Since the post-financial crisis era began more than a decade ago, record low-interest rates and the Fed’s acquisition of $4 trillion of the highest quality fixed-income assets has led investors to scratch and claw for any asset, regardless of quality, offering returns above the rate of inflation. 

Financial media articles and Wall Street research discussing this dynamic are a dime-a-dozen. What we have not heard a peep about, however, are the inherent risks within the corporate bond market that have blossomed due to the way many corporate debt investors are managed and their somewhat unique strategies, objectives, and legal guidelines. 

This article offers insight and another justification for moving up in credit within the corporate bond market. For our prior recommendation to sell junk debt based on yields, spreads, and the economic cycle, we suggest reading our subscriber-only article Time To Recycle Your Junk. If you would like access to that article and many others, you can sign up for RIA Pro and enjoy all the site has to offer with a 30-day free trial period. 

Investor Restraints

By and large, equity investors do not have guidelines regulating whether or not they can buy companies based on the strength or weakness of their balance sheets and income statements. Corporate bond investors, on the other hand, are typically handcuffed with legal and/or self-imposed limits based on credit quality. For instance, most bond funds and ETFs are classified and regulated accordingly by the SEC as investment grade (rated BBB- or higher) or as high yield (rated BB+ or lower). Most other institutions, including endowments and pension funds, are limited by bylaws and other self-imposed mandates. The large majority of corporate bond investors solely traffic in investment grade, however, there is a contingency of high-yield investors such as certain mutual funds, ETFs (HYG/JNK), and other specialty funds.

Often overlooked, the bifurcation of investor limits and objectives makes an analysis of the corporate bond market different than that of the equity markets. The differences can be especially interesting if a large number of securities traverse the well-defined BBB-/BB+ “Maginot” line, a metaphor for expensive efforts offering a false line of security.

Corporate Bond Market Composition

The U.S. corporate bond market is approximately $6.4 trillion in size. Of that, over 80% is currently rated investment grade and 20% is junk-rated.This number does not include bank loans, derivatives, or other forms of debt on corporate balance sheets.

Since 2000, the corporate bond market has changed drastically in size and, importantly, in credit composition. Over this period, the corporate bond market has grown by 378%, greatly outstripping the 111% growth of GDP.  The bar chart below shows how the credit composition of the corporate bond market shifted markedly with the surge in debt outstanding. 

As circled, the amount of corporate bonds currently rated BBB represents over 40% of corporate bonds outstanding, doubling its share since 2000. Every other rating category constitutes less of a share than it did in 2000. Over that time period, the size of the BBB rated sector has grown from $294 billion to $2.61 trillion or 787%.

The Risk

To recap, there is a large proportion of investment grade investors piled into securities that are rated BBB and one small step away from being downgraded to junk status. Making this situation daunting, many investment grade investors are not allowed to hold junk-rated securities. If only 25% of the BBB-rated bonds were downgraded to junk, the size of the junk sector would increase by $650 billion or by over 50%. Here are some questions to ponder in the event downgrades on a considerable scale occur to BBB-rated corporate bonds:  

• Are there enough buyers of junk debt to absorb the bonds sold by investment-grade investors?
• If a recession causes BBB to BB downgrades, as is typical, will junk investors retain their current holdings, let alone buy the new debt that has entered their investment arena?
• Will retail investors that are holding the popular junk ETFs (HYG and JNK) and not expecting large losses from a fixed income investment, continue to hold these ETFs?
• Will forced selling from ETF’s, funds, and other investment grade holders result in a market that essentially temporarily shuts down similar to the sub-prime market in 2008?

We pose those questions to help you appreciate the potential for a liquidity issue, even a bond market crisis, if enough BBB paper is downgraded. If such an event were to occur, we have no doubt someone would eventually buy the newly rated junk paper. What concerns us is, at what price will buyers step up?  

Implied Risk

Given that downgrades are a real and present danger and there is real potential for a massive imbalance between the number of buyers and sellers of junk debt, we need to consider how close we may be to such an event. To provide perspective, we present a graph courtesy of Jeff Gundlach of DoubleLine.

The graph shows the implied ratings of all BBB companies based solely on the amount of leverage employed on their respective balance sheets. Bear in mind, the rating agencies use several metrics and not just leverage. The graph shows that 50% of BBB companies, based solely on leverage, are at levels typically associated with lower rated companies.

