one to miss out on other profitable investments. Rather, I plan to simply keep this analysis in the back of my mind. If financial markets seize up (again), I know what to look for: decentralizing, market fixes.

Following causal chains of events is one of the many challenges of macro investing. While the spike in repo rates is perplexing, proper first principles can bring some clarity. Faulty ones, however, breed only surprises.

Yeah… Barry Bonds, a Major League Baseball (MLB) player, put up some amazing stats in his career. What sets him apart from other players is that he got better in the later years of his career, a time when most players see their production rapidly decline.

Before the age of 30, Bonds hit a home run every 5.9% of the time he was at bat. After his 30^th birthday, that rate almost doubled to over 10%. From age 36 to 39, he hit an astounding .351, well above his lifetime .298 batting average. Of all Major League baseball players over the age of 35, Bonds leads in home runs, slugging percentage, runs created, extra-base hits, and home runs per at bat. We would be remiss if we neglected to mention that Barry Bonds hit a record 762 homeruns in his MLB career and he also holds the MLB record for most home runs in a season with 73.

But… as we found out after those records were broken, Bond’s extraordinary statistics were not because of practice, a new batting stance, maturity, or other organic factors. It was his use of steroids. The same steroids that allowed Bonds to get stronger, heal quicker, and produce Hall of Fame statistics will also take a toll on his health in the years ahead.  

Turn on CNBC or Bloomberg News, and you will inevitably hear the hosts and interviewees rave on and on about the booming markets, low unemployment, and the record economic expansion. To that, we say Yeah… As in the Barry Bonds story, there is also a “But…” that tells the whole story.

As we will discuss, the economy is not all roses when one considers the massive amount of monetary steroids stimulating growth. Further, as Bonds too will likely find out at some point in his future, there will be consequences for these performance-enhancing policies.

Wicksell’s Wisdom

Before a discussion of the abnormal fiscal and monetary policies responsible for surging financial asset prices and the record-long economic expansion, it is important to impart the wisdom of Knut Wicksell and a few paragraphs from a prior article we published entitled Wicksell’s Elegant Model.

“According to Wicksell, when the market rate (of interest) is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Essentially, Wicksell warns that when interest rates are lower than they should be, speculation in financial assets is spurred and investment into the real economy suffers. The result is a boom in financial asset prices at the expense of future economic activity. Sound familiar? 

But… Monetary Policy

The Fed’s primary tool to manage economic growth and inflation is the Fed Funds rate. Fed Funds is the rate of interest that banks charge each other to borrow on an overnight basis. As the graph below shows, the Fed Funds rate has been pinned at least 2% below the rate of economic growth since the financial crisis. Such a low relative rate spanning such a long period is simply unprecedented, and in the words of Wicksell not “optimal policy.” 

Until the financial crisis, managing the Fed Funds rate was the sole tool for setting monetary policy. As such, it was easy to assess how much, if any, stimulus the Fed was providing at any point in time. The advent of Quantitative Easing (QE) made this task less transparent at the same time the Fed was telling us they wanted to be more transparent.  

Between 2008 and 2014, through three installations of QE, the Fed bought nearly $3.2 trillion of government, mortgage-backed, and agency securities in exchange for excess banking reserves. These excess reserves allowed banks to extend more loans than would be otherwise possible. In doing so, not only was economic activity generated, but the money supply rose which had a positive effect on the economy and financial markets.

Trying to quantifying the amount of stimulus offered by QE is not easy. However, in 2011, Fed Chairman Bernanke provided a simple rule in Congressional testimony to allow us to transform a dollar amount of QE into an interest rate equivalent. Bernanke suggested that every additional $6.6 to $10 billion of excess reserves, the byproduct of QE, has the effect of lowering interest rates by 0.01%. Therefore, every trillion dollars’ worth of new excess reserves is equivalent to lowering interest rates by 1.00% to 1.50% in Bernanke’s opinion. In the ensuing discussion, we use Bernanke’s more conservative estimate of $10 billion to produce a .01% decline in interest rates.

The graph below aggregates the two forms of monetary stimulus (Fed Funds and QE) to gauge how much effective interest rates are below the rate of economic growth. The blue area uses the Fed Funds – GDP data from the first graph. The orange area representing QE is based on Bernanke’s formula. 

Since the financial crisis, the Fed has effectively kept interest rates 5.11% below the rate of economic growth on average. Looking back in time, one can see that the current policy prescription is vastly different from the prior three recessions and ensuing expansions. Following the three recessions before the financial crisis, the Fed kept interest rates lower than the GDP rate to help foster recovery. The stimulus was limited in duration and removed entirely during the expansion. Before comparing these periods to the current expansion, it is worth noting that the amount of stimulus increased during each expansion. This is a function of the growth of debt in the economy beyond the economy’s growth rate and the increasing reliance on debt to generate economic growth. 

The current expansion is being promoted by significantly more stimulus and at much more consistent levels. Effectively the Fed is keeping rates 5.11% below normal, which is about five times the stimulus applied to the average of the prior three recessions. 

Simply the Fed has gone from periodic use of stimulus to heal the economy following recessions to a constant intravenous drip of stimulus to support the economy.

Moar

Starting in late 2015, the Fed tried to wean the economy from the stimulus. Between December of 2015 and December of 2018, the Fed increased the Fed Funds rates by 2.50%. They stepped up those efforts in 2018 as they also reduced the size of their balance sheet (via Quantitative Tightening, “QT”) from $4.4 trillion to $3.7 trillion.

The Fed hoped the economic patient was finally healing from the crisis and they could remove the exorbitant amount of stimulus applied to the economy and the markets. What they discovered is their imprudent policies of the post-crisis era made the patient hopelessly addicted to monetary drugs.

Beginning in July 2019, the Fed cut the target for the Fed Funds rate three times by a cumulative 0.75%. A month after the first rate cut they abruptly halted QT and started increasing their balance sheet through a series of repo operations and QE. Since then, the Fed’s balance sheet has reversed much of the QT related decrease and is growing at a pace that rivals what we saw immediately following the crisis. It is now up almost a half a trillion dollars from the lows and only $200 billion from the high watermark. The Fed is scheduled to add $60 billion more per month to its balance sheet through April. Even more may be added if repo operations expand.

The economy was slowing, and markets were turbulent in late 2018. Despite the massive stimulus still in place, the removal of a relatively small amount of stimulus proved too volatility-inducing for the Fed and the markets to bear.

Summary

Wicksell warned that lower than normal rates lead to speculation in financial assets and less investment into the real economy. Is it any wonder that risk assets have zoomed higher over the last five years despite tepid economic growth and flat corporate earnings (NIPA data Bureau of Economic Analysis -BEA)? 

When someone tells you the economy is doing fine, remind them that Barry Bonds was a very good player but the statistics don’t tell the whole story.

To provide further context on the extremity of monetary policy in America and around the world, we present an incredible graph courtesy of Bianco Research. The graph shows the Bank of England’s balance sheet as a percentage of GDP since 1700. If we focus on the past 100 years, notice the only period comparable to today was during World War II. England was in a life or death battle at the time. What is the rationalization today? Central banker inconvenience?

While most major countries cannot produce similar data going back that far, they have all experienced the same unprecedented surge in their central bank’s balance sheet.

Assuming today’s environment is normal without considering the but…. is a big mistake. And like Barry Bonds, who will never know when the consequences of his actions will bring regret, neither do the central bankers or the markets. 

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

AAPL – Apple, Inc.

• There is a common denominator to all of the charts this week, which is they are at or above 3-standard deviations of the 200-dma. These extreme extensions tend not to last long and generally result in a 3-5% corrective process, or more.
• We sold a small bit of AAPL last week to take profits and reduce our weighting to roughly a 1/2 position in the portfolio. We will look to reweight the position between $220-230.
• Besides the large deviation in price, the buy signal and the overbought condition are also at extremes.
• Stop is set at $260 for profits, and $220 for whole position.

JNJ – Johnson & Johnson

• We bought JNJ when it was out of favor with the market over their “talc” lawsuit issues.
• With the bulk of the those issues behind them, the stock has rebounded sharply.
• As noted last week, we took profits in the position. At 3-standard deviations, combined with extreme overbought conditions and buy signal, a correction is likely.
• We will look to buy the position back to weight on a correction that holds our stop level.
• We are moving our stop up to $135.00

AGNC – Agency Mortgage REIT

• We bought 2 positions to benefit from a steepening of the 10-2 yield curve which has indeed come to pass.
• Since we are at full weight in AGNC, and only 1/2 weight in NLY, we took profits in AGNC as recommended last week.
• We are maintaining our stop at $14 as we will add back to the position following some corrective action.

CVS – CVS Health Corp.

• We bought CVS in mid-last year and the reversal in price has led to a terrific add. We like this position long-term and are watching the correction process closely.
• With the buy signal being reduced and support holding around $72, we would like to see the overbought condition fully reverse and give us an entry point between $64 and $66.
• Be patient for now, and we will update the position accordingly.
• Stop is set at $62

DEM – Emerging Markets High Dividend Fund

• We added a small position in international exposure with the weakening of the U.S. Dollar. While we are slightly positive in the position currently, it is extremely overbought and will correct with the overall market.
• Importantly, DEM needs to remain above the 200-dma and work off the overbought condition before adding further weight to the sector or position.
• Since this was a “trading position” to begin with, we are maintaining a fairly tight “discretionary stop,” but our “full stop” remains the 200-dma currently.
• Stop is set at $42.

HCA – HCA Healthcare

• We reduced our position in HCA from overweight following the sharp rally to 3-standard deviation territory.
• We will look to add back into our holding on a pullback that doesn’t violate our stop level and reduced the massive overbought condition and or completely reverse the buy signal.
• Hold remaining positions for now but move stops up to the 200-dma.
• Stop is set at $130.

DOV – Dover Corp.

• DOV has been a great performer for the portfolio particularly as the “trade war” has gotten resolved.
• DOV is exceedingly overbought (Yes, 3-standard deviations) and the buy signal extremely extended. A correction is inevitable.
• We have taken profits previously, but we take additional profits soon.
• Stop loss moved up to $100

MU – Micron Technology

• MU was an add for us in 2019. We had bought it previously but got stopped out, however, our second entry has performed much better.
• MU is now exceedingly overbought with an extended buy signal and deviation in price.
• As noted last week, we have taken profits and reduced our weighting slightly. A pullback that holds support and doesn’t violate our stop can be used to reweight the position.
• Stop-loss moved up to $45

UNH – United Healthcare

• UNH has surged higher in recent months after struggling with “Medicare for all” from Democratic candidates last year. (Along with the rest of our Healthcare stocks)
• We love this position and will continue to hold it, however, the position is SO extremely extended we took profits as noted last week.
• We will add back on a correction that holds support, and doesn’t violate our stop levels.
• Stop loss moved up to $250

MSFT – Microsoft

• MSFT has been grinding higher as money is chasing AAPL and MSFT now. It’s a SoftApple market!
• MSFT, like many other of our positions, is now extremely overbought and extended above the 200-dma.
• We reduced our position slightly to take in some profits for now, however, we will look to add back to MSFT at a lower price.
• Stop loss is moved up to $140

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

There is a common theme running through most of the sectors currently which is that they are trading more than 2-standard deviations above the 200-dma. I have added a blue shaded area to each graph which represents this band of deviation from the green line which is the 200-dma. Deviations of this extreme tend not to last long.

Basic Materials

• XLB tested and failed at all-time highs. While support exists at the previous breakout level of $59, XLB remains at the top of its deviation range and is on an extended “buy” signal currently.
• The sector is working off its previously extreme overbought condition, so a setup to add to our current position is coming. It will be important that XLB doesn’t violate our stop-loss during this corrective process.
• We currently hold 1/2 position and are looking to add the second 1/2 during this corrective process. We will update this analysis when we add to our holdings.
• Short-Term Positioning: Neutral
  • Last Week: Hold current positions with a tighter stop-loss.
  • This Week: Hold current positions with a tighter stop-loss.
  • Stop-loss moved back to $57 to allow for entry.
• Long-Term Positioning: Neutral

Communications

• XLC finally broke out to new highs and is now more than 2-standard deviations above the 200-dma.
• Because of the extension we did reduce our allocation to the sector modestly. We will look to use a pullback to support to reweigh the sector.
• With a “buy signal” in place, there is a bias to the upside, but a correction is coming. XLC must hold support at $50.
• If you need to add a position, wait for a pull back to test the recent breakout support level and add there.
• XLC is currently 2/3rds weight in portfolios.
• Short-Term Positioning: Bullish
  • Last Week: Hold trading positions
  • This Week: Reduced weighting in portfolio
  • Stop adjusted to $50
• Long-Term Positioning: Neutral

Energy

• Unlike most other sectors of the market, XLE is not extremely extended.
• XLE finally broke above the 200-dma but is currently wrestling with previous support, now resistance, and is extremely overbought. The buy signal is also getting extended.
• As noted previously, we added 1/2 position of AMLP to our portfolios. On any weakness which does not violate the 200-dma we will add 1/2 position of XLE to the portfolio. The reason we are cautious is that these rallies have repeatedly failed in the past.
• Short-Term Positioning: Bearish
  • Last week: Added 1/2 AMLP to Portfolios
  • This week: Looking to add 1/2 XLE – patience.
  • No position currently
• Long-Term Positioning: Bearish

Financials

• XLF is extremely extended above the 200-dma which puts the sector at risk of a more severe correction.
• The buy signal is also extremely extended which suggests that you should be taking profits and reducing risk if you are long the sector.
• We will look to add XLF to our portfolio on a pullback that doesn’t violate long-term support or break the current bullish trend.
• Currently, XLF is holding near highs but not participating with the rally in the broader market.
• Short-Term Positioning: Bullish
  • Last week: Hold Positions
  • This week: Hold Positions
  • Stop-loss adjusted to $28
• Long-Term Positioning: Neutral

Industrials

• XLI also is pushing well above the 200-dma with such previous extensions having led to fairly sharp corrections.
• With XLI exceedingly overbought short-term, and on a very extended buy signal, be cautious chasing the sector currently.
• We are looking for a bit of consolidation and/or pullback to work off some of the extreme overbought condition before increasing our weighting.
• We have adjusted our stop-loss for the remaining position. We are looking to add back to our holdings on a reversal to a buy signal.
• Short-Term Positioning: Neutral
  • Last week: Hold 1/2 position
  • This week: Hold 1/2 position.
  • Stop-loss adjusted to $77
• Long-Term Positioning: Neutral

Technology

• XLK is extremely overbought on both a price and momentum basis like most other sectors of the market.
• We reduced our position in XLK from overweight to target portfolio weight due to the extreme extension currently. A correction is coming.
• Be careful chasing the sector currently. Take profits and rebalance risks accordingly.
• Short-Term Positioning: Bullish
  • Last week: Hold position
  • This week: Reduce Overweight to Target Weight
  • Stop-loss adjusted to $80
  • Long-Term Positioning: Neutral

Staples

• Defensive sectors have started to perform better as money is just chasing “everything” now.
• XLP continues to hold its very strong uptrend as has now broken out to new highs. However, XLP is back to more extreme overbought and extended above the 200-dma.
• Importantly, a “buy signal” has been registered. Look for pullbacks to support to add weight to portfolios. Maintain a stop at the 200-dma.
• We previously took profits in XLP and reduced our weighting from overweight.
• Short-Term Positioning: Bullish
  • Last week: Hold positions, take profits if needed.
  • This week: Hold positions, take profits if needed.
  • Stop-loss adjusted to $59
  • Long-Term Positioning: Bullish

Real Estate

• XLRE has been consolidating its advance within a very tight pattern but is holding support at previous support levels and the uptrend line.
• We had previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected which has now been completed.
• XLRE is now on a VERY deep “sell signal” and is very oversold. Both of those conditions are showing signs of reversing.
• With support holding current longs, and trading positions can be added to portfolios. We are fully weighted the sector currently so there isn’t any change required in our portfolios at this time.
• Short-Term Positioning: Bullish
  • Last week: Hold position.
  • This week: Hold position.
  • Stop-loss adjusted to $35.00 for profits.
• Long-Term Positioning: Bullish

Utilities

• XLU continues to maintain its bullish trend and recently rallied to test previous highs.
• If the “sell signal” is reversed, this will be very bullish for XLU, and should suggest a decline in interest rates is simultaneously occurring.
• We noted previously that after taking profits, we had time to be patient and wait for the right setup. That opportunity came last week, so if you added exposure, hold for now with a stop at $61. If you need to add exposure to Utilities, you can still do so with a tight stop.
• The long-term trend line remains intact but XLU and the sell signal are beginning to reverse.
• We are currently at full weight, so no change is required currently.
• Short-Term Positioning: Bullish
  • Last week: Hold position.
  • This week: Hold current position / Add trading positions if needed
  • Stop-loss adjusted to support at $59.00, $61 for new positions.
• Long-Term Positioning: Bullish

Health Care

• XLV has remained intact and is now more extended than we have seen it in quite some time.
• XLV is extremely overbought which will give way sooner than later. Because of the extension we reduced the overweight position in our portfolios to target weight.
• The move in Healthcare has been parabolic, and the sector is too extended to add positions currently.
• Short-Term Positioning: Neutral
  • Last week: Hold position.
  • This week: Took profits – reduced overweight to target weight.
  • Stop-loss adjusted to $94
• Long-Term Positioning: Bullish

Discretionary

• We added to our holdings previously to participate with the current rally, but XLY is now pushing an extreme extension above the 200-dma.
• We took profits last week and reduced the position slightly.
• Hold current positions for now, but take profits and rebalance risks accordingly. New positions can be added on a pullback to the breakout level that holds and works off the overbought condition.
• Short-Term Positioning: Neutral
  • Last week: Hold position
  • This week: Hold position
  • Stop-loss adjusted to $120.
• Long-Term Positioning: Neutral

Transportation

• XTN has broken out of consolidation but quickly ran into resistance at the 2-standard deviation level above the 200-dma.
• If XTN can breakout above current resistance there is a potential to test old highs.
• Be patient, XTN has a good bit of work to do to prove its position in portfolios.
• Short-Term Positioning: Neutral
  • Last week: No position
  • This week: No position
• Long-Term Positioning: Bearish

In this past weekend’s newsletter, we discussed the exceedingly deviated price, and overbought conditions, not to mention valuations, as key reasons why we slightly reduced risk in our portfolios.

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels. 

In the Equity Portfolios, we reduced our weightings in some of our more extended holdings such as Apple (AAPL,) Microsoft (MSFT), United Healthcare (UNH), Johnson & Johnson (JNJ), and Micron (MU.)

In the ETF Sector Rotation Portfolio, we reduced our overweight positions in Technology (XLK), Healthcare (XLV), Mortgage Real Estate (REM), Communications (XLC), Discretionary (XLY) back to portfolio weightings for now.”

Not surprisingly, I received more than a few emails chastising me for “bailing on the bull market, which is clearly going higher.” 

Such is hardly the case. We simply reduced our weighting in some of the companies which have had substantial gains over the last year. We remain primarily long-biased in our portfolios, but given the extreme technical overbought, and deviated conditions, it was prudent to raise some cash and protect our gains.

However, it wasn’t just the conditions we discussed which have us concerned about the markets in the short term. Investor positioning has also reached rather extreme levels. As Bob Farrell once wrote:

“When all experts agree, something else is bound to happen.”

Currently, with investors all extremely long equity exposure, the risk of a correction has become elevated.

Our composite “fear/greed” indicator, which is comprised of investor positioning, shows much the same as “bullish sentiment” has become rather extreme.

Every week, we provide RIAPRO subscribers (Try Free for 30-Days) with the latest updated technical composite score as well. This composite gauge combines extension, deviation, and momentum into a single weekly measure. Readings above 90 (Currently 92.31) are always associated with corrective actions in the market.

With all of these conditions aligned, the “probability” of a short-term correction has increased. Given that risk outweighs reward in the short-term, we decided it was prudent to reduce the numerator of that equation.

Why We Reduced Risk

It may seem irrational that we would reduce our risk exposure as the market continue to rise. Less exposure to equities, means less upside performance of the portfolio, or rather, “opportunity cost.” As I noted:

“While the markets could certainly see a push higher in the short-term from the Fed’s ongoing liquidity injections, the gains for 2020 could very well be front-loaded for investors. Taking profits and reducing risks now may lead to a short-term underperformance in portfolios, but you will likely appreciate the reduced volatility if, and when, the current optimism fades.”

However, the problem for the majority of investors is the inability to predict whether the next correction will be just a “correction” within an ongoing bull market advance or something materially worse. Unfortunately, by the time most investors figure it out – it is generally far too late to do anything meaningful about it. 

By reducing risk now it provides us three benefits for the future.

1. Less equity risk, and higher cash levels, lowers the volatility of the portfolio which will allow us to navigate a correction process, and protect our investment capital.
2. It gives us capital to reinvest back into positions we currently own at better prices; or,
3. Buy new positions which have corrected in price.

While it is entirely true that “you can not time the market,” you can do some analysis and make deliberate changes to avoid problems.

As shown below, price deviations from the 50-week moving average have been important markers for the sustainability of an advance historically. Prices can only deviate so far from their underlying moving average before a reversion eventually occurs. (You can’t have an “average” unless price trades above and below the average during a given time frame.)

Notice that price deviations became much more augmented heading into 2000 as electronic trading came online, and Wall Street turned the markets into a “casino” for Main Street.

At each major deviation of price from the 50-week moving average, there has either been a significant correction or something materially worse. Currently, the deviation from the 50-week moving average is the second-highest level in history, next to the 1999 “dot.com” mania.

How bad could it be?

Measuring The Mean Reversion 

Given the current momentum of the market, combined with the Fed’s ongoing liquidity interventions, we only expect a correction of 5-10% to reset the overbought, optimistic, and deviated markets. Such a correction can be used to increase equity exposure and bring equity holdings back to target weights.

However, there is a risk of a larger mean reverting event, yet this is a possibility completely dismissed by the mainstream media under the guise of “this time is different.” 

With the market trading more than 3-standard deviations above the 50-week moving average, historical reversions have tended to be more brutal. I have laid out support levels below.

At this juncture, a correction back to the 2018 lows would entail a 25% decline. However, if a “bear market” growls, the 2015-16 highs become the target which is 34% lower. The lows of 2016 would require a 43% draft, with the 2008 highs posting a 52% “crash.” 

That can’t happen you say?

We had two 50% declines since the turn of the decade, and the next major market decline will be fueled by the massive levels of corporate debt, underfunded pensions, and evaporation of “stock buybacks,” which have accounted for almost 100% of net purchases since 2018.

Then there is also the other possibility as noted by technical analyst J. Brett Freeze, CFA:

“The Wave Principle suggests that the S&P 500 Index is completing a 60-year, five-wave motive structure. If this analysis is correct, it also suggests that a multi-year, three-wave corrective structure is immediately ahead. We do not make explicit price forecasts, but the Wave Principle proposes to us that, at a minimum, the lows of 2009 will be surpassed as the corrective structure completes.”

Anything is possible, and if he is right, such a decline will eclipse the 85% decline of the Dow following the 1929 peak when stocks last reached what seemed to be a “permanently high plateau.”

We Play The Probabilities

The probability is that we will see the 5-10% correction which will be used to increase our exposure.

Just don’t dismiss the possibilities.

“You play the probabilities; but prepare for the possibilities.”

No one knows with certainty what the future holds which is why we must manage portfolio risk accordingly and be prepared to react when conditions change.

While I am often tagged as “bearish” due to my analysis of economic and fundamental data for “what it is” rather than “what I hope it to be,” I am actually neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy which focus on capital preservation and long-term “risk-adjusted” returns.

As such, let me remind you of the 15-Risk Management Rules I have learned over the last 30-years:

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

The current market advance both looks, and feels, like the last leg of a market “melt up” as we previously witnessed at the end of 1999. How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things do come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives.

This is why focusing on “risk controls” in the short-term, and avoiding subsequent major draw-downs, the long-term returns tend to take care of themselves.

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

• On Friday, the market had a small drop after we took profits in our portfolios. However, that drop did little to resolve any of the overbought conditions which currently exisit.
• The S&P remains more than 2-standard deviations above the 200-dma (shaded blue area).
• The “buy signal” (lower panel) is back to levels of extensions normally only seen with short-term tops and corrective actions, particularly when combined with extreme extensions and deviations from long-term means.
• As noted we took profits in both the ETF and Equity Model (See Portfolio Commentary) and we still recommend taking profits and rebalancing risks in positions accordingly. We will likely have a much better entry point in the next couple of months to buy into.
• Short-Term Positioning: Neutral Due To Extension
  • Last Week: Hold position
  • This Week: Take profits and rebalance to target weights.
  • Stop-loss moved up to $300
  • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

• As goes the S&P 500, goes the DIA, especially when MSFT & AAPL are the two top holdings and drivers of the advance in both markets. (We reduced both of those holdings last week.)
• The “buy” signal is extremely extended along with a very overbought condition.
• Hold current positions and take profits, but as with SPY, wait for a correction before adding further exposure.
• Short-Term Positioning: Neutral due to extensions
  • Last Week: Hold current positions
  • This Week: Take profits and rebalance risk.
  • Stop-loss moved up to $275
• Long-Term Positioning: Neutral

Nasdaq Composite

• Again, like SPY, the Nasdaq is just “crazy” extended currently. With QQQ now pushing the limits of 3-standard deviations, a correction is inevitable, it is just a function of time now.
• The Nasdaq “buy signal” is also back to extremely overbought levels so look for a correction to add exposure.
• Short-Term Positioning: Neutral due to extensions.
  • Last Week: Hold position
  • This Week: Take profits and rebalance risks.
  • Stop-loss moved up to $195
• Long-Term Positioning: Neutral due to valuations

S&P 600 Index (Small-Cap)

• As noted above, small-caps have also pushed above 2-standard deviations of the 200-dma.
• With the buy signal also extremely extended, and the index overbought, like all the other markets, a correction will provide a better entry point to add to our positions.
• That correction has started and the current support level is being tested. A failure here and the previous breakout levels will be the next important support and our stop level.
• Short-Term Positioning: Neutral due to extensions.
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop loss moved up to $69
• Long-Term Positioning: Neutral

S&P 400 Index (Mid-Cap)

• Like SLY, MDY is also extremely extended and deviated above the 200-dma, and it has started to correct a bit finally.
• With MDY’s “buy” signal extremely extended, and very overbought, this is a prime setup for a correction. Hold off adding exposure until we see a better entry point.
• Short-Term Positioning: Neutral due to extensions.
  • Last Week: No holding
  • This Week: No holding
• Long-Term Positioning: Bullish

Emerging Markets

• EEM continues to underperform but did finally breakout above resistance. The next target will be the old highs.
• With the “buy signal” extremely extended, the set up to add exposure is not present. Be patient for a correction that does not violate our stop.
• EEM has tested, and held the 61.8% Fibonacci retracement level, so if it can break above the recent high, that will continue the bullish trend.
• The Dollar (Last chart) is the key to our international positioning. The dollar looks to have confirmed a break lower which should support our thesis of adding back international exposure.
• Short-Term Positioning: Neutral
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop-loss set at $43
• Long-Term Positioning: Neutral

International Markets

• Like EEM, EFA rallied out of its consolidation channel and broke out.
• But, like EEM, the market is both EXTREMELY overbought and extended. Also, EFA is testing old highs which, as previously expected, is providing short-term resistance.
• As with EEM, the key to our positioning is the US Dollar.
• Short-Term Positioning: Neutral
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop-loss set at $67
• Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

• Oil finally broke above the downtrend resistance line from the 2018 highs, which is bullish. However, the spurt from the “Iran spat,” shot oil prices to the 61.8% Fibonacci retracement level where it failed badly.
• With oil prices falling back below $60/bbl, it is imperative that oil maintains the 200-dma support level.
• As noted last week, with the short-term buy signal for oil is extended, the struggle we saw was not unexpected.
• Add positions on weakness that doesn’t violate the 200-dma
• Short-Term Positioning: Neutral
  • Last Week: Hold positions.
  • This Week: Hold positions
  • Stop-loss for any existing positions is $58.
• Long-Term Positioning: Bearish

Gold

• Gold found its mojo last week, as Iran sparked fear in the markets. However, it faded a bit as tensions quickly dissapated.
• With gold now testing old highs, our positioning looks good particularly given that gold remains on a sell-signal currently. A reversal of the signal could suggest further highs to come.
• We used the recent weakness to add to our GDX and IAU positions taking them back to full weightings.
• Short-Term Positioning: Neutral
  • Last week: Hold positions.
  • This week: Hold positions
  • Stop-loss for whole position adjusted to $137
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

• Bond prices rallied last week, again, and are testing downtrend resistance. For now bonds remain in a bearish channel, suggesting higher yields are still likely short-term.
• I suspect we are going to get some economic turmoil sooner, rather than later, which will lead to a correction in the equity markets and an uptick in bond prices. The weak employment and wages report last Friday suggested such may be coming.
• Use lower bounds of the downtrend, and the 200-dma, to add to holdings currently.
• Short-Term Positioning: Bullish
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop-loss is moved up to $132
• Long-Term Positioning: Bullish

U.S. Dollar

• Previously, we noted the dollar broke down below both the 200-dma and the bullish trend line. It then retested, and failed, at that previous support level which confirms a breakdown in the dollar from its previous bullish channel.
• Last week, the dollar has rallied back to that all important previous support line. IF the dollar can break back above that level, and hold, then commodities, and oil, will likely struggle.
• As stated last time: “It may be too early for a sharper dollar decline currently, as the U.S. economy is still the “cleanest shirt in the dirty laundry.”
• Be patient for now on commodity related exposures. Momentum still rules the market as a whole.
• The “sell” signal remains intact currently suggesting there is further downside, if it begins to reverse that will be an important clue.

A recent article on MarketWatch by Sanjib Saha caught my attention:

“After taking the Series 65 exam last February, I set a goal for 2019: Help 10 friends and family members with their finances. Instead of giving specific investment advice, I wanted to educate them on money matters. I knew that they would benefit from one-on-one discussions, well-regarded books, educational videos and credible websites.”

Think about that for a moment. Here is a young man, who grew up during the longest bull market in history, just took his exam last year, has no real investment experience to speak of, and is now giving advice to people with no investment knowledge.

What could possibly go wrong?

While the majority of the article is grossly misinformed and a regurgitation of the “bullish mantras,” there was one paragraph that jumped out with respect to investment success and failure over time. To wit:

“Many years ago, Aisha, received a windfall that she needed to invest. She interviewed a few financial advisers and went with someone who had an impressive job title, a long list of designations and a friendly demeanor. She regularly reviewed her portfolio with the adviser, but never considered there might be performance problems. After all, a paid professional ought to do better than the market, not worse—or so she thought.

As it turned out, her portfolio had more than doubled over 16½ years.Aisha was impressed, until she backtested an identical asset allocation—one with half U.S. stocks and half corporate bonds. A 50-50 allocation consisting of just two broadly diversified index funds would have quadrupled her money over the same holding period. She stared at the results in disbelief. The opportunity cost was huge.”

The Comparison Trap

This is one of the biggest tools used by financial advisors to get clients to switch their accounts over to a “better” program. Let me explain.

Comparison is the cause of more unhappiness in the world than anything else. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. Social comparison comes in many different guises. “Keeping up with the Joneses,” is one well-known way.

Think about it this way.

If your boss gave you a Mercedes as a yearly bonus, you would be thrilled, right? However, what if you found out shortly afterward that everyone else in the office got two cars.

WTF? Now, you are ticked.

But really, are you deprived of getting a Mercedes? Shouldn’t that enough?

Comparison-created unhappiness and insecurity is pervasive, judging from the amount of spam touting everything from weight-loss to plastic surgery. The basic principle seems to be that whatever we have is enough, until we see someone else who has more. Whatever the reason, comparison in financial markets can lead to remarkably bad decisions.

It is this ongoing measurement against some random benchmark index which remains the key reason why investors have trouble patiently sitting on their hands, letting whatever process they are comfortable with, work for them. They get waylaid by some comparison along the way and lose their focus.

If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that “everyone else” made 14%, you’ve now made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy.

Therein lies the dirty little secret. Money in motion creates revenue. The creation of more and more benchmarks, indexes, and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.

Aisha, for example, was completely happy with doubling her money over the last 16-years, until our young, inexperienced, newly minted financial advisor showed her “what she could have had.” Now she will make decisions which will potentially increase the amount of risk she is taking in the second most expensive bull market in history.