If 50% of BBB-rated bonds were to get downgraded, it would entail a shift of $1.30 trillion bonds to junk status. To put that into perspective, the entire junk market today is less than $1.25 trillion, and the subprime mortgage market that caused so many problems in 2008 peaked at $1.30 trillion. Keep in mind, the subprime mortgage crisis and the ensuing financial crisis was sparked by investor concerns about defaults and resulting losses.

As mentioned, if only a quarter or even less of this amount were downgraded we would still harbor grave concerns for corporate bond prices, as the supply could not easily be absorbed by traditional buyers of junk.   

Recommendation

Investors should stay ahead of what might be a large event in the corporate bond market. We recommend corporate bond investors focus on A-rated or solid BBB’s that are less likely to be downgraded. If investment grade investors are forced to sell, they will need to find replacement bonds which should help the performance of better rated corporate paper. What makes this recommendation particularly easy is the fact that the current yield spread between BBB and A-rated bonds are so tight. The opportunity cost of being wrong is minimal. At the same time, the benefits of avoiding major losses are large. 

With the current spread between BBB and A-rated corporate bonds near the tightest level since the Financial Crisis, the yield “give up” for moving up in credit to A or AA-rated bonds is a low price to pay given the risks. Simply, the market is begging you not to be a BBB hero.

Data Courtesy St. Louis Federal Reserve

Summary

The most important yet often overlooked aspect of investing is properly recognizing and quantifying the risk and reward of an investment. At times such as today, the imbalance between risk and reward is daunting, and the risks and/or opportunities beg for action to be taken.

We believe investors are being presented with a window to sidestep risk while giving up little to do so. If a great number of BBB-rated corporate bonds are downgraded, it is highly likely the prices of junk debt will plummet as supply will initially dwarf demand. It is in these types of events, as we saw in the sub-prime mortgage market ten years ago, that investors who wisely step aside can both protect themselves against losses and set themselves up to invest in generational value opportunities.

While the topic for another article, a large reason for the increase in corporate debt is companies’ willingness to increase leverage to buy back stock and pay larger dividends. Investors desperate for “safer but higher yielding” assets are more than willing to fund them. Just as the French were guilty of a false confidence in their Maginot Line to prevent a German invasion, current investors gain little at great expense by owning BBB-rated corporate bonds.

The punchline that will be sprung upon these investors is that the increase of debt, in many cases, was not widely used for productive measures which could have strengthened future earnings making the debt easier to pay off. Instead, the debt has weakened a great number of companies.

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 let’s get to the sector analysis.

ABT – Abbott Laboratories

• As noted previously, earlier this year we made a decision to overweight healthcare in portfolios. This has proved to be defensive with healthcare holding up despite the pullback in the market.
• We remain long our holding of ABT currently with stops moved up to support.
• Stop is set at $72.50

AEP – American Electric Power

• Defensive Utility and Real Estate stocks continue to get a bid during turmoil as well. We remain long utilities currently.
• AEP is overbought short-term but remains on a buy signal for now.
• While stops have been moved up to important support we will take profits on a break of $82.
• Stop-loss is moved up to $78

BA – Boeing Corp.

• A couple of months ago we took 1/2 position in BA on the initial sell-off following the 737 MAX crash.
• We said then we would give the stock a wide berth to find its bottom and it has been basing since then.
• It is still too early to take on additional holdings and with BA on a “sell” signal and not deeply oversold we will be patient.
• Stop-loss remains at $300 for now.

DOV – Dover Corp.

• Despite the restart of the trade war, DOV continues to hold its ground.
• We continue to hold our position for now and continue to keep a close eye on industrial and material sectors.
• Our stop is set at $87.50

HCA – HCA Healthcare

• Both HCA and UNH continue to hold critical support levels and have been working off their overbought condition.
• As noted above, money has been rotating into healthcare which is why we continue to overweight holdings there for now.
• Stop-loss remains at $115 for now.

MSFT – Microsoft Corp.

• Money continues to chase technology despite the more extreme overbought conditions in the sector.
• We remain long our position after taking profits and will look for an opportunity to increase exposure.
• Our stop-loss is moved to $112.50

NSC – Norfolk Southern

• Despite lackluster performance in the “transportation” sector, Railroads continue to hold up much better than the market.
• NSC is overbought but remains on a buy signal.
• Stop-loss is set at $180.