Our Worst Enemy

I have written about the psychological issues which impede investors returns over longer-term time frames in the past. The two biggest factors, according to Dalbar Research, which lead to chronic investor underperformance over time are:

• Lack of capital to invest, and;

• Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. Of course, not having the capital to invest is equally important.

These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.

Behavioral biases are an issue which remains little understood and accounted for when individuals begin their investing journey. There are (9) nine of these behavioral biases specifically which impact investors the most.

• Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
• Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
• Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
• Mental Accounting – Separating performance of investments mentally to justify success and failure.
• Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
• Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
• Regret – Not performing a necessary action due to the regret of a previous failure.
• Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
• Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

These cognitive biases impair our ability to remain emotionally disconnected from our money. As a consequence, we are continually lured into making decisions which are inherently bad for our long-term outcomes.

The Advisor’s Role

These psychological and behavioral issues are exceedingly difficult to control and lead us regularly to making poor investment decisions over time. But this is where the role of an “experienced advisor” should be truly defined and valued.

While the performance chase, a by-product of the very behavioral issues we wish to control, leads everyone to seek out last years “hottest” performing manager or advisor, this is not really the advisor’s main role. The role of an advisor is NOT beating some random benchmark index or to promote a “buy and hold” strategy. (There is no sense in paying for a model you can do yourself.)

Jason Zweig summed it well:

“The only legitimate response of the investment advisory firm, in the face of these facts, is to ensure that it gets no blood on its hands. Asset managers must take a public stand when market valuations go to extremes — warning their clients against excessive enthusiasm at the top and patiently encouraging clients at the bottom.”

Given that individuals are emotional and subject to emotional swings caused by market volatility, the advisors role is not only to be a portfolio manager, but also a psychologist. Dalbar suggested four successful practices to reduce harmful behaviors:

1. Set Expectations Below Market Indices: Change the threshold at which the fear of failure causes investors to abandon an investment strategy. Set reasonable expectations and do not permit expectations to be inferred from historical records, market indexes, personal experiences or media coverage. The average investor cannot be above average. Investors should understand this fact and not judge the performance of their portfolio based on broad market indices.
2. Control Exposure to Risk: Include some form of portfolio protection that limits losses during market stresses. Explicit, reasonable expectations are best set by agreeing on a goal that consists of a predetermined level of risk and expected return. Keeping the focus on the goal and the probability of its success will divert attention away from frequent fluctuations that lead to imprudent actions
3. Monitor Risk Tolerance: Periodically reevaluate investor’s tolerance for risk, recognizing that the tolerance depends on the prevailing circumstances and that these circumstances are subject to change. Even when presented as alternatives, investors intuitively seek both capital preservation and capital appreciation. Risk tolerance is the proper alignment of an investor’s need for preservation and desire for capital appreciation. Determination of risk tolerance is highly complex and is not rational, homogenous nor stable.
4. Present Forecasts In Terms Of Probabilities: Simply stating that past performance is not predictive creates a reluctance to embark on an investment program. Provide credible information by specifying probabilities, or ranges, that create the necessary sense of caution without negative effects. Measuring progress based on a statistical probability enables the investor to make a rational choice among investments based on the probability of reward.

The challenge, of course, it understanding that the next major impact event, and market reversion, will NOT HAVE the identical characteristics of the previous events. This is why comparing today’s market to that of 2000 or 2007 is pointless. Only the outcome will be the same.

One thing that all the negative behaviors have in common is that they can lead investors to deviate from a sound investment strategy which was narrowly tailored towards their goals, risk tolerance, and time horizon.

The best way to ward off the aforementioned negative behaviors is to employ a strategy that focuses on one’s goals and is not reactive to short-term market conditions. The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.

The reality is that the majority of advisors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

When the impact event occurs, advisors who are prepared to handle responses, provide clear messaging, and an action plan for both conserving investment capital and eventual recovery will find success in obtaining new clients.

The “do-it-yourself” crowd will also come to learn the value of experience. When the impact event occurs, the losses in passive investments, “yield-chase” investments, and ETF’s will be substantially larger than individuals currently imagine. Those losses will permanently impair individuals ability to obtain their financial goals.

If you don’t believe me, then explain why, with 30 of the last 40 years in major bull market trends, is a large majority of the population woefully underfunded for retirement?

The reason is that investing is not simple. If it was, everyone would be rich. The reality is that whatever gains investors have garnered over the last decade will be largely wiped away by the next impact event.

Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy” but never “when to sell.”

You can do better.

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• This Is Nuts
• Portfolio Position Review
• MacroView: Has The Fed Trapped Itself?
• Financial Planning Corner: By The Numbers For 2020
• Sector & Market Analysis
• 401k Plan Manager

Follow Us On: Twitter, Facebook, Linked-In, Sound Cloud, Seeking Alpha

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Catch Up On What You Missed Last Week

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Market Review & Update

When you sit down with your portfolio management team, and the first comment made is “this is nuts,” it’s probably time to think about your overall portfolio risk. On Friday, that was how the investment committee both started and ended – “this is nuts.” 

We have been discussing the overbought, extended, and complacent market over the last couple of weeks, but on Friday, I tweeted out a couple of charts that illustrated the excess. 

The first chart was comparing the Nasdaq to the S&P 500 index. Both are banded by 2-standard deviations bands of the 200-WEEK moving average. there are a couple of things which should jump out immediately:

1. The near-vertical price acceleration in the markets has been a historical hallmark of late-stage cycle advances, also known as a “melt up” phase.
2. When markets get more than 2-standard deviations above their long-term moving average, reversions to the mean have tended to follow shortly after that. 

Currently, both of those conditions exist in the chart above. However, if it were only price acceleration, we would just be mildly concerned. However, investor complacency has also reached more extreme levels with PUT/CALL ratio now hitting historically high levels. (The put/call ratio is the ratio of “put options” being bought on the S&P 500 (theoretically to hedge risk) versus the number of “call” options purchased to “lever up” risk.)

Lastly, all of our indicators from momentum to relative strength are all suggesting risk substantially outweighs reward currently. 

While none of this means the market will “crash,” it does suggest the risk/reward ratio is not in favor of the bulls short-term. 

However, we are mindful that in the short-term, the market is currently obsessed with the Fed’s monetary interventions (the topic of this week’s MacroView), which are supportive of the markets currently. However, as my friend and colleague Doug Kass summed noted this week:

“It is growing increasingly clear to me that global stock markets are in the process of making a speculative move (driven by global liquidity) that may even compare to the advances that culminated in the seminal market tops in the Fall of 1987 and in the Spring of 2000.

As today’s trading day comes to a close, it is apparent that, like the 1997 Long Boom paradigm expressed in a column in Wired Magazine during the dot.com bubble –– the current market is similarly viewed as in its own, new liquidity-based paradigm.

No longer is the market hostage to the real economy or sales and profit growth – stuff I have spent four decades analyzing. Instead, liquidity is seen as an overriding influence, actually it has become the sine quo non.

As such, historical valuations become increasingly irrelevant, and price momentum is the lodestar.“

He is right. 

Currently, almost every single valuation metric is at historic extremes, yet investors continue to take on increasing levels of risk due to nothing more than “F.O.M.O – Fear Of Missing Out.” 

As Doug goes on to note:

“We live in unusual times – in which central bankers have adopted policy unlike any point in history. Near-zero interest rates around the world have become commonplace and are accepted with little thought given to the adverse consequences. Forgetting history, central bankers seem to have no idea that they have created another monster again – just as they did in 1999.

Meanwhile, corporate profits are lower (year over year), and the rate of global GDP growth remains below the historic trendline – as it takes more and more debt to deliver a unit of production.

The climb in stocks will likely end badly as it is not supported by the fundamental (social, economic, political and geopolitical) backdrop and, increasingly, classical valuation metrics have moved to the highest percentiles in history (enterprise value/EBIT, price to sales, market capitalizations to GDP, etc.)

Yes, “this is nuts,” which is why we took profits out of portfolios on Friday.

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Portfolio Positioning

On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels. 

In the Equity Portfolios, we reduced our weightings in some of our more extended holdings such as Apple (AAPL,) Microsoft (MSFT), United Healthcare (UNH), Johnson & Johnson (JNJ), and Micron (MU.)

In the ETF Sector Rotation Portfolio, we reduced our overweight positions in Technology (XLK), Healthcare (XLV), Mortgage Real Estate (REM), Communications (XLC), Discretionary (XLY) back to portfolio weightings for now. 

The Dynamic Portfolio was allocated to a market neutral position by shorting the S&P index itself.

Let me state clearly, we did not “sell everything” and go to cash. We simply reduced our holdings to raise cash, and capture some of the gains we made in 2019. When the market corrects we will use our cash holdings to either add back to our current positions, or add new ones.

One of the areas we have been discussing recently is the opportunity that may be presenting itself in the Energy sector. With oil prices rising, and valuations better than other areas of the market, there are some trading opportunities starting to appear.

While our portfolios are designed to have longer-term holding periods, we understand that things do not always go as planned. This is why we enter positions on a trading basis only, which are short-term until both the position, and the overall thesis, starts to mature.

Last week, we presented some technical analysis on three major energy ETF’s and seven individual companies which may be presenting a trading opportunity in the near future. You can view all of our portfolio models, which are live accounts, at RIA PRO. (Try the service for 30-days RISK FREE)

But from a broad perspective, the Energy sector is showing some signs of life. The break above the 200-dma, as well as the downtrend from previous highs, gives the sector a much more bullish tone currently. However, there are still many issues that overhang the energy market in the longer-term from cash flows, to leverage, to economic demand, which will likely keep energy markets fairly range-bound through 2020 and beyond.

The complete analysis we presented to RIAPRO clients last week is presented here.

3300 To 3500, And Back Again

In July of 2019, we laid out our prognostication the S&P 500 could reach 3300 amid a market melt-up though the end of the year. On Friday, the market touched 3280, which, as they say, is “close enough for Jazz.”

However, with the Federal Reserve having “turned on the liquidity taps,” it is entirely possible the markets could continue their upward momentum towards 3500.

The potential “fly in the ointment” is if the economic, employment, and profit data fail to recover as anticipated. With 2020 earnings estimates already cut markedly heading into the year, further downward revisions will likely begin to weigh on investor sentiment. 

Friday’s employment report was weak and exposed the anomaly caused by the autoworkers strike in the blockbuster November report. CEO and CFO confidence remain very suppressed currently, and if their views don’t start to improve markedly in the short-term we are likely to start seeing much weaker employment reports. 

While the markets could certainly see a push higher in the short-term from the Fed’s ongoing liquidity injections, the gains for 2020 could very well be front-loaded for investors. 

Taking profits and reducing risks now may lead to a short-term underperformance in portfolios, but you will likely appreciate the reduced volatility if, and when, the current optimism fades.

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The Macro View

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

See You Next Week

By Lance Roberts, CIO

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Financial Planning Corner

REGISTER NOW for our most popular workshop: THE RIGHT LANE RETIREMENT CLASS

• The Westin, Austin at the Domain- 11301 Domain Drive, Austin, TX 78758
• February 8th from 9-11am.

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

by Danny Ratliff, CFP®, ChFC®

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Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders

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S&P 500 Tear Sheet

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Performance Analysis

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

“Don’t fight the Fed”

That’s how I started out last week’s “Macroview.”

“That is the current mantra of the market as we begin 2020, and it certainly seems to be the right call. Over the last few months, the Federal Reserve has continued its ‘QE-Not QE’ operations, which has dramatically expanded its balance sheet. Many argue, rightly, the current monetary interventions by the Fed are technically ‘Not QE’ because they are purchasing Treasury Bills rather than longer-term Treasury Notes.

However, ‘Mr. Market’ doesn’t see it that way. As the old saying goes, ‘if it looks, walks, and quacks like a duck…it’s a duck.'” 

As we discussed, there is something “broken” in the financial system when it requires massive injections of capital to maintain sufficient liquidity. This was a point noted by Curvature Securities’ Scott Skyrm in his daily “Repo Market Commentary” via Zerohedge:

“Indeed, something appears amiss, because the total overnight and term Fed RP operations on Friday were greater than on year end! On year-end, the Fed had pumped a total of $255.95 billion into the market verses $258.9 billion on Friday.”

When these excessive “Repurchase Operations” initially began in late September, we were told they were to meet corporate tax payments. The issue with that excuse is that corporate tax payments come due every quarter and are easy to forecast weeks in advance. Why was last October’s payment period so different? But, following October 15th, the “repo” operations should have been no longer needed, however, the funding not only continued, but grew.

As the end of the year approached, we were told liquidity was needed to meet “the turn,” as 2019 ended, and 2020 began. Once again, this excuse falls short as, without exception, every year ends on December 31st. So, after nearly a decade of NO “repo” operations, as shown below, what is really going on?

What is clear, is the Fed may be trapped in their own process, a point made by Mark Cabana of BofAML:

“It seems implausible to me that the Fed will be able to stop their repo operations by the end of January.”

The Fed’s New Liquidity Trap

We previously discussed the “liquidity trap” the Fed has gotten themselves into, along with Japan, which will plague economic growth in the future. To wit:

“The signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.”

Our “economic composite” indicator is comprised of 10-year rates, inflation (CPI), wages, and the dollar index. Importantly, downturns in the composite index leads GDP.

The Fed’s problem is not only are they caught in an “economic liquidity trap,” where monetary policy has become ineffective in stimulating economic growth, but are also captive to a “market liquidity trap.”

As Mr. Skrym noted:

“The problem with the broken repo market, and the Fed’s respective Repo operations, is similar to the problem observed with QE, and the Fed’s balance sheet in general, over the past decade. The market has gotten addicted to the easy Fed liquidity.” 

This can be seen in the chart below.

Whenever the Fed, or other Global Central Banks, have engaged in “accommodative monetary policy,” such as QE and rate cuts, asset prices have risen. However, as denoted by the “red” shaded areas, when those activities are not present, asset prices have declined.

In short, the market has become addicted to QE, and like any drug addict, when the drug was taken away in 2018, as the Fed hiked rates and reduced their balance sheet in an attempt to normalize policy, the market dropped by nearly 20%.

To understand why this is important we have to go back to what Ben Bernanke said in 2010 as he launched the second round of QE:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

I highlight the last sentence because it is the most important. Consumer spending makes up roughly 70% of GDP, therefore increased consumer confidence is critical to keeping consumers in action. The problem is the economy is no longer a “productive” economy, but rather a “financial” one. A point made by Ellen Brown recently:

“The financialized economy – including stocks, corporate bonds and real estate – is now booming. Meanwhile, the bulk of the population struggles to meet daily expenses. The world’s 500 richest people got $12 trillion richer in 2019, while 45% of Americans have no savings, and nearly 70% could not come up with $1,000 in an emergency without borrowing.

Central bank policies intended to boost the real economy have had the effect only of boosting the financial economy. The policies’ stated purpose is to increase spending by increasing lending by banks, which are supposed to be the vehicles for liquidity to flow from the financial to the real economy. But this transmission mechanism isn’t working, because consumers are tapped out.”

If consumption retrenches, so does the economy.

When this happens debt defaults rise, the financial system reverts, and bad things happen economically.

For this reason the Federal Reserve has been engaged in an ongoing campaign to “avoid the pain” experienced during the financial crisis. This was a question asked of Janet Yellen during her semi-annual Humphrey-Hawkins testimony by Rep. Edward Royce. I am going to break this down for clarity.

“ROYCE: I’m worried that the Federal Reserve has created a third pillar of monetary policy, that of a stable and rising stock market. And I say that because then-Chairman Bernanke, when he appeared here, stated repeatedly that, ‘the goal of QE was to increase asset prices like the stock market to create a wealth effect.’”

As stated, Ben Bernanke clearly states the goal of Q.E. was to increase asset prices. As Royce continues he clearly identifies the Fed’s “new liquidity trap:”

“ROYCE: That seems as though that was goal. It would stand to reason then that in deciding to raise rates and reduce the Fed’s QE balance sheet standing at a still record $4.5 trillion, one would have to be prepared to accept the opposite result, a declining stock market, and a slight deflation of the asset bubble that QE created.

Yet, every time in the past three years when there has been a hint of raising rates and the stock market has declined accordingly, the Fed has cited stock market volatility as one of the reasons to stay the course and hold rates at zero.

Read the last paragraph again.

Royce understands that in order to normalize monetary policy, and return markets to a more normal state of operation, some pain would have to be expected.

So, what was Yellen’s response.