UTX – United Technologies

• UTX has recently pulled back from its highs and is sitting on support. We would like to see support hold and have the overbought condition worked off a bit before adding to our position.
• Defensive sectors continue to get a bid from investors looking for safety and yield so we like our positioning for now.
• Our stop-loss is moved to $125

VZ – Verizon

• VZ continues to perform well because my kids are using all their data and I am getting the bill.
• VZ just broke out to an all-time high after consolidating for several months. This is a good sign.
• We will add to the position when we get a corresponding buy signal. We would like to see the recent move higher consolidate and hold at higher levels confirming the breakout.
• Stop loss is currently set at $58

YUM – Yum Brands

• Who doesn’t like Kentucky Fried Chicken? YUM continues to power higher along support.
• Currently, YUM is very overbought and is potentially threatening a sell signal. So, we will be patient here looking for an opportunity to add exposure.
• Stop-loss is set at $92.50. Look to add at $95 if it holds.

The recent Nationwide Retirement Institute® Consumer Social Security PR Study conducted by Harris Poll queried 1,315 U.S. adults aged 50 and over who collect or plan to collect Social Security benefits. Recent retirees, future retirees and those who retired in 10+ years were polled. The results of this study provide a formidable glimpse into perceptions of Social Security and how they change over time.

Here are 5 highlights for future retirees who seek to maximize benefits and understand how Social Security fits into a holistic financial plan that benefits from guaranteed lifetime income.

Current & future retirees see Social Security as their primary source of retirement income.

Social Security as a primary source of retirement income towers over retirement accounts like 401ks and IRAs for current, future retirees and those who retired over a decade ago. Social Security has become the primary pension for the masses. It’s not an incidental benefit, or ‘icing on the cake,’ to a secure retirement journey. It is now the centerpiece, although it wasn’t designed to be.

Therefore, it’s a future recipient’s responsibility not to succumb to fear mongering (SS IS GOING BROKE!) and plan objectively to get the most out of the program as it exists today. Don’t shortchange lifetime family benefits by at least 25% and file for Social Security retirement benefits at age 62 unless the money is absolutely required to survive. Also, consider a non-working spouse left behind. Survivor benefits are greater if a primary wage earner waits until age 70 to claim retirement benefits.

A third of recent and 10+ retirees say health problems are interfering with retirement.

Poor health can quickly drain the happiness out of retirement. Thankfully, a majority of recent and 10+ retirees enjoy good health. The key is to consider health as an investment you cannot afford to ignore. Medicare included, Fidelity estimates that a couple will spend a total of $280,000 throughout retirement for healthcare costs.

According to Dr. Steven M. Gundry, author of the revolutionary book on how to age ‘youthfully,’ The Longevity Paradox, only 2% of a longevity footprint is DNA; success lies mostly in lifestyle habits. The reduction of animal proteins, an increase in good fats (like olive oil), and moderate exercise can all add healthy years to retirement. Amazingly, those who take on healthy habits later in life (50+), see an exponential increase in longevity when compared to those who started sooner! If you want to get the most out of Social Security and take advantage of greater lifetime benefits at age 70, well, you’re going to need to live until age 85.

Health problems occurred much sooner than expected for many retirees.

Health problems appear to come out of the blue. In reality, they are decades in the making. Eight in ten 10+ retirees or 81%, say health issues occurred sooner than expected; 61% said they occurred more than 5 years sooner than were expected.

The quality of life can be greatly enhanced if you can objectively examine and alter daily habits. Over 3 years ago, I began to re-train my brain (let’s call it mental trickery), to add or subtract $100 from my retirement accounts whenever I did something positive or negative that affected my health. Eat a burger, subtract $100; complete a workout, add $100. You get the picture. Now, I live in consistent debit and credit mode. It’s on autopilot in my head. At the end of a week, I want to be net positive $500. I brought the negative impact of poor health in the future into my present to monetize the pain! If you adhere to a budget, refrain from eliminating the expense of a fitness membership and get to the gym on a regular basis. Make a week’s worth of healthy lunches at home and ‘brown bag’ it. Your finances will be healthier too as opposed to spending $7-$10 bucks a day eating lunch out or grabbing a bite on the go.

Under a quarter of future retirees admit to not knowing which expenses might be withheld from Social Security.