YELLEN: It is not a third pillar of monetary policy. We DO NOT target the level of stock prices. That is not an appropriate thing for us to do.”

Yes, the Fed absolutely targets the financial markets with their policies. However, as Royce notes above, it will require a level of pain to wean the markets off of ongoing liquidity. In 2018, the Fed learned their lesson of what would happen as the small adjustment to monetary policy they did make resulted in a market decline of nearly 20%, yield curves inverted, and threats of a recession rose.

They aren’t willing to make that mistake again. The subsequent policy reversal pushed the markets to new record highs, which has been a function of  valuation expansion due to the lack of improvement in underlying fundamentals and earnings.

The Inextricable Problem

The problem is that stopping the current “repo” operations is that it could well spark another “repo market crisis,” especially with $259 billion in liquidity pumped currently. Notably, that is even more than what was at year end to fulfill “the turn.”

The BIS recently explained why these operations lift asset prices.

Repo markets redistribute liquidity between financial institutions: not only banks (as is the case with the federal funds market), but also insurance companies, asset managers, money market funds and other institutional investors. In so doing, they help other financial markets to function smoothly. Thus, any sustained disruption in this market, with daily turnover in the U.S. market of about $1 trillion, could quickly ripple through the financial system. The freezing-up of repo markets in late 2008 was one of the most damaging aspects of the Great Financial Crisis (GFC).

You really have to ask what is going on here. Wall Street veteran Caitlin Long provided a clue.

U.S. Treasuries are the most rehypothecated asset in financial markets, and the big banks know this. [They] are the core asset used by every financial institution to satisfy its capital and liquidity requirements, which means that no one really knows how big the hole is at a system-wide level.

This is the real reason why the repo market periodically seizes up. It’s akin to musical chairs – no one knows how many players will be without a chair until the music stops.

As ZeroHedge noted, this isn’t just a bank issue.

Hedge funds are the most heavily leveraged multi-strategy funds in the world, taking something like $20 billion to $30 billion in net assets under management and levering it up to $200 billion. As noted by The Financial Times:

“Some hedge funds take the Treasury security they have just bought and use it to secure cash loans in the repo market. They then use this fresh cash to increase the size of the trade, repeating the process over and over and ratcheting up the potential returns.”

So….it’s a hedge fund problem, right?

Probably.

“The repo-funded [arbitrage] was (ab)used by most multi-strat funds, and the Federal Reserve was suddenly facing multiple LTCM (Long-Term Capital Management) blow-ups which could have started an avalanche. Such would have resulted in trillions of assets being forcefully liquidated as a tsunami of margin calls hit the hedge funds world.”

Think “Lehman crisis” multiplied by a factor of four.

The Fed’s position is they must continue inflating a valuation bubble despite the inherent, and understood, risks of doing so. However, with no alternative to “emergency measures,” the Fed is trapped in their own process. The longer they continue their monetary interventions, the more impossible it becomes for the Fed to extricate itself without causing the crash they want to avoid.

Stated simply, the longer the Fed avoids normalizing monetary policy, and weaning the “crack addicted” markets off of their “liquidity drug,” the bigger the “reversion” will be “when,” not “if,” it occurs.

The only question is how much longer can Jerome Powell continue “pushing on a string.”

REGISTER NOW for our most popular workshop:

THE RIGHT LANE RETIREMENT CLASS

• The Westin Austin at the Domain- 11301 Domain Drive, Austin, TX 78758
• February 8th from 9-11am.

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Hopefully you’ve had some time to reflect and grade yourself on your financial progress for 2019 and you’re ready to take 2020 by the horns. The new year brings new numbers to be aware of to ensure you’re taking advantage of all you can. There are many contribution limits, income limits and a vast array of numbers used in financial planning, but here are a few more common ones to make sure you’re staying on track.

Retirement Plans:

For employees:

401(k), 403(b), most 457 plans and the federal governments Thrift Savings Plan employee contributions have increased from $19,000 to $19,500. The maximum amount employees + employers can contribute has also gone up to $57,000.

For those of you over 50 the catch up provision has increased from $6,000 to $6,500.

Please, please don’t overlook the Roth option if you have it within your plan.

For Small Business Owners:

SIMPLE IRA plan contribution limits have been increased from $13,000 to $13,500. There is also a catch up provision of $3,000 for individuals over 50.

SEP IRA contribution limits have also increased from $56,000 to $57,000 or 25% of income whichever is lower.

IRA’s

While the maximum contribution limits for IRA’s of $6,000 and a catch up provision of $1,000 for those over 50 remained unchanged. The income limits for deductibility in the case of the Traditional IRA and the ability to contribute to a Roth IRA did change a bit.

Traditional IRA

You can always make a contribution to a Traditional IRA with no income limitations, but your contribution may not be deductible for income tax purposes. For those of you who would like to make a tax deductible contribution which I assume is most of you, the numbers have changed slightly. There is such a thing as a “phase out limit”. This applies if you make over a certain amount of income you can still contribute and deduct, but the amount will be reduced that you can deduct.

Then there are those who can’t make tax deductible contributions at all.

If you and your spouse are not covered by an employer sponsored plan then regardless of income you can make a deductible contribution.

If you are covered by an employer sponsored plan here is what you need to know about those phase out limits. If you’re single or Head of Household the income limit starts at $65,000 and ends at $75,000. Meaning that if you make between $65,000 and $75,000 your deductible contribution will be reduced, but if you make over $75,000 you can’t deduct your contribution for income tax purposes. If you file Married Filing Jointly that number is $104,000 to $124,000.

Now if only one of you is covered by an employer sponsored plan the income limit for tax deductible contributions goes up to $196,000-206,000.

Roth IRA

Roth IRA’s are a little trickier than their older brethren the Traditional IRA. You can either contribute or you can’t. In the case of the Roth the benefit isn’t a tax deduction, but paying taxes now, funding the Roth with after tax funds and enjoying tax free growth and distributions should you meet a couple of small stipulations.  Roth contributions can be withdrawn at any time without a 10% penalty, but the earnings could be subject to taxes and the 10% early withdrawal penalty if you don’t meet the following:

• Withdrawals must be taken after 59 ½
• Withdrawals must be taken after a five year holding period

There are also a few qualifying events that may preclude you from having to pay taxes and/or 10% penalty, but we’ll save those for another post.

Here are the numbers you need to know to determine if you can or can’t contribute to a Roth IRA.

If you’re single or Head of Household and make under $124,000 you can make a full Roth contribution of $6,000 if you’re over 50 you can also make the additional $1,000 catch up contribution. If you make over $124,000, but less than $139,000 then you will be able to make a partial contribution. Over $139,000 you’re out of luck on a Roth IRA.

Married Filing Jointly income numbers for eligibility to contribute to a Roth increase a bit as well increasing from $193,000-$203,000 to $196,000- $206,000.

Saving for Health Care

There are two main types of accounts designed to help pay for medical expenses. If you can utilize them both that’s great, most don’t have that choice, but if you have to choose I really like the Health Savings Account.

Health Savings Accounts (HSA)

If you have access to a Health Savings Account max it out and if you can pay medical expenses out of pocket don’t use these funds.

This is the only account in the world which will give you a triple tax benefit-funds go in pre-tax, grow tax free and come out tax free if used for qualified medical expenses. Fidelity did a study last year that estimated the average 65 year old couple will spend $280,000 in health care expenses. You must be in a high deductible health insurance plan to utilize a HSA, but we are seeing more and more employers offering these types of plans.

This year if you are single you can contribute $3,550 and families can contribute $7,100 to an HSA. There is also an additional catch up provision of $1,000 for those 55 and older.

Flexible Spending Accounts (FSA)

FSA’s which are typically use it or lose it now have an annual contribution limit of $2,750 up from $2,700 in 2019.

Social Security and Medicare

We spend a lot of time discussing Social Security and Medicare and for good reason. According to our workshop attendance in 2019 there is a thirst for knowledge in these areas. I understand, they both can be confusing and this is an area that contains “stealth taxes.”

Social Security

Social Security had a couple of increases in 2020, for instance the estimated maximum monthly benefit if turning full retirement age (66) in 2020 is now $3,011.

OASDI which is an acronym for Old-Age, Survivors, Disability Insurance (Social Security Trust) taxes income up to $137,700 this is an increase from $132,900 in 2019. The current tax is 6.20% on earnings up to the applicable taxable maximum amount of $137,000. The Medicare portion is 1.45% on all earnings.

The retirement earnings test exempt amounts have also increased. In layman’s terms, if you take social security prior to full retirement age you will have $1 in benefits withheld for every $2 over $18,240/yr.

The year an individual reaches full retirement age that number increases to $48,600/yr, but only applies to earning for months prior to attaining full retirement age. In this instance $1 in benefits will be withheld for every $3 in earning above the limit.

Medicare

Medicare Part B premiums have also increased from $135.50 to $144.60. The first threshold for premium increases or surcharges has also increased for single filers to $87,000 to $109,000 and $174,000 up to $218,000 for joint filers. If you’re above those first numbers your monthly premium goes up to $202. 40 and it only goes up incrementally from there.

These are some of the more common numbers we watch for to either try to keep more money in your pocket or make sure you’re maximizing all funding sources. Now is a great time to check to ensure you’ve updated any systematic contributions to reflect the new numbers. After all, I know you’re paying yourselves first.

This past week was our annual family ski trip, which is why our postings have been lighter than normal this week. We will return next week back with our full schedule.

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

The Week In Blogs

The Next Decade: Valuations & The Destiny Of Low Returns

Financial Planning Corner: A Change To RMD’s For Post-49’ers

Technically Speaking: Markets Dismiss Iran As The Fed “Put” Remains

Can Six Myths Keep The Market Going?

Investing Versus Speculating

Market Bubbles: It’s Not The Price, It’s The Mentality.

The Best Of “The Lance Roberts Show

Video Of The Week

Michael Lebowitz & I discussing the Fed Repo operations and the trap they have gotten themselves into.

Our Best Tweets Of The Week

"I think this market is fully valued and not undervalued, but I don’t think it’s overvalued,” – Jeremy Siegel

Really? pic.twitter.com/XzIEtqkPcT

— Lance Roberts (@LanceRoberts) January 9, 2020

Peakest complacency

— Michael Lebowitz, CFA (@michaellebowitz) January 9, 2020

Lots of commentary about how the $QQQ is outperforming the $SPY. Just one note, there are only a few times in the last 25-years where both markets were trading 3-standard deviations above their 200-WEEK MA.
This is one of them. pic.twitter.com/OEpJ1rpXV6

— Lance Roberts (@LanceRoberts) January 10, 2020

Jeremy Siegel is an Uber Bull, therefore fully valued for him is grossly overvalued using most popular metrics. pic.twitter.com/Xk0QcBr2jI

— Michael Lebowitz, CFA (@michaellebowitz) January 9, 2020

Agree. We have a couple of big themes for 2020 in portfolios.
1) Lower #dollar
2) Long #energy, #commodities, #gold
3) Long #international/#emerging
4) Long #bonds.
5) Long #hedges
6) Long #value vs #momentum pic.twitter.com/YhztuUHfjG

— Lance Roberts (@LanceRoberts) January 6, 2020

Our Latest Newsletter

What You Missed At RIA Pro

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

Energy Sector Analysis: 1-09-2020

See you next week!

“Oh, a storm is threat’ning my very life today
If I don’t get some shelter oh yeah I’m gonna fade away” – Rolling Stones

The graph below plots 15 years’ worth of quarterly earnings per share for a large, well known publicly traded company. Within the graph’s time horizon is the 2008 financial crisis and recession. Can you spot where it occurred? Hint- it is not the big dip on the right side of the graph or the outsized increase in the middle.

The purpose of asking the question is to point out that this company has very steady earnings growth with few instances of marked variation. The recession of 2008 had no discernable effect on their earnings. It is not a stretch to say the company’s earnings are recession-proof.

The company was formed in 1886 and is the parent of an iconic name brand known around the world. The company has matured into a very predictable company, as defined by steady earnings growth.

Fundamentally, this company has all the trappings of a safe and conservative investment the likes of which are frequently classified as defensive value stocks. These kinds of companies traditionally provide a degree of safety to investors during market drawdowns. Today, however, this company and many other “shelter stocks” are trading at valuations that suggest otherwise.

What is Value?

Determining the intrinsic value for an investment is a crucial baseline metric that investors must calculate if they want to properly determine whether the share price of a company is rich, cheap, or fair.

Investors use a myriad of computations, forecasts, and assumptions to calculate intrinsic value. As such, the intrinsic value for a company can vary widely based on numerous factors. 

We broadly define intrinsic value as the price that a rational investor would pay for the discounted cash flows, after expenses, of a company. More simply, what is the future stream of net income worth to you? As value investors, we prefer to invest in companies where the market value is below the intrinsic value. Doing so provides a margin of safety.

Jim Rogers, the former partner of George Soros, put it this way: “If you buy value, you won’t lose much even if you’re wrong.”

Calculating the intrinsic value with a high level of confidence is difficult, if not impossible, for some companies. For instance, many smaller biotech companies are formed to find a cure or treatment for one or two medical ailments. These firms typically lose money and burn through funding during the research and development (R&D) stage. If they successfully find a treatment or cure and financially survive the long FDA approval process, the shareholders are likely to receive hefty returns. The outcome may also be positive if they have a promising medication and a suitor with deep pockets buys the company. Because the outcome is uncertain, many biotech companies fail to maintain enough funding through the R&D stage.

Calculating an intrinsic value for a small biotech company can be like trying to estimate what you may win or lose at a roulette table. The number of potential outcomes is immense and highly dependent on your assumptions. 

At the other end of the spectrum, there are mature companies with very predictable cash flows, making intrinsic value calculations somewhat simple, as we will show.

Coca-Cola

Coca Cola (KO) is the company we referenced in the opening section. KO is one of the most well-known companies in the world, with an array of products sold in almost every country. KO is mature in its lifecycle with very dependable sales and earnings growth. The question we raise in this analysis is not whether or not KO is a good company, but whether or not its stock is worth buying.  To answer this question, we will determine its intrinsic value and compare it to the current value of the company.

The textbook way to calculate intrinsic value is to discount the future cash flows of the company. The calculation entails projecting net income for the next 30 years, discounting those annual income figures at an appropriate rate, and summing up the discounted cash flows. The answer is the present value of the total earnings stream based on an assumed earnings growth rate.

In our intrinsic value model for KO, we assumed an earnings growth rate of 4.5%, derived from its 20 year annualized earnings growth rate of 5.4% and it’s more recent ten year annualized growth rate of 2.9%. Recent trends argue that using 5.4% is aggressive. We used a discounting factor of 7% representing the historical return on equities. The model discounted 30 years of estimated future earnings.

The model, with the assumptions above, yields an intrinsic value of $157 billion. The current market cap, or value, of KO is $235 billion, meaning the stock is about 51% overvalued. Even if we assume the longer-term 20-year growth rate (5.4%), the stock is still 35% overvalued.

To confirm the analysis and illustrate it in a different format, we calculated what the stock price would be on a rolling basis had it grown in line with the prior rate of ten years of earnings growth. As shown in the graph and table below, the market value is currently 55% above the model’s valuation for KO.  The green and red areas highlight how much the stock was overvalued and undervalued.

To check our analysis, we enlisted our friend David Robertson from Arete Asset Management and asked him what intrinsic value his cash flow based model assigned to KO. The following is from David:

In looking at the valuation of KO, I see a couple of familiar patterns. The most obvious one is that the warranted value, based on a long-term model that discounts expected cash flows, is substantially below the current market value. Specifically, the warranted value per share is about $21, and nowhere near the mid-50s current market price. The biggest reason for this is that the discounted value of future investments has declined the last few years substantially due to lower economic returns and lower sustainable growth rates. In other words, as the company’s ability to generate future returns has diminished, its stock price has completely failed to capture the change.

The chart below from David compares his model’s current and future intrinsic value (Arete target) with the annual high, low, and closing price for KO.  David’s graph is very similar to what we highlighted above; KO has been trading at a steep premium to its intrinsic value for the last few years.

Lastly, we share a few more facts about KO’s valuations.

• Revenues (sales) have been in decline since 2012
• Price to Sales (6.99) is at a 20 year high and three times greater than the faster growing S&P 500
• Price to Earnings (25.83 –trailing 12 mos.) is at a 17 year high
• Price to Book (11.24) is at an 18 year high
• Enterprise Value to EBITDA is at an eight-year high
• Capital Expenditures are at a 15 year low and have declined rapidly over the last eight years
• Book Value is at a ten year low
• Debt has tripled over the last ten years while revenues and earnings have grown at about 15-20% over the same period

When Value Becomes Growth

In 2018 we wrote a six-part RIA Pro series called Value Your Wealth. Part of the series was devoted to the current divergence between value and growth stocks and the potential for outsized returns for value investors when the market reverts to the mean. In the article, we explored mutual funds and S&P sectors to show how value can be defined, but also how the title “value” is being mischaracterized.

One of the key takeaway from the series is that finding value is not always as easy as buying an ETF or fund with the word “value” in it. Nor, as we show with KO, can you rely on traditional individual stock mainstays to provide true value. Today’s value hunters must work harder than in years past.

Based on our model, KO traded below the model’s intrinsic value from 2003 through 2013 and likely in the years prior. As noted, its average discount to intrinsic value during this period was 41%. Since 2014 KO has traded well above its intrinsic value.

In 2014 passive investing strategies started to gain popularity. As this occurred, many companies’ share prices rose faster than their earnings growth. These stocks became connected to popular indexes and disconnected from their fundamentals. The larger the company and the more indexes they are in, the more that the wave of passive investing helped the share price. KO meets all of those qualifications. As the old saying goes, if you buy enough of them, the price will go up.

Summary

Buying “Value” is not as easy as buying shares in well-known companies with great brand names, proven track records, and relative earnings stability. As we exemplified with KO, great companies do not necessarily make great investments.

The bull market starting in 2009 is unique in many aspects. One facet that we have written extensively on is how so many companies have become overpriced due to indiscriminate buying from passive investment strategies. This has big implications for the next equity market drawdown as companies like KO may go down every bit as much or even more than the broader market.

Be careful where you seek shelter in managing your portfolio of stocks; it may not be the safe bunker that you think it is.  

In a follow-up article for RIA Pro, we will present similar analysis and expose more “value” companies.

“Actually, one of the dangers is that people could be throwing risk to the wind and this [market] could be a runaway. We sometimes call that a melt-up and produces prices too high and then if there’s a shock, you come down to Earth and that could impact sentiment. I think this market is fully valued and not undervalued, but I don’t think it’s overvalued,” – Jeremy Siegel

Here is an interesting thing.

“Market bubbles have NOTHING to do with valuations or fundamentals.”

Hold on…don’t start screaming “heretic,” and building gallows just yet.

Let me explain.

I can’t entirely agree with Siegel on the market being “fairly valued.” As shown in the chart below, the S&P 500 is currently trading nearly 90% above its long-term median, which is expensive from a historical perspective.

However, since stock market “bubbles” are a reflection of speculation, greed, emotional biases; valuations are only a reflection of those emotions.

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you an elementary example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.

Notice that with the exception of only 1929, 2000, and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently. 

Secondly, all market crashes have been the result of things unrelated to valuation levels such as liquidity issues, government actions, monetary policy mistakes, recessions, or inflationary spikes. Those events were the catalyst, or trigger, that started the “reversion in sentiment” by investors.

For Every Buyer

You will commonly hear that “for every buyer, there must be a seller.”

This is a true statement. The issue becomes at “what price.” What moves prices up and down, in a normal market environment, is the price level at which a buyer and seller complete a transaction.

Market crashes are an “emotionally” driven imbalance in supply and demand.

In a market crash, the number of people wanting to “sell” vastly overwhelms the number of people willing to “buy.” It is at these moments that prices drop precipitously as “sellers” drop the levels at which they are willing to dump their shares in a desperate attempt to find a “buyer.” This has nothing to do with fundamentals. It is strictly an emotional panic, which is ultimately reflected by a sharp devaluation in market fundamentals.

Bob Bronson once penned:

“It can be most reasonably assumed that markets are sufficient enough that every bubble is significantly different than the previous one, and even all earlier bubbles. In fact, it’s to be expected that a new bubble will always be different than the previous one(s) since investors will only bid up prices to extreme overvaluation levels if they are sure it is not repeating what led to the last, or previous bubbles. Comparing the current extreme overvaluation to the dotcom is intellectually silly.

I would argue that when comparisons to previous bubbles become most popular – like now – it’s a reliable timing marker of the top in a current bubble. As an analogy, no matter how thoroughly a fatal car crash is studied, there will still be other fatal car crashes in the future, even if the previous accident-causing mistakes are avoided.”

Comparing the current market to any previous period in the market is rather pointless. The current market is not like 1995, 1999, or 2007? Valuations, economics, drivers, etc. are all different from cycle to the next. Most importantly, however, the financial markets adapt to the cause of the previous “fatal crashes,” but that adaptation won’t prevent the next one.

It’s All Relative

Last week, in our MacroView, I touched on George Soros’ theory on bubbles, which is worth expanding a bit on in the context of this article.

“Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, the markets are far from equilibrium conditions.

Every bubble has two components:

1. An underlying trend that prevails in reality, and; 
2. A misconception relating to that trend.

When positive feedback develops between the trend and the misconception, a boom-bust process is set into motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend is sustained by inertia.

As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.”

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.

The chart below is an example of asymmetric bubbles.

The pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view. Prices reflect the psychology of the market, which can create a feedback loop between the markets and fundamentals.

This pattern of bubbles can be seen at every bull market peak in history. The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis with an overlay of the asymmetrical bubble shape.

As Soro’s went on to state:

“Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions.

• In the passive or cognitive function, the fundamentals are supposed to determine market prices. 
• In the active or manipulative function market, prices find ways of influencing the fundamentals. 

When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”

Currently, there is a strong belief the financial markets are not in a bubble, and the arguments supporting that belief are based on comparisons to past market bubbles.

It is likely that in a world where there is virtually “no fear” of a market correction, an overwhelming sense of “urgency” to be invested, and a continual drone of “bullish chatter;” the markets are poised for the unexpected, unanticipated, and inevitable event.

Reflections

When thinking about excess, it is easy to see the reflections of excess in various places. Not just in asset prices but also in “stuff.” All financial assets are just claims on real wealth, not actual wealth itself. A pile of money has use and utility because you can buy stuff with it. But real wealth is the “stuff” — food, clothes, land, oil, and so forth.  If you couldn’t buy anything with your money/stocks/bonds, their worth would revert to the value of the paper they’re printed on (if you’re lucky enough to hold an actual certificate). 

But trouble begins when the system gets seriously out of whack.

“GDP” is a measure of the number of goods and services available and financial asset prices represent the claims (it’s not a very accurate measure of real wealth, but it’s the best one we’ve got.) Notice the divergence of asset prices from GDP as excesses develop.

What we see is that the claims on the economy should, quite intuitively, track the economy itself. Excesses occur whenever the claims on the economy, the so-called financial assets (stocks, bonds, and derivatives), get too far ahead of the economy itself.

This is a very important point. 

“The claims on the economy are just that: claims. They are not the economy itself!”

Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today.

The increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable correction at some point in the future. The only missing ingredient for such a correction is the catalyst to bring “fear” into an overly complacent marketplace.  

It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: “Stocks have now reached a permanently high plateau.” 

This “time IS different.” 

However, “this time” is only different from the standpoint the variables are not exactly the same as they have been previously. The variables never are, but the outcome is always the same.

We have been discussing the opportunity that may be presenting itself in the Energy sector. With oil prices rising, and valuations better than other areas of the market, there are some trading opportunities starting to appear.

While the portfolios are designed to have longer-term holding periods, we understand that things do not always go the way we plan. We are entering the energy sector on a trading basis only, which could be very short-term, until both the positions and the overall thesis begins to mature.

While there are a LOT of energy companies to choose from, we have eliminated all companies which are NOT PROFITABLE from our analysis. All candidates must also pay a dividend to comply with our total return thesis and portfolio strategy.

Sector ETF’s

XLE – Energy Select Sector SPDR

• With the broad energy sector on a buy signal, we are looking to add exposure to our portfolios.
• We have been reluctant to move too quickly as previous rally attempts to the 200-dma have been selling opportunities.
• With the sector very overbought short-term, we are looking for a pullback in the broader energy sector to add 1/2 position to the Equity and ETF portfolios.
• Stop is will be set at $58 after entry.

IEO – iShares U.S. Oil & Gas Exploration

• As with the broader energy space, Oil & Gas exploration has also broken about the 200-dma and is on a buy signal.
• As with XLE, IEO is very overbought and needs a correction to work off the overbought position before positions can be added.
• The stop is set at $53 after entry.

IEZ – iShares U.S. Oil Equipment & Services

• Oil & Equipment Services doesn’t look as convincing as the refining and major oil companies look.
• While IEZ is very overbought it is just now making an attempt to break above the 200-dma. It is too early to consider this space as most of the companies in the sector are not profitable and are carrying a lot of debt.

Individual Securities

CVX – Chevron Corp.

• CVX hasn’t done much in the last couple of years either good or bad.
• Currently, CVX is on a sell signal, which is improving and close to turning positive, and the position is currently holding the 200-dma.
• With a near 5% yield, the return has almost solely come from the dividend over the last couple of years.
• We like this company and will look to add a position if the buy signal turns positive and support holds. 
• Stop is set at $112.50 after entry.

EOG – EOG Resources

• EOG has had an extremely sharp move and is overbought with a very extended buy signal currently.
• EOG needs to correct, work off the overbought condition, and reduce the buy signal before an entry can be made.
• Take profits if you are long currently,
• Stop is set at $70

FANG – Diamond Back Drilling

• FANG is currently testing its 200-dma which has been the downtrend resistance point for the stock.
• The stock is currently very overbought, but is just registering a “buy signal.”
• We are going to watch this stock closely, it needs more work before becoming a potential trade.
• If long currently, take profits.
• Stop is set at $75

KMI – Kinder Morgan

• KMI has had a lot of problems since their acquisition of El Paso Energy.
• The stock is currently very overbought, but is close to registering a “buy signal” after holding support at the 200-dma.
• KMI needs to correct a little, and hold support at the 200-dma, to provide for a decent entry point. If oil prices correct, that entry point will be come likely.
• If long the position, take profits.
• Stop loss is set at $20

MPC – Marathon Petroleum Corp.

• MPC is a little different picture than the others
• MPC had a very strong rally, got very extended, and is now correcting that extension.
• With the position holding support at the 200-dma, there is a decent trading setup to add to portfolios. We also like the 3.6% yield.
• Buy 1/2 position at current levels.
• Stop is tight at the 200-dma or $56.

PXD – Pioneer Natural Resources

• PXD has had a very strong run over and is both extended on its buy signal and very overbought.
• Wait for a correction which holds support at the 200-dma and works off the overbought and extended condition.
• Take profits if long the position currently.
• Stop loss is set at $140

XOM – Exxon Mobil

• XOM has rallied off of lows where we added to our existing position last year.
• However, while it has failed at the 200-dma it has registered a short-term buy signal.
• While we are roughly flat in the position currently, performance has been disappointing while we are collecting the 5% yield.
• We will continue to hold the position for now, but may look to reduce it on any rally in the near future.
• Stop loss remains at $66

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

ABT – Abbott Laboratories

• We bought ABT in early 2019, and have taken profits twice along the way.
• ABT has been on a deep “sell signal” for a while and is close to reversing that signal while have maintained a fairly tight consolidation range over the last 6-months.
• We are maintaining our current stop level, and will look to add to our holding between on a pullback to 82.50.
• Stop is set at $77.50

JNJ – Johnson & Johnson

• We bought JNJ when it was out of favor with the market over their “talc” lawsuit issues.
• With the bulk of the those issues behind them, the stock has rebounded sharply. We are going to take profits in the position as it is now EXTREMELY overbought and more than 2-standard deviations above the 200-dma.
• We are moving our stop up to $132.50

AGNC – Agency Mortgage REIT

• We bought 2 positions to benefit from a steepening of the 10-2 yield curve which has indeed come to pass.
• Since we are at full weight in AGNC, and only 1/2 weight in NLY, we are going to take profits in AGNC and reduce the position slightly as it is grossly extended and deviated from its long-term mean.
• We are maintaining our stop at $14 as we will add back to the position following some corrective action.

AMZN – Amazon.com, Inc.

• We bought AMZN in 2019 heading into the winter shopping season.
• While the stock has risen, it remains on a sell signal currently, but is close to reversing to a buy.
• AMZN is overbought short-term but a correction that holds the 200-dma will allow us to add to our position.
• Stop is set at $1700

AEP – American Electric Power Co.

• AEP has remained a strong performer for us, and we like Utilities heading into 2020.
• AEP has been on a sell-signal for quite some time, and has held both the bullish trend and support levels.
• We are watching for a reversal of the sell signal for an opportunity to increase our exposure accordingly which would be coincident with a decline in interest rates.
• Stop is set at $87.50

IAU – Gold

• We sold 1/2 of IAU near the peak in gold prices (as it was 2-standard deviations above the 200-dma) to bring in profits and protect our position.
• When then added back to IAU in early December.
• IAU has broken out to new highs and while overbought on a short-term basis it is close to registering a buy signal.
• We are looking to overweight our position in Gold given the right setup which is likely approaching soon.
• Stop is currently set at $13.6.

DOV – Dover Corp.

• DOV has been a great performer for the portfolio particularly as the “trade war” has gotten resolved.
• DOV is exceedingly overbought and the buy signal extremely extended. A correction is inevitable.
• We have taken profits previously, but we will take additional profits very soon.
• Stop loss moved up to $100

MU – Micron Technology

• MU was an add for us in 2019. We had bought it previously but got stopped out, however, our second entry has performed much better.
• MU is now exceedingly overbought with an extended buy signal
• We are looking to take some profits and rebalance our risk in the position for a pullback in the next month or two.
• Stop-loss moved up to $45

UNH – United Healthcare

• UNH has surged higher in recent months after struggling with “Medicare for all” from Democratic candidates last year.
• We love this position and will continue to hold it, however, the position is SO extremely extended we are going to reduce our overweight holding to portfolio weight.
• Stop loss moved up to $250

UTX – United Technology

• UTX has shot higher in recent days as conflict rose with Iran.
• UTX, like many other of our positions, is now extremely overbought and extended above the 200-dma.
• We will look to reduce our position slightly and take in some profits for now and look to add back to UTX at a lower price.
• Stop loss is moved up to 137.50

Value investing is an active management strategy that considers company fundamentals and the valuation of securities to acquire that which is undervalued. The time-proven investment style is most clearly defined by Ben Graham and David Dodd in their book, Security Analysis. In the book they state, “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

There are countless articles and textbooks written about, and accolades showered upon, the Mount Rushmore of value investors (Graham, Dodd, Berkowitz, Klarman, Buffett, et al.). Yet, present-day “investors” have shifted away from the value proposition these greats profess as the time-tested secret to successful investing and compounding wealth.  

The graph below shows running ten year return differentials between value and growth. Clearly, as shown, investors are chasing growth at the expense of value in a manner that is quite frankly unprecedented over the last 90 years.

Data Courtesy French, Fama, and Dartmouth

In the 83 ten year periods starting in 1936, growth outperformed value only eight times. Five of those ten year periods ended in each of the last five years.

Contrast

Value stocks naturally trade at a discount to the market. Companies with weaker than market fundamental growth leads to discounted valuations and a perception among investors that is too pessimistic about their ability to eventually achieve a stronger growth trajectory.

Growth stocks are those that pay little or no dividends but promise exceptional revenue and earnings growth in the future.

The outperformance of growth over value stocks is natural in times when investors become exuberant. Modern-day market participants claim superior insight into this Fed-controlled, growth-friendly environment. Based on the media, it appears as if the business cycle is dead, and recessions are an archaic thing of the past. Growth stocks promising terrific streams of cash flow at some point in the future rule the day. This naturally leads to investors becoming too optimistic and extrapolate strong growth far into the future.

Meanwhile, value companies tend to retain an advantage by offering higher market yields than growth stocks. That edge may only be 1 or 2% but compounded over time, it is significant. The problem is that when valuations on the broad market become elevated, as they are now, that premium compresses and diminishes the income effect. The problem is temporary, however, assuming valuations eventually mean-revert.

One other important distinction of value companies is that they, more commonly than growth companies, end up as takeover targets. Historically, this has served as another premium in favor of value investing. Over the course of the past 12 years, however, corporate capital has uncharacteristically been more focused on growth companies and the ability to tell their shareholder a tale of wild earnings growth that accompany their takeover targets. This is likely due to the environment of ultra-low interest rates, highly accommodative debt markets, and investors that are not focused on the inevitability of the current business cycle coming to an end.