Close to half of future retirees admit they don’t know what can be withheld from Social Security payments or believe nothing is withheld. Generally, Medicare Part B and D premiums are withheld from Social Security. Unfortunately, there will be years (I fear more often), when Social Security cost of living adjustments (COLA) will be 100% reduced to compensate for increases in Part B base premiums. For example, in 2020, COLA is expected to be 1.7%. Medicare Part B monthly base premiums are expected to increase to $144.30 from $135.50 – a 6.5% increase – which will more than offset the COLA for Social Security.

Those who pay monthly Medicare premiums out-of-pocket due to waiting until age 70 to collect larger Social Security benefits, will be subject to 100% of the increase in the Medicare premium amount in 2020. Recipients who already have their Part B premiums deducted from Social Security cannot pay more than the COLA adjustment per the Hold Harmless Provision. Eventually, those who are subject to Hold Harmless do get hit with full premium increases as future cost of living adjustments allow.

A comprehensive retirement plan should not only cover Medicare expenditures along with an appropriate rate of annual inflation (we use 4.5%), but also include out of pocket healthcare costs which take into account the possible loss of inflation adjustments for Social Security due to increases in Part B and D premium costs.

Older adults underestimate how long the average 65-year-old will live.

Older adults believe women will live to 83.7. In actuality, they will live to 89 years old. On average, men will live to be 87. Older adults think men will live to be 81.6. Longer life expectancies warrant serious consideration to postponing Social Security until age 70, especially in the face of dwindling private pensions. In other words, guaranteed income is important to the survivability of an investment portfolio comprised of variable assets like stocks and bonds. During periods of future low investment returns which already may have started, the maximization of guaranteed income options can help retirees to adjust or reduce portfolio withdrawal rates.

If a future Social Security recipient waits until age 70, monthly payments can be 32 percent higher than the benefits earned at full retirement age. Currently, full retirement age is 66 and 2 months for those born in 1955; for people born in 1960 or later, FRA is 67.

It’s important to partner with a financial professional who understands the devastating impact of impetuous Social Security claiming decisions. In numerous cases, RIA Certified Financial Planners® have prevented individuals from losing thousands of dollars in lifetime and survivor income benefits due to misinformation from brokers, friends with strong opinions and plain old misconceptions.

If you need a customized Social Security maximization report or a second opinion on the best claiming options for your situation, reach out to us.

We’re happy to assist.

“Price is what you pay, value is what you get.” – Warren Buffett

Just recently, I discussed the importance of valuations as it relates to investors who are close to retirement age. To wit:

“Unless you have contracted ‘vampirism,’ then you do NOT have 90, 100, or more, years to invest to gain ‘average historical returns.’ Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.

What drives those 12-15 year periods of flat to little return? Valuations.”

Despite commentary to the contrary, the evidence is quite unarguable. As shown in the chart below, the cyclical nature of valuations and asset prices is clear.

In the short-term, a period of one year or less, political, fundamental, and economic data has very little impact on the market. This is especially the case in a late-stage bull market advance, such as we are currently experiencing, where the momentum chase has exceeded the grasp of the risk being undertaken by unwitting investors.

What investors most often overlook, due to this “short-termism” or the “fear of missing out,” is the risk being undertaken which will lead to less optimistic outcomes over the investment time frame of 10 to 20-years.

Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals. However, our focus today is looking at future returns over the next decade from current valuation levels which, again, are expected to be low to negative.

As I discussed previously in “You Carry An Umbrella In Case It Rains:”

“While daily, weekly, and monthly indications are useful, taking a look at ‘quarterly’ data can give us clues as to the ‘real risk’ investors are taking on at any given time. Is this the beginning of a major bull market cycle? Or, are we nearing the end of one? How you answer that question, given the relatively short time frame of the majority of investors (hint – you don’t have 100-years to reach your goals), can have an important impact on your outcome.

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

Unfortunately, it never is.

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

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

Even after the sideways action over the last 18-months, the extended technical measures remain. Importantly, this doesn’t mean the market will mean revert tomorrow, it does imply that forward returns for current levels will be substantially lower than they have been over the last several years.

Yes, I know.

“P/E’s don’t matter anymore because of Central Bank interventions, low interest rates, accounting gimmicks, share buybacks, etc.”

It was the same in 2000 and 2007 when the “bull market psychology” makes such antiquated ideas like “value” seem irrelevant.

The important point to understand is that over the long-term investing period “value” and “returns” are both inextricably linked and diametrically opposed. As shown above, given current valuation levels, forward returns are expected to be lower than the long-term average.

Before we look at different valuation measures, let’s review what “low forward returns” does and does not mean.

• It does NOT mean the stock market will have annual rates of return of sub-3% each year over the next 10-years.
• It DOES mean the stock market will have stellar gains in some years, a big crash somewhere in between, or several smaller ones, and the average return over the decade will be low. 

“This is shown in the table and chart below which compares a 7% annual return (as often promised) to a series of positive returns with a loss, or two, along the way. (Note: the annual average return without the crashes is 7% annually also.)”

“From current valuation levels, two-percent forward rates of return are a real possibility. As shown, all it takes is a correction, or crash, along the way to make it a reality.”

This isn’t a prediction, it is just statistical probability and simple math.

With the premise in mind, let’s take a look at a variety of valuation measures as compared to forward 10-year returns.

The Charts

Tobin’s Q-ratio measures the market value of a company’s assets divided by its replacement costs. The higher the ratio, the higher the replacement costs resulting in lower returns going forward.

Just as a comparison, I have added Shiller’s CAPE-10. Not surprisingly, the two measures not only have an extremely high correlation, but the return outcome remains the same.

One of the arguments has been that higher valuations are acceptable because interest rates have been so low. As we can see below, when we take the smoothed P/E ratio (CAPE-10 above) and compare it to the 10-year average of interest rates (inverted scale) going back to 1900, the valuation to interest rate argument fails.

As noted above, historical valuation measures have been dismissed for a variety of reasons from Central Bank interventions to the rise of automation. However, while earnings can be manipulated through a variety of measures like share buybacks, accounting gimmickry, and wage suppression, “sales,” or “revenue,” which occurs at the top-line of the income statement is much harder to “fudge.” Not surprisingly, the higher the level of price-to-sales, the lower the forward returns have been. You may also want to notice the current price-to-sales is hovering near the highest level in history.

Corporate return on equity (ROE) sends the same message.

Even Warren Buffett’s favorite indicator, market cap to GDP, clearly suggests that investments made today will have a rather lackluster return over the next decade.

Even when we invert the P/E ratio, and look at earnings/price, or more commonly known as the “earnings yield,” the message remains the same.

We can reverse the analysis, as noted last week, and look at the “cause” of excess valuations which is investor “greed.”

“As investors chase assets, prices rise. Of course, as prices continue to rise, investors continue to crowd into assets finding reasons to justify overpaying for assets. However, there is a point where individuals have reached their investing limit which leaves little buying power left to support prices. Eventually, prices MUST mean revert to attract buyers again.”

The chart below shows household ownership of equities as a percent of household ownership of cash and bonds. (The scale is inverted and compared to the 5-year return of the S&P 500.)

Just like valuation measures, ownership of equities is also at historically high levels and suggests that future returns for equities over the next 5, 10, and 20-years will approach ZERO.

No matter, how many valuation measures you wish to use, there is no measure which currently suggests valuations are “cheap” enough to provide investors with sufficiently high enough returns over the next decade to meet their investment goals.

Let me be clear, I am not suggesting the next “financial crisis” is just around the next corner. I am simply suggesting that based on a variety of measures, forward returns will be relatively low as compared to what has been witnessed over the last decade. Such results are historically NOT a factor of “just one” issue but rather a culmination of issues which are simultaneously ignited by a single, unforeseen, catalyst.

As Doug Kass noted on Monday, there is a growing list of issues which will coalesce given the right catalyst.

• Slowing economic growth
• Trade/Tariffs
• Credit spreads have begun to widen
• Geopolitical uncertainties (Russia, China, North Korea, Iran)
• Fiscal policy uncertainty
• Earnings growth at risk
• A very crowded momentum trade (ETF)

Most importantly, as stated above, none of these factors or measures mean the markets will just produce single-digit rates of return each year for the next decade. The reality is there will be some great years to be invested over that period, unfortunately, like in the past, the bulk of those years will be spent making up the losses from the coming recession and market correction. 

That is the nature of investing in the markets. There will be fantastic bull market runs as we have witnessed over the last decade, but in order for you to experience the up, you will have to deal with the eventual down. It is just part of the full-market cycle which encompass every economic and business cycle.