Active versus Passive

Another related facet to the value versus growth discussion is active versus passive investment management. Although active management may be involved in either category, value investing, as mentioned above, must be an active strategy. Managers involved in active management require higher fees for those efforts. Yet, as value strategies have underperformed growth for the past 12 years, many investors are questioning the active management logic.

Why pay the high fees of active managers when passive management suffices at a cost of pennies on the dollar? But as Graham and Dodd defined it, passive strategies are not investing, they are speculating. As the graph below illustrates, the shift out of active management and into passive funds is stark.

Overlooking the historical benefits and outperformance of value managers, current investors seek to chase returns at the lowest cost. This behavior is reflective of a troubling lack of discipline and suggests that investors are complacent about the possibility of having their equity wealth cut in half as it was in two episodes since 2000.

Pure passive investing, investing in a mutual fund or exchange-traded fund (ETF) that mimics an index, represents a low-fee approach to speculation. It does not involve “thorough analysis,” the promise of “safety of principal,” or an “adequate return.” Capital received is immediately deployed and invested dollars are weighted most heavily toward the most expensive stocks. This approach represents the opposite of the “buy-low, sell-high” golden rule of investing.

Active management, on the other hand, involves analytical rigor by usually seasoned managers and investors seeking out opportunities in good companies in which to invest at the best price.

Definition of Terms

To properly emphasize the worth of value investing, it is important first to define a couple of key terms that many investors tend to take for granted.

Risk – Contrary to Wall Street marketing propaganda, risk is not a number calculated by a formula in a spreadsheet. Risk is simply the likelihood of a substantial and permanent loss of capital with no ability to ever recover. Exposure to risk cannot be mitigated by blind diversification. Real risk cannot be quantified by processing the standard deviation of historical returns or the sophisticated variations of Value-at-Risk. These calculations and the many assumptions within them lead to misperceptions and misplaced confidence.

Wealth – Wealth is savings. It is that which is left over after consumption and is the accumulation of savings over time. Wealth results from the compounding of earnings. Wealth is not the net value of assets minus liabilities. That is a balance sheet metric that can change dramatically and suddenly depending on economic circumstances. An investor who seeks to sell high and buy low, like a business owner who prudently waits for opportunities to buy out competitors when they are distressed, uniquely illustrates proper wealth management and are but two forms of value investors.

Economic Worldview

Understanding these terms is important because it affects one’s economic worldview and the ability to make prudent investment decisions consistently. As Dylan Grice of Edelweiss Holdings describes it:

“Language is the machinery with which we conceptualize the world around us. Devaluing language is tantamount to devaluing our ability to think and understand.” Grice continues, clarifying that point, “linguistic precision leads to cognitive precision.”

Value investors understand that compounding wealth depends on avoiding large losses. These terms and their proper definitions serve as a rock-solid foundation for sound reasoning and analytical rigor of market forces, central bank policies, and geopolitical dynamics that influence global liquidity, asset prices, and valuations. They enable critical foresight.

Proper definitional terms clarify the logical framework for an investor to benchmark their wealth, net of inflation, rather than obsessing with benchmarking returns to those of the S&P 500 or other passive indexes. Redefining one’s benchmark to inflation plus some excess return properly aligns target returns with life goals. Comparisons to the returns of the stock market are irrelevant to your goals and induce one to be dangerously urgent and speculative.

Value investing is having the courage to be opportunistic when others are pessimistic, to buy what others are selling, and to embrace volatility because it is in those times of upheaval that the greatest opportunities arise. That courage is derived from clarity of goals and a sturdy premise of assessing value. This is not an easy task in a world where the discounting mechanism itself has become so disfigured as to be rendered little more than a reckless guess.  

Properly executed, value investing seeks to find opportunities to deploy capital in such a way that reduces risk by acquiring assets at prices that are sufficiently below intrinsic value. This approach also extends to potential gains and creates a desirable performance asymmetry.

In the words of famed investor and former George Soros colleague, Jim Rogers, “If you buy value, you won’t lose much even if you’re wrong.” And let’s face it, everybody in this business is wrong far more than they’re right.

Summary

Analytically, safety, and profits are rooted in buying assets with abnormally large risk premiums and then having the patience to wait for mean reversion. It often requires the rather unconventional approach of identifying those areas where there is distress and misguided selling is occurring.

As briefly referenced above in the definition of wealth, a value investor manages money as a capitalist business owner would manage his company. A value investor is more interested in long-term survival. Their decisions are motivated by investing in companies that are doing those things that will add to the substance and durability of the enterprise. They are interested in companies that aim to enhance the cash flow of the operation and, ideally, do so with a very long time-preference and as a habitual pattern of behavior.

Unlike a business owner and an “investor,” most people who buy stocks think in terms of acquiring financial securities in hopes of selling them at a higher price. As a result, they make decisions primarily with a concern about what other investors’ expectations may be since that will determine tomorrow’s price. This is otherwise known as speculation, not investing, as properly defined by Graham and Dodd.

Although value investing strategies have underperformed relative to growth strategies for the past decade, the extent to which value has become cheap is reaching its limit.

We leave you with a question to ponder; why do you think Warren Buffet’s Berkshire Hathaway is sitting on $128 billion in cash?

Piper Jaffray forecasts by year end 2020, the S&P 500 (SPX) will hit 3600, a 12.8 % increase. Of eighteen analysts interviewed by Marketwatch only three forecasters expect a decline for the SPX. Will the SPX reach 3600?  The SPX has soared over 400 % from a low of 666 in 2009 to over 3200 at the close of 2019. Mapping the SPX ten year history onto a psychology market cycle map of growth and decline phases poses interesting questions. As the market has zoomed over 400% upwards over ten years, it is clearly in the Mania Phase. Yet, the US economy is growing at the slowest rate of any economic recovery since WWII at 2.2 % GDP per year, why the disconnect?

Source: Patrick Hill – 12-31-19

One reason for the disconnect is investment analysts and the media lead investors to believe there is no downside risk. On New Year’s Eve, Goldman Sachs released a prediction for 2020 claiming that the ‘tools of the Great Moderation’ (Fed policy shift) begun 30 years ago low-interest rates, low volatility, sustainable growth and muted inflation are still in place and were only interrupted by the 2008 financial crisis. Plus we would add the Dotcom crash. GS concluded that the economy ‘was nearly recession-proof.’

The mainstream financial media also feed the Mania Phase with stories like Goldman Sachs declaring the Great Moderation is working with our economy in a ‘new paradigm’. We are to believe there will not be a recession because our policymakers have the economy under control.  Really?  With over $17 trillion of negative debt worldwide to keep the world economy going, central banks have succeeded in sustaining worldwide GDP at 1 – 2 % and falling as of late! For the SPX market to not descend into the Blow Off phase, investors will need to continue to believe in six economic myths:

1. The Growth Phase of the Economic Cycle is Continuing
2. Consumers Will Bailout the Economy
3. The Fed Will Keep the Economy Humming
4. If the Fed Fails Then the Federal Government Will Provide Stimulus
5. The Trade War Won’t Hurt Global Growth
6. The Economy and Markets Are Insulated from World Politics

Let’s look at each myth that is likely to affect portfolio and market performance in the next year.  This analysis is based on research data of economic, social, government, business trends and observation of markets and the economy. If markets are to continue to climb, either policymakers must solve difficult issues or investors must continue to believe these myths are true. The first myth establishes a critical framework for viewing all economic activity. We are actually at the end of the growth phase of the economic cycle; here is why.

Myth 1. The Growth Phase of the Economic Cycle is Continuing

The Fed has reported that the economy is still in ‘mid-cycle’ phase.  We differ with this position as several indicators show the economy is reaching the end of its growth cycle and ready to revert to the mean. As GDP is driven 70 % by consumers, let’s look at what is really happening to consumers.  The ratio of current consumer conditions minus consumer expectations is at levels seen just before prior recessions not mid-stage growth economies.

Sources: The Conference Board, The Wall Street Journal, The Daily Shot – 6/14/19

In the chart below, consumers are stretched as loan default rates are rising despite a 50-year low unemployment rate. Rising delinquencies tend to signal rising unemployment and economic decline is likely in the near future.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 6/4/19

Of major concern is that the manufacturing sector is now in a recession based on five months of ISM reports below the 50 % economic expansion benchmark. The overall contraction is validated as 70 % of manufacturing sub-sectors are contracting as noted in the report below.  While the US economy is primarily driven by services, the manufacturing sector has a multiplier effect on productivity, support services, and employment with high paying jobs. Note the contraction in sub-sectors is reaching levels last seen before recessions.

            Sources Oxford Economics, The Wall Street Journal, The Daily Shot – 12-20-19

There are other indicators pointing to the end of the growth phase.  For example, the inversion of the 2 – 10 yield curve last summer is now steepening – often seen before an economic slowdown. Another indicator is the number of firms with negative earnings launching IPOs in 2019 was at levels not seen since 2000. Finally, productivity and capital investments are at ten year lows.

Myth 2.  Consumers Will Bailout the Economy

Market pundits have been quick to rely on the consumer to continue spending at growth sustaining rates.  Yet, budgets for the middle class are squeezed as consumers cope with student loan debt payments, new car payments, health care bills, and credit card debt.  The Bloomberg Personal Finance Index dropped significantly in October:

Source: Bloomberg, The Wall Street Journal, The Daily Shot – 11/10/19

Car loans now span seven years on average versus five years a few years ago. Further, the new loans ‘roll in’ debt from previous car purchases due to negative equity in the owner’s trade-in vehicle.  Vehicle price increases up to 10 % over the last year for both cars and trucks add to the debt burden.  Car debt is beginning to weigh on consumers as delinquencies are climbing:

Sources: NY Federal Reserve, The Wall Street Journal, The Daily Shot – 10/29/19

Today, credit card rates are running at a ten-year peak of 17 – 22 % have seen no relief despite the Fed cutting rates.  There is a record spread between the Federal Funds rate and credit card rates as banks seek new revenue sources beyond making loans. Many consumers are turning to credit cards to pay bills to sustain their lifestyle as their wages are not keeping up with rising living costs.

In addition, consumers are increasingly working at more than one job to be sure they can pay their bills.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19

Workers need to take on multiple jobs in the gig economy. McKinsey & Company estimates that 52 million people are gig workers or a third of the 156 million person workforce. Contractors have no job security.  Gig workers often receive hourly wages with no health, retirement or other benefits. The lack of benefits means they have limited or no financial safety net in the event of an economic slowdown.

There are other key indicators of consumer financial distress, for example, consumer spending on a quarter over quarter basis has continued to decline, Bankrate reports that 50 % of workers received no raise in the last year.  Real wages (taking into account inflation) for 80 % of all workers have been stagnant for the past twenty years.  Uncertain economic forces are putting consumers in a financial bind, for more details, please see our post: Will the Consumer Bailout the Economy?

Myth 3.  The Fed Will Keep the Economy Humming

The Fed has said it will do whatever necessary to keep the economy growing by keeping interest rates low and injecting liquidity into the financial system. However, a survey on Fed actions shows that 70 % of economists interviewed believe the Fed is running out of ammo to turnaround the economy.

Sources: The Wall Street Journal, The Daily Shot – 12-30-19

We agree with their perspective that the Fed is entering an economic space where no central bank has gone before.  In the past, the Fed lowered rates when an economic downturn was evident. Just prior to earlier recession’s interest rates were at a higher starting level of at least 4 – 5 %.  Plus, today the Fed has returned to pumping liquidity into the economy via its repo operation and QE as shown below.

Sources: The Federal Reserve of St. Louis, The Wall Street Journal, The Daily Shot – 12/30/19

The International Bureau of Settlements (BIS) disclosed in their analysis of recent Fed repo operations that funding supported not only banks but hedge funds. A key concern is the nature of the hedge fund bailout. How steep is the loss being mitigated? Is there a possibility of contagion? Is more than one hedge fund involved?  Should the Fed be bailing out hedge funds that are overextended due to speculation? The Fed is already using its tools at the height of the current economic growth cycle. The Fed financial tools are too stretched to turnaround an economy in a recession from multiple financial bubbles bursting.

The Fed continues to declare that inflation is at 2.1 %, missing the reality of what consumers are actually paying for goods and services.  We find from industry research that finds inflation is likely in the 6 – 10% range. Inflation should be defined as price increases of goods and services that consumers buy, not inflation defined by a formula to suit political needs. Using inflation lifestyle ‘cost of living’ data, which is not transparent or available for audit does not meet the foundational data needs of investors.  Gordon Haskett Research Advisors conducted a study by purchasing a basket of 76 typical items consumers frequently buy at Walmart and Target.  Their study showed that from June 2018 to June 2019, prices increased by about 5.5%. 

Other industry research supports inflation running at a much higher level than government figures. On a city by city basis, Chapwood has developed an index for 500 items in major metropolitan areas of the US.  Chapwood reports the average national inflation level to be about 10 %.  Note inflation is compounded; for example, in San Jose a five year average price increase of 13% is for each year. An item costing $1.00 would cost $1.13 the next year and then $1.28 the third year and so forth. It is likely workers caught in a squeeze between stagnant wages and 10 % inflation will not be able to continue to sustain present levels of economic growth.

Real inflation at 6 – 10 % has major policy, portfolio, and social implications.  For example, with the ten year Treasury Bond at 1.90% and inflation at 6 %, we are actually living in a ’de facto negative interest’ economy of – 4.10 %.  Higher inflation levels fit the financial reality of what workers, portfolio managers, and retirees are facing in managing their finances.  Many workers must take multiple jobs and develop a ‘side hustle’ to just keep up with inflation much less get ahead. For portfolio managers, they must grow their portfolio at much higher rates than was previously thought just to maintain portfolio value.  Finally, for retirees on a fixed income portfolio it is imperative they have additional growth income sources or part-time work to keep up with inflation eating away at their portfolio. For more details on our analysis of a variety of inflation, categories see our post: Is Inflation Really Under Control?

One additional assumption about Fed intervention repeated by many analysts is the Fed liquidity injections mean that corporate sales and profits will bounce back.  For some financially sensitive industries this argument may be true. For other firms with excellent credit ratings, they may be able to obtain low-interest loans to ride out falling sales. But, the reality is that corporations build and sell products based on demand. If demand falls, low-interest loans will not increase sales.  Only new products, new channels, reduced pricing, marketing and other initiatives will revive sales.

Myth 4.  If the Fed Fails Then the Federal Government Will Provide Stimulus

European Central Bank leaders have called on European governments to provide economic stimulus for their markets.  Picking up on this idea, analysts have proposed the US government move on infrastructure and other spending programs. However, tax cuts, low-interest rates, stock buybacks, and record corporate debt offerings have shifted a huge balance of world-wide wealth to the private sector.  For 40 years, there has been a significant increase in private capital worldwide while public wealth has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al. – 2018

Essentially, central banks, Wall Street, and governments have built monetary and economic systems that have increased private wealth at the expense of public wealth.  The lack of public capital makes the creation of major levels of public goods and services nearly impossible. The US government is now running $1 trillion yearly deficits with public debt at record levels not seen since WWII and total debt to GDP at all-time highs. The development of public goods and services like basic research and development, education, infrastructure, and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions.  Congress may pass an ‘infrastructure’ bill in 2020 but given the election, it is likely to be lightly funded to pass both houses of Congress and receive the president’s signature.

Myth 5.  The Trade War Won’t Hurt Global Growth

By closing the Phase One trade deal, the market has been sighing with relief with observers declaring that trade will resume a growth track.  Yet, the Phase One deal is not a long term fix. If anything, the actions on the part of both governments have been to dig in for the long term.  The Chinese government has taken several key actions in parallel to the deal to move their agenda ahead.

China has quietly raised the exchange rate of their currency to offset some of the impact of still in place tariffs on the U.S. economy.  The government made a major move to block US and foreign companies from providing key technical infrastructure. The technology ministry has told government agencies that all IT hardware and software from foreign firms are to be replaced by Chinese systems within three years. If the Chinese government decides to establish ‘China only’ network standards it may be difficult for US firms to even work with state-sponsored companies or private businesses that must meet China’s only standards. Apple and Microsoft would have to build two versions of their products. One version for the Chinese economy and one for the world.  A critical change is taking place in world trade which is the establishment of a two-block trading world.  China is a key growth market at a 20 % – 30 % increase in sales annually for US multinational companies. For these corporations navigating the trade war will be problematic even with the Phase One agreement.  Our post characterizing this major change in world trade can be found at: Navigating a Two Block Trading World.  