How you choose to handle the second-half of the full-market cycle is entirely up to you. However, “this time is not different,” and in the end, many investors will once again be reminded of this simple fact.

Unfortunately, those reminders tend to come in the most brutal of manners.  

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

Basic Materials

• As noted previously, XLB failed at the 2018 peak. The “buy” signal, which was extremely extended as noted by the horizontal dashed red line, set up the inevitable correction.
• The trade war with China will likely continue to weigh on materials and we previously sold 1/2 of our position.
• Short-Term Positioning: Neutral
  • Last Week: Sold 1/2 position.
  • This Week: Hold balance for rally to $55 to $55 1/2
  • Stop-loss moved up to $53, sell remaining half on rally..
• Long-Term Positioning: Bearish

Communications

• XLC broke support previously and failed at a rally turning support into resistance.
• XLC is not oversold yet so remain patient.
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 position
  • This Week: Hold 1/2 position
  • Stop-loss moved up to $47
• Long-Term Positioning: Bearish

Energy

• As noted last week, the rally in oil prices pushed XLE into resistance at the March lows. That resistance is currently holding.
• XLE is currently at a critical juncture. A failure below the 200-dma is going to bring the low-$50’s into focus.
• The current “buy signal” remains intact and the sector is oversold short-term. Use any rally to reduce exposure to the sector for now.
• Short-Term Positioning: Neutral
  • Last week: Hold and wait for a pullback to support to add.
  • This week: Stop violated, sell on rally that fails to get above $64 this week.
  • Stop-loss adjusted to $63
• Long-Term Positioning: Bearish

Financials

• We noted last week that XLF broke out above initial resistance but was running into a cluster of previous tops from last year. That rally failed last week with the decline in the yields weighing on earnings outlook.
• XLF remains on a “buy” signal currently and the overbought condition is being reduced.
• Short-Term Positioning: Neutral
  • Last week: Recommended “hold” 1/2 position
  • This week: Hold 1/2 position, add on a pullback to $25 that holds.
  • Stop-loss moved up to $25.00
• Long-Term Positioning: Bearish

Industrials

• XLI has put in a “triple top” at recent highs which makes that resistance level critically important.
• For now, the buy signal in lower panel is very extended but is being reduced. XLI is not completely oversold yet, use a rally to reduce positioning in the sector for now.
• Short-Term Positioning: Neutral
  • Last week: Sold 1/2 position
  • This week: Hold remaining position, look to sell on failed rally to $77
  • Stop-loss moved up to $72
• Long-Term Positioning: Neutral

Technology

• XLK is on a “Buy” signal (bottom panel) but, as stated three weeks ago, had reached a “crazy” extension like many other sectors of the market. A correction was inevitable and we previously recommended taking profits.
• The market is becoming very confined to a smaller number of stocks leading the charge higher. Technology has become the poster child for momentum.
• The correction failed to hold support at $75 and the rally failed turning that previous support into resistance. With the sector not grossly oversold look for more selling pressure this week.
• Short-Term Positioning: Bullish
  • Last week: Hold 1/2 position
  • This week: Hold 1/2 position
  • Stop-loss moved up to $70
• Long-Term Positioning: Neutral

Staples

• XLP held up much better than the broad market recently and we continue to hold positions in this sector. As money seeks defense, XLP and XLU have been the “go to.”
• XLP’s “buy” signal (lower panel) is back to extreme levels. So, taking profits remains advised. XLP is also flirting with the trendline from the 2016 lows.
• Currently overbought, however a pullback to $53-55 can be used to add exposure.
• Short-Term Positioning: Bullish
  • Last week: Holding full position, take profits and rebalance.
  • This week: Take profits if you haven’t done so.
  • Profit stop-loss moved up to $55.50
• Long-Term Positioning: Bullish

Real Estate

• XLRE, along with XLU, has continued to attract money flows for defensive positioning amidst falling interest rates.
• We previously recommended taking profits and rebalancing risk. That is still advisable.
• Buy signal is being reduced, but XLRE remains overbought short-term.
• We recently added 1/2 position of XLRE and will add the second 1/2 on a pullback to support at $34.50.
• Short-Term Positioning: Bullish
  • Last week: “Hold” 1/2 position
  • This week: Hold 1/2 position.
  • Stop-loss adjusted to $33.50
• Long-Term Positioning: Bullish