The U.S. has placed sanctions on Chinese sponsored network provider Huawei, effectively limiting the network vendor from US government and private networks.  The Phase One agreement includes the US canceling planned tariffs for December 15^th in 2019 and rolling back tariffs to 7.5 % on $120 billion of goods imposed on September 1^st of last year. Yet, tariffs of 25 % remain in place on $250 billion of Chinese goods.  The Chinese have canceled retaliatory tariffs planned for December 15^th and plan to increase purchases of US goods and services by $200 billion over two years. In addition, China will purchase US agriculture products at a $40 billion rate per year from a baseline of $24 billion in 2017.  If the Chinese follow through on their purchase commitments US companies should see increased sales.  However, history on Chinese purchases shows they forecast large purchases but small purchases are made.

A major trade issue has been created when the US decided not to appoint any new judges to the World Trade Organization court for disputes. The court cannot hear or make decisions on any disputes any longer; meaning countries will resort to free-for-all negotiations on trade disputes.  We expect as economies falter, nationalist policies on trade will gain more popularity and world trade will continue to decline after a slight blip up from the U.S.-China Phase One deal.

Sources: BCOT Research, The Wall Street Journal, The Daily Shot – 12/16/19

Finally, prior to the trade war global trade has been facing major headwinds. Since 2008, global firms have looked to open more international markets to sell their goods, but have met sales resistance causing revenue and profits to be flat or decline.  We expect the flattening of global sales to output to continue and eventually decline as overall world trade falls.

CEOs in a Conference Board survey rate trade as a major concern as they look at a highly uncertain economic picture.  Marc Benioff, CEO of Salesforce, described his concerns at a company all hands meeting last November:

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

Myth 6. The Economy and Markets Are Insulated from World Politics

Protests have broken out in Hong Kong, Iraq, Iran, Chile, and other world cities while stock markets continue their climb.  Yet, when the U.S. killed a key Iranian general the overnight S &P futures market fell 41 pts before recovering and closing 23 pts lower. The VIX soared 22 % overnight before settling back to close for a 12 % increase at 14.02.  The U.S. – Iran conflict does not seem to be under control with most Middle East analysts predicting a major retaliation by the Iranian government. The price of oil spiked 4 % before settling to a 3.57 % increase on fears the Iranians may attack oil tankers in the Gulf.  An escalating conflict will drive oil prices higher, disturb supply chains and likely tip the world economy into a recession.

We saw during the negotiations for the Phase One trade deal how rumors both in China and the U.S. would send the S & P futures market up or down by 10 – 15 points depending upon whether the news was positive or negative. Algo traders would drop 30k contracts in a matter of seconds to make huge moves in SPX price, while the VIX was at 12.50, supposedly a calm market. The chart below shows how positive and negative news whipsawed the market.

Source: Liz Ann Sonders – Schwab – 12-7-19

Political news not only moves markets but the economy as well.  When the president tweets a tariff threat, consumers and industry move swiftly to buy those goods before their prices go up.  Businesses have to build the product quickly, sell it and they are left with falling sales as future purchases are pulled forward.  Business to business deals are caught up in this constant flip flop on trade policies as well. CEOs must make investment decisions to build a plant in a particular country 1 – 3 years in advance. They must calculate their allocation plans based on inadequate information and in a highly uncertain policy environment.  Often, rather than make an investment decision, executives will wait for the economic clouds to clear.

Summary:

The current bull market run has set record highs continuously.  Yet, as the saying goes: markets go up in stair steps and down in an elevator.  As a selling panic sets in the market goes into a free fall. If an economic myth is revealed by market action, corporate results, economic reports or an event the loss of belief causes the market to fall much faster than a slow stair step up.

The prudent investor will recognize the end of the business cycle is likely underway. It is time to prepare for an economic slowdown and a resulting equity market reversion to the mean. A reversion to the mean quite often requires that markets swing beyond the mean.

The wary investor will ask hard questions of their financial advisor and review corporate reports with an eye on fundamentals. Financial success is likely to result from good risk management and implementation combined with agility to make mid-course corrections.  Investors should test their assumptions based on breaking trends that may impact portfolio performance.  At the same time, constantly flipping investments will lead to poor performance. Allocate funds to different portfolio groups based on long, medium and short term goals to keep from being emotionally swept up in temporary market swings. The key is to be prepared for the unknown, or a black swan event.  Expect the unexpected and consider the advice of market legends like Bernard Baruch:

“Some people boast of selling at the top of the market and buying at the bottom – I don’t believe this can be done. I had bought when things seemed low enough and sold when they seemed high enough. In that way, I have managed to avoid being swept along to those wild extremes of market fluctuations which prove so disastrous.”

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

In September of last year, something still unexplained happened in the “repo” short-term financing market. Liquidity dried up, interest rates spiked, and the Fed stepped in to save the day.

Story over? No. The Fed has had to keep saving the day, every day, since then.

We Hear Different Theories

The most frightening one is that the repo market itself is actually fine, but a bank is wobbly and the billions in daily liquidity are preventing its collapse.

Who might it be? I have been told, by well-connected sources, that it could be a mid-sized Japanese bank. I was dubious because it would be hard to keep such a thing hidden for months.

But then this week, Bloomberg reported some Japanese banks, badly hurt by the BOJ’s negative rate policy, have turned to riskier debt to survive. So, perhaps it’s fair to wonder.

Whatever the cause, the situation doesn’t seem to be improving.

Something Wicked Is Going On

On Dec. 12 a New York Fed statement said its trading desk would increase its repo operations around year end “to ensure that the supply of reserves remains ample and to mitigate the risk of money market pressures.”

Notice at the link how the NY Fed describes its plans. The desk will offer “at least” $150 billion here and “at least” $75 billion there. That’s not how debt normally works.

Lenders give borrowers a credit limit, not a credit guarantee plus an implied promise of more. The US doesn’t (yet) have negative rates, but the Fed is giving banks negative credit limits. In a very precise violation of Bagehot’s Dictum.

We have also just finished a decade of the loosest monetary policy in American history, the partial tightening cycle notwithstanding. Something is very wrong if banks still don’t have enough reserves to keep markets liquid.

Part of it may be that regulations outside the Fed’s control prevent banks from using their reserves as needed. But that doesn’t explain why it suddenly became a problem in September, necessitating radical action that continues today.

Here’s the official line, from the  minutes of the unscheduled Oct. 4 meeting at which the FOMC approved the operation.

Staff analysis and market commentary suggested that many factors contributed to the funding stresses that emerged in mid-September. In particular, financial institutions’ internal risk limits and balance sheet costs may have slowed the distribution of liquidity across the system at a time when reserves had dropped sharply and Treasury issuance was elevated.

So the Fed blames “internal risk limits and balance sheet costs” at banks. What are these risks and costs it was unwilling to accept, and why?

We still don’t know. There are lots of theories. Some even make sense.

QE4 Has Begun

Whatever the reason, it was severe enough to make the committee agree to both repo operations and the purchase of $20 billion a month in Treasury securities and another $20 billion in agencies.

It insists the latter isn’t QE, but it sure walks and quacks like a QE duck. So, I and many others call it QE4.

As we learned with previous QE rounds, exiting is hard. Remember that 2013 “Taper Tantrum?” Ben Bernanke’s mild hint that asset purchases might not continue forever infuriated a liquidity-addicted Wall Street.

The Fed needed a couple more years to start draining the pool and then did so in the stupidest possible way by both raising rates and selling assets at the same time.

Having said that, I have to note the Fed has few good choices. As mistakes compound over time, it must pick the least-bad alternative. But with each such decision, the future options grow even worse. So eventually instead of picking the least-bad, they will have to pick the least-disastrous one. That point is drawing closer.

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The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

There is a common theme running through most of the sectors currently which is that they are trading more than 2-standard deviations of the 200-dma. I have added a blue shaded area to each graph which represents this band of deviation from the green line which is the 200-dma. Deviations of this extreme tend not to last long.

Basic Materials

• XLB tested and failed at all-time highs. While support exists at the previous breakout level of $59, XLB remains at the top of its deviation range and is on an extended “buy” signal currently.
• The sector is working off its previously extreme overbought condition, so a setup to add to our current position is coming. It will be important that XLB doesn’t violate our stop-loss during this corrective process.
• We currently hold 1/2 position and are looking to add the second 1/2 during this corrective process. We will update this analysis when we add to our holdings.
• Short-Term Positioning: Neutral
  • Last Week: Hold current positions with a tighter stop-loss.
  • This Week: Hold current positions with a tighter stop-loss.
  • Stop-loss moved back to $57 to allow for entry.
• Long-Term Positioning: Neutral

Communications

• XLC finally broke out to new highs and is now more than 2-standard deviations above the 200-dma.
• With a “buy signal” in place, there is little for us to do currently but wait, a correction is coming, but it will be critical for XLC to hold support at $50.
• If you need to add a position, wait for a pull back to test the recent breakout support level and add there.
• XLC is currently a full-weight in portfolios.
• Short-Term Positioning: Bullish
  • Last Week: Hold trading positions
  • This Week: Hold trading positions.
  • Stop adjusted to $50
• Long-Term Positioning: Neutral

Energy

• Unlike most other sectors of the market, XLE is not extremely extended.
• XLE finally broke above the 200-dma but is currently wrestling with previous support, now resistance, and is extremely overbought. The buy signal is also getting extended.
• As noted previously, we added 1/2 position of AMLP to our portfolios. On any weakness which does not violate the 200-dma we will add 1/2 position of XLE to the portfolio. The reason we are cautious is that these rallies have repeatedly failed in the past.
• Short-Term Positioning: Bearish
  • Last week: Added 1/2 AMLP to Portfolios
  • This week: Looking to add 1/2 XLE – patience.
  • No position currently
• Long-Term Positioning: Bearish

Financials

• XLF is extremely extended above the 200-dma which puts the sector at risk of a more severe correction.
• The buy signal is also extremely extended which suggests that you should be taking profits and reducing risk if you are long the sector.
• We will look to add XLF to our portfolio on a pullback that doesn’t violate long-term support or break the current bullish trend.
• Short-Term Positioning: Bullish
  • Last week: Hold Positions
  • This week: Hold Positions
  • Stop-loss adjusted to $28
• Long-Term Positioning: Neutral

Industrials

• XLI also is pushing well above the 200-dma with such previous extensions having led to fairly sharp corrections.
• With XLI exceedingly overbought short-term, and on a very extended buy signal, be cautious chasing the sector currently.
• We are looking for a bit of consolidation and/or pullback to work off some of the extreme overbought condition before increasing our weighting.
• We have adjusted our stop-loss for the remaining position. We are looking to add back to our holdings on a reversal to a buy signal.
• Short-Term Positioning: Neutral
  • Last week: Hold 1/2 position
  • This week: Hold 1/2 position.
  • Stop-loss adjusted to $77
• Long-Term Positioning: Neutral

Technology

• XLK is extremely overbought on both a price and momentum basis like most other sectors of the market.
• We are currently target weight on Technology, but may increase exposure on a pullback to support within the overall uptrend. (A retest of the breakout that holds)
• Be careful chasing the sector currently. Take profits and rebalance risks accordingly.
• Short-Term Positioning: Bullish
  • Last week: Hold position
  • This week: Hold position
  • Stop-loss adjusted to $80
  • Long-Term Positioning: Neutral

Staples

• Defensive sectors have started to perform better as money is just chasing “everything” now.
• XLP continues to hold its very strong uptrend as has now broken out to new highs. However, XLP is back to more extreme overbought and extended above the 200-dma.
• Importantly, a “buy signal” has been registered. Look for pullbacks to support to add weight to portfolios. Maintain a stop at the 200-dma.
• We previously took profits in XLP and reduced our weighting from overweight.
• Short-Term Positioning: Bullish
  • Last week: Hold positions, take profits if needed.
  • This week: Hold positions, take profits if needed.
  • Stop-loss adjusted to $59
  • Long-Term Positioning: Bullish

Real Estate

• XLRE has been consolidating its advance within a very tight pattern but is holding support at previous support levels and the uptrend line.
• We had previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected which has now been completed.
• XLRE is now on a VERY deep “sell signal” and is very oversold. Both of those conditions are showing signs of reversing.
• With support holding, trading positions can be added to portfolios. We are fully weighted the sector currently so there isn’t any change required in our portfolios at this time.
• Short-Term Positioning: Bullish
  • Last week: Hold position.
  • This week: Hold position.
  • Stop-loss adjusted to $35.00 for profits.
• Long-Term Positioning: Bullish

Utilities

• XLU continues to maintain its bullish trend and recently rallied to test previous highs.
• If the “sell signal” is reversed, this will be very bullish for XLU, and should suggest a decline in interest rates is simultaneously occurring.
• We noted previously that after taking profits, we had time to be patient and wait for the right setup. That opportunity came last week, so if you added exposure, hold for now with a stop at $61. If you need to add exposure to Utilities, you can still do so with a tight stop.
• The long-term trend line remains intact but XLU and the sell signal are beginning to reverse.
• We are currently at full weight, so no change is required currently.
• Short-Term Positioning: Bullish
  • Last week: Hold position.
  • This week: Hold current position / Add trading positions if needed
  • Stop-loss adjusted to support at $59.00, $61 for new positions.
• Long-Term Positioning: Bullish

Health Care

• XLV has remained intact and is now more extended than we have seen it in quite some time.
• XLV is extremely overbought which will give way sooner than later. Take profits and rebalance holdings. The “buy signal” is also at record levels of extension. This will reverse, be cautious.
• The move in Healthcare has been parabolic, and the sector is too extended to add positions currently. We took profits last week and reduced our overweight to target portfolio weight for now.
• Short-Term Positioning: Neutral
  • Last week: Hold position.
  • This week: Took profits – reduced overweight to target weight.
  • Stop-loss adjusted to $94
• Long-Term Positioning: Bullish

Discretionary

• We added to our holdings previously to participate with the current rally, but XLY is now pushing an extreme extension above the 200-dma.
• The good news is that XLY finally broke above overhead resistance and triggered a “buy signal” as we expected previously. This is bullish for the sector.
• Hold current positions for now, but take profits and rebalance risks accordingly. New positions can be added on a pullback to the breakout level that holds and works off the overbought condition.
• Short-Term Positioning: Neutral
  • Last week: Hold position
  • This week: Hold position
  • Stop-loss adjusted to $120.
• Long-Term Positioning: Neutral

Transportation

• XTN has broken out of consolidation but quickly ran into resistance at the 2-standard deviation level above the 200-dma.
• If XTN breaks can continue to consolidate above the the breakout level and work off the overbought condition and extended buy signal, which it is doing now, positions can be added.
• Be patient, XTN has a good bit of work to do to prove its position in portfolios.
• Short-Term Positioning: Neutral
  • Last week: No position
  • This week: No position
• Long-Term Positioning: Bearish

You would think that with the U.S. taking out a top Iranian commander, threats of military action flying between the U.S. and Iran, not to mention the “Selective Service” website crashing over concerns of World War III, the markets would be in full “sell” mode.

Surreal headline pic.twitter.com/lyItw6vD3n

— Hipster (@Hipster_Trader) January 4, 2020

Due to the spread of misinformation, our website is experiencing high traffic volumes at this time. If you are attempting to register or verify registration, please check back later today as we are working to resolve this issue. We appreciate your patience.

— Selective Service (@SSS_gov) January 3, 2020

If you thought that would be the case, you were wrong.

Here is the market from the beginning of the year through yesterday’s close.

The dismissal by the market of the situation with Iran suggests only a couple of things:

1. The market sees no inherent risk from Iran other than a lot of “saber rattling,” or
2. Given the Federal Reserve’s recent transition to a “do anything” monetary policy stance, all “risks” are being dismissed under the assumption the Fed has become a “cure all” for any market ill.

Since this is a technical post on the financial markets and investing, I won’t get into all the risks inherent from a conflict with Iran. However, if we assume there are indeed “risks” with Iran, then it becomes apparent the market is betting on the Fed.

As I noted in this past weekend’s missive, the Fed has been dumping massive amounts of liquidity into the system over the last few weeks. To wit:

“But concerns over potential Iranian conflict quickly abated as the markets returned their focus to the Federal Reserve, and the continued pump of monetary liquidity into the markets. 