Utilities

• Like Real Estate above, XLU has finally taken a breather from its recent advance but not much of one.
• Long-term trend line remains intact, and money is chasing XLU in defense from the trade war.
• Previous support continues to hold.
• Buy signal is beginning to work off some of the excess. (bottom panel) and the sector is currently back to overbought.
• Short-Term Positioning: Bullish
  • Last week: Rebalance holdings and continue to hold.
  • This week: Hold position, look to add 1/2 position to portfolios on a pullback to $56.
  • Stop-loss moved up to $54.
• Long-Term Positioning: Bullish

Health Care

• Sell-signal (bottom panel) remains intact currently but previous support is holding.
• While Healthcare is holding up for now, there is a downtrend forming in the sector. Keeps stops in place.
• XLV has been in a consolidation for the last 18-months. So whichever direction healthcare breaks out to will be a big move.
• XLV is reversing the oversold condition but still has upside from current levels.
• Short-Term Positioning: Neutral
  • Last week: Hold current position.
  • This week: Hold current position.
  • Stop-loss set $86
• Long-Term Positioning: Neutral

Discretionary

• XLY, like XLK above, broke back below its previous high turning that support back into resistance for now.
• The “buy” signal remains extremely elevated but is being reduced currently. XLY is not oversold as of yet so caution is advised. A break below last week’s lows will likely suggest much lower levels.
• Short-Term Positioning: Neutral
  • Last week: Sold 1/2 of position.
  • This week: Hold 1/2 position with stops in place.
  • Stop-loss moved up to $112.50
• Long-Term Positioning: Neutral

Transportation

• XTN has continued to lag the overall market and continues to suggest there is “something wrong” economically.
• While XTN is on a buy signal. (bottom panel) the short-term overbought condition is being reversed.
• As we have been saying for several weeks, our “sell stop” was triggered previously. No real need to rush back into adding a new position. We will watch and see what happens.
• Short-Term Positioning: Neutral
  • Last week: No position
  • This week: Looking to add a position that holds support at $56-57 if support at $60 gives way.
• Long-Term Positioning: Bearish

This past weekend, I was digging through some old articles and ran across one that needed to be readdressed on “human stupidity” as it relates to investing.

The background was a study done in 1976 by a professor of economic history at the University of California, Berkeley. Carol M. Cipolla published an essay outlining the fundamental laws of a force he perceived as humanity’s greatest existential threat: Stupidity.

Stupid people, according to Cipolla, share several identifying traits:

• they are abundant,
• they are irrational, and;
• they cause problems for others without apparent benefit to themselves

The result is that “stupidity” lowers society’s total well-being and there are no defenses against stupidity. According to Cipolla:

“The only way a society can avoid being crushed by the burden of its idiots is if the non-stupid work even harder to offset the losses of their stupid brethren.”

Of course, if we look at the world around us today, watch or read the diatribe produced by financial and news outlets, or pay attention to politics, it certainly seems that since the advent of the “smartphone” and “social media” the percentage of “stupidity” has clearly risen. (Either that, or we are just more aware of the massive amount of “stupidity” around us. Thankfully, it seems to be contained primarily in Florida.)

We can’t really do much about the seemingly rising level of “general stupidity,” however, we can apply Cipolla’s five basic laws of human stupidity to investing and the mistakes investors repeatedly make over time.

Law 1: Always and inevitably everyone underestimates the number of stupid individuals in circulation.

“No matter how many idiots you suspect yourself surrounded by you are invariably low-balling the total.” – Cipolla

In investing, the problem of investor “stupidity” is compounded by a variety of biased assumptions that are made.  Individuals assume that when the media publishes something, the superficial factors like the commentator’s job, education level, or other traits suggest they can’t possibly be stupid. We, therefore, attach credibility to their opinion as long as it confirms our own.

This is called “confirmation bias.”

If we believe the stock market is going to rise, then we tend only to seek out news and information that supports our view. This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. I discussed this previously in why “Media Headlines Will Lead You To Ruin.”

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”

This is why “social media” has become such a pervasive problem in the spread of misinformation as individuals huddle into their own “echo chambers” which excludes both intelligent debates and, in many cases, actual facts. It is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.

Law 2: The probability that a certain person be stupid is independent of any other characteristic of that person.

Cipolla posits stupidity is a variable that remains constant