Currently, we are told there is ‘nothing to worry about’ concerning the financial system. Maybe, but the amount of liquidity being injected dwarfs all previous injections by massive proportions.

Those injections continue to run unabated currently, which has lulled the markets into a more extreme state of complacency. This can see in the low reading of bearish investors and the suppressed levels of the put/call ratio. Both suggest there is “no fear” of a market correction currently. (h/t Soberlook)

Here is the investor conundrum.

With the market currently on registering of the monthly buy signals, which confirmed the bull market in the S&P 500 had resumed following the 2018 Fed/Trade induced sell-off, there is also the risk of a short-term correction. Previously, when the market was this extended, deviated from longer-term means, and excessively bullish, a correction has always occurred. The problem for investors is maintaining patience in the process.

The chart below shows the issues. When the market becomes more than 2-standard deviations above the 200-WEEK (4-year) moving average, you have gotten a correction, or a deeper mean-reverting event. However, since this a weekly chart, those corrective processes can take some time to occur. This lures investors into thinking “this time is different,” just before an event has tended to reduce their investment capital

Optimistically Cautious Short-Term

In the short-term, our outlook remains optimistically cautious due to the aforementioned ongoing liquidity injections from the Federal Reserve. As we noted to our RIAPro Subscribers yesterday (Try Free For 30-Days):

“The markets remain positively biased but have gotten overly extended in the short-term. We suggest remain long current holdings, but take profits and rebalance risks in positions accordingly. We will likely have a much better entry point in the next couple of months to ‘buy’ into.”

While we remain optimistic on stocks over the next couple of months, as we are in the “seasonally strong period” of the year, there are several risks which need monitoring closely.

The most obvious risk is a reversal of the Fed’s monetary policy. Currently, the Fed’s balance sheet has almost entirely reversed last year’s decline. Subsequently, changes in the S&P 500 have closely tracked weekly changes to the Fed’s balance sheet. As noted last week:

Of course, it should be expected that if the Fed reverses those flows, then equities will likely follow suit.

Secondly, ultimately, will be valuations.

Yes, I know that “valuations” do not seem to matter currently, however, it is important to realize they will eventually matter, and they will matter a lot.

Currently, the S&P 500 trading roughly 20x current reported earnings estimates of $161.87 per share for the end of 2020, based on data from S&P Dow Jones. Going back to the year 1988, on average, the S&P 500 trades for around 16x times trailing earnings estimates. But it isn’t just P/E ratios which are rich. As we discussed yesterday, multiple measures of the markets are trading at levels which have denoted much lower rates of returns going forward.

What this suggests is that for equities to see a continued, and significant, advance in 2020, it will require investors to continue paying higher prices for equity ownership. While this may seem to make sense in a “low-interest rate” world, historically overpaying for earnings growth has often turned out poorly.

In other words, what investors are betting on is that earnings will catch up with price. However, currently, there is no evidence such will be the case as earnings have been repeatedly ratcheted lower since April 2019.

As shown in the chart below, earnings for the entire 2020 period started at $174.29/share. At that time, the beginning of April, the S&P 500 was trading at 2892. While the forward P/E seemed reasonable at 16.5x earnings, which was roughly equal to the long-term average, this assumed earnings estimates were correct. However, with the S&P 500 trading, as of yesterday’s close, at 3246, estimates for 2020 have fallen to just $161.87. That $12 decline in estimates, combined with a 354 point (an 11.8% advance) in the market, brings that forward P/E multiple to a rather expensive 20.05x reported earnings.

Of course, the risk to investors is that earnings growth fails to recover as we head further into 2020. Currently, there is evidence from the manufacturing, employment and wage data which suggests such could indeed be the case.

The Path Ahead

What is clear is that the path ahead for stocks is much less certain than a year ago when we were coming off deeply depressed sentiment levels, and the Fed was rapidly reversing monetary policy from “tightening” to “easing.”  With equities now 30% higher than they were then, the Fed mostly on hold in terms of rate cuts, and “repo” operations slated to end in the next couple of months, it certainly seems that expectations for substantially higher market values may be a bit optimistic.

Furthermore, as noted, if signs of economic improvement don’t start to lift expectations for earnings growth into the last half of the year, it could prove problematic given current valuations.

However, if the economy does show improvement, it could result in yields rising on the long-end of the curve, which could also make stocks less attractive. This would effectively keep a lid on just how much risk some investors will be willing to take, and the price they are willing to pay.

One thing is for certain, the sharp rise in stocks in 2019 has left prices at levels that already seem expensive on numerous measures. As such it will required investors to take on increasing levels of risk if prices are going to push higher this year. While this is certainly not an improbability given the current levels of complacency and optimism, it is just worth noting that outcomes of such endeavors have always been poor.

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

“The market has a habit of sucking investors in to inflict the most pain possible.”

Just make sure you aren’t one of them.

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

1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.

2. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move.This could be disastrous if the market reverses sharply in the short term. Again, move slowly.

3. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and 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.

5. Move “stop loss” levels up to current breakout levels for each position. Managing a portfolio without “stop loss” levels is like driving with your eyes closed.
6. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.

7. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

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

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

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

• Despite the market not making much headway last week, the S&P is currently more than 2-standard deviations above the 200-dma (shaded blue area). You are going to see this extreme extension in several charts below.
• The “buy signal” (lower panel) is back to levels of extensions normally only seen with short-term tops and corrective actions, particularly when combined with extreme extensions and deviations from long-term means.
• Take profits and rebalance risks in positions accordingly. We will likely have a much better entry point in the next couple of months to buy into.
• Short-Term Positioning: Neutral Due To Extension
  • Last Week: Hold position
  • This Week: Take profits and rebalance to target weights.
  • Stop-loss moved up to $300
  • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

• So goes the S&P 500, so goes the DIA especially when MSFT & AAPL are the two top holdings and drivers of the advance in both markets.
• The “buy” signal is extremely extended along with a very overbought condition.
• Hold current positions, but as with SPY, wait for a correction before adding further exposure.
• Short-Term Positioning: Neutral due to extensions
  • Last Week: Hold current positions
  • This Week: Hold current positions.
  • Stop-loss moved up to $275
• Long-Term Positioning: Neutral

Nasdaq Composite

• Like SPY, the technology heavy Nasdaq has broken out to new highs but is pushing very extended levels. As noted with SPY above, the QQQ is more than 2-standard deviations above the 200-dma. This will likely not last long.
• The Nasdaq “buy signal” is also back to extremely overbought levels so look for a consolidation or correction to add exposure.
• The liquidity from the Fed has pushed markets to more dangerous levels. Be careful
• Short-Term Positioning: Neutral due to extensions.
  • Last Week: Hold position
  • This Week: Hold position
  • Stop-loss moved up to $195
• Long-Term Positioning: Neutral due to valuations

S&P 600 Index (Small-Cap)

• As noted above, small-caps have also pushed above 2-standard deviations of the 200-dma.
• With the buy signal also extremely extended, and the index overbought, like all the other markets, a correction will provide a better entry point to add to our positions.
• Short-Term Positioning: Neutral due to extensions.
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop loss moved up to $69
• Long-Term Positioning: Neutral

S&P 400 Index (Mid-Cap)

• Like SLY, MDY is also extremely extended and deviated above the 200-dma.
• MDY’s “buy” signal is also extremely extended, as well being very overbought, which is a prime setup for a correction. Hold off adding exposure until we see a better entry point.
• Short-Term Positioning: Neutral due to extensions.
  • Last Week: No holding
  • This Week: No holding
• Long-Term Positioning: Bullish

Emerging Markets

• EEM continues to underperform but did finally breakout above resistance. The next target will be the old highs.
• However, with the “buy signal” extremely extended, the set up to add exposure is not present. Be patient for a correction that does not violate our stop.
• The Dollar (Last chart) is the key to our international positioning. The dollar looks to have confirmed a break lower which should support our thesis of adding back international exposure.
• Short-Term Positioning: Neutral
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop-loss set at $43
• Long-Term Positioning: Neutral

International Markets

• Like EEM, EFA rallied out of its consolidation channel and broke out.
• But, like EEM, the market is both EXTREMELY overbought and extended. Also, EFA is testing old highs which will likely provide short-term resistance.
• As with EEM, the key to our positioning is the US Dollar.
• Short-Term Positioning: Neutral
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop-loss set at $67
• Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

• Oil finally broke above the downtrend resistance line from the 2018 highs, which is bullish. With Iran kicking up and a weaker dollar prospect, our recent oil adds, and desire to add more, seem to be the right call for now.
• The short-term buy signal for oil is a bit extended and with oil testing the Fibonacci retracement level, we might see oil struggle in the next week or so. In the short-term it will be what happens in Iran that drives speculators, longer-term it will be the dollar.
• Add positions on weakness that doesn’t violate the 200-dma
• Short-Term Positioning: Neutral
  • Last Week: Hold positions.
  • This Week: Hold positions
  • Stop-loss for any existing positions is $58.
• Long-Term Positioning: Bearish

Gold

• Gold found its mojo last week, as Iran sparked fear in the markets.
• With gold now testing old highs, our positioning looks good particularly given that gold remains on a sell-signal currently. A reversal of the signal could suggest further highs to come.
• We used the recent weakness to add to our GDX and IAU positions taking them back to full weightings.
• Short-Term Positioning: Neutral
  • Last week: Hold positions.
  • This week: Hold positions
  • Stop-loss for whole position adjusted to $137
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

• Bond prices rallied last week, but failed at the downtrend resistance keeping bonds in a bearish channel for now, suggesting higher yields are still likely short-term.
• I suspect we are going to get some economic turmoil sooner, rather than later, which will lead to a correction in the equity markets and an uptick in bond prices.
• Use lower bounds of the downtrend, and the 200-dma, to add to holdings currently.
• Short-Term Positioning: Bullish
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop-loss is moved up to $132
• Long-Term Positioning: Bullish

U.S. Dollar

• Last week, we noted the dollar broke down below both the 200-dma and the bullish trend line. It then retested, and failed, at that previous support level which confirms a breakdown in the dollar from its previous bullish channel.
• This is an important development, as noted above, which supports our thesis on adding commodities, gold, energy, and international holdings to our portfolios.
• However, while we are picking around the edges, it may be too early for a sharper dollar decline currently, as the U.S. economy is still the “cleanest shirt in the dirty laundry.” We will wait and watch closely.
• The “sell” signal remains intact currently suggesting the sell-off could have some room to go.

Jani Ziedins via Cracked Market recently penned an interesting post:

“As for what comes next, is this bull market tired? Is a crash long overdue? Not if you look at history. Stocks rallied for nearly 20 years between the early 1980s and the late 1990s. By that measure, we could easily see another decade of strong gains before the next “Big One”. Of course, the worst day in stock market history happened during that 20-year bull market in 1987, so we cannot be complacent. But the prognosis for the next 10 years is still good even if we run into a few 20% corrections along the way.”

After a decade of strong, liquidity-driven, post-crisis returns in the financial markets, investors are hopeful the next decade will deliver the same, or better. As Bob Farrell once quipped:

“Bull markets are more fun than bear markets.” 

However, from an investment standpoint, the real question is:

“Can the next decade deliver above average returns, or not?”

Lower Returns Ahead?

Brian Livingston, via MarketWatch, previously wrote an article on the subject of valuation measures and forward returns.

“Stephen Jones, a financial and economic analyst who works in New York City, tracks the formulas that several market wizards have disclosed. He recently updated his numbers through Dec. 31, 2018, and shared them with me. Buffett, Shiller, and the other boldface names had nothing to do with Jones’s calculations. He crunched the financial celebrities’ formulas himself, based on their public statements.”

“The graph above doesn’t show the S&P 500’s price levels. Instead, it reveals how well the projection methods estimated the market’s 10-year rate of return in the past. The round markers on the right are the forecasts for the 10 years that lie ahead of us. All of the numbers for the S&P 500 include dividends but exclude the consumer-price index’s inflationary effect on stock prices.”

• Shiller’s P/E10 predicts a +2.6% annualized real total return.
• Buffett’s MV/GDP says -2.0%.
• Tobin’s “q” ratio indicates -0.5%.
• Jones’s Composite says -4.1%.

(Jones uses Buffett’s formula but adjusts for demographic changes.) 

Here is the important point:

“The predictions might seem far apart, but they aren’t. The forecasts are all much lower than the S&P 500’s annualized real total return of about 6% from 1964 through 2018.”

While these are not guarantees, and should never be used to try and “time the market,” they are historically strong predictors of future returns.

As Jones notes:

“The market’s return over the past 10 years,” Jones explains, “has outperformed all major forecasts from 10 years prior by more than any other 10-year period.”

Of course, as noted above, this is due to the unprecedented stimulation the Federal Reserve pumped into the financial markets. Regardless, markets have a strong tendency to revert to their average performance over time, which is not nearly as much fun as it sounds.

The late Jack Bogle, founder of Vanguard, also noted some concern from high valuations:

“The valuations of stocks are, by my standards, rather high, butmy 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 includes “all of the bad stuff.” 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, versus current real valuations which are pushing nearly 30x earnings.

“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.” – Jack Bogle

These views are vastly different than the optimistic views currently being bantered about for the next decade.

However, this is where an important distinction needs to be made.

Starting Valuations Matter Most

What Jani Ziedins missed in his observation was the starting level of valuations which preceded those 20-year “secular bull markets.”  This was a point I made previously:

“The chart below shows the history of secular bull market periods going back to 1871 using data from Dr. Robert Shiller. One thing you will notice is that secular bull markets tend to begin with CAPE 10 valuations around 10x earnings or even less. They tend to end around 23-25x earnings or greater. (Over the long-term valuations do matter.)”

The two previous 20-year secular bull markets begin with valuations in single digits. At the end of the first decade of those secular advances, valuations were still trading below 20x.

The 1920-1929 secular advance most closely mimics the current 2010 cycle. While valuations started below 5x earnings in 1919, they eclipsed 30x earnings ten-years later in 1929. The rest, as they say, is history. Or rather, maybe “past is prologue” is more fitting.

Low Returns Mean High Volatility

When low future rates of return are discussed, it is not meant that each year will be low, but rather the return for the entire period will be low. The chart below shows 10-year rolling REAL, inflation-adjusted, returns in the markets. (Note: Spikes in 10-year returns, which occurred because the 50% decline in 2008 dropped out of the equation, has previously denoted peaks in forward annual returns.)

(Important note: Many advisers/analysts often pen that the market has never had a 10 or 20-year negative return. That is only on a nominal basis and should be disregarded as inflation must be included in the debate.)

There are two important points to take away from the data.

1. There are several periods throughout history where market returns were not only low, but negative.(Given that most people only have 20-30 functional years to save for retirement, a 20-year low return period can devastate those plans.)
2. Periods of low returns follow periods of excessive market valuations and encompass the majority of negative return years. (Read more about this chart here)

“Importantly, it is worth noting that negative returns tend to cluster during periods of declining valuations. These ‘clusters’ of negative returns are what define ‘secular bear markets.’” 

While valuations 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 and should never be used in any investment strategy which has such a focus. However, in the longer term, valuations are strong predictors of expected returns.

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, without question, expensive. 

Furthermore, note that forward 10-year returns do NOT improve from historically expensive valuations, but decline rather sharply.

Warren Buffett’s favorite valuation measure is also screaming valuation concerns (which may explain why he is sitting on $128 billion in cash.). 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. 

Again, with this indicator at the highest valuation level in history, it is a bit presumptuous to assume that forward returns will continue to remain elevated,.

Bull Now, Pay Later

In the short-term, the bull market continues as the flood of liquidity, and accommodative actions, from global Central Banks, has lulled investors into a state of complacency rarely seen historically. As Richard Thaler, the famous University of Chicago professor who won the Nobel Prize in economics stated:

“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.”

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 125% since 2007 peak, which is roughly 3x the growth in corporate sales and 5x more than GDP.

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 another decade of a continued bull market is very enticing as the “fear of missing out” overrides the “fear of loss.”

Let me conclude with this quote from Vitaliy Katsenelson which sums up our investing view:

“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.”

For long-term investors, the reality that a clearly overpriced market will eventually mean revert should be a clear warning sign. Given the exceptionally high probability the next decade will be disappointing, gambling your financial future on a 100% stock portfolio is likely not advisable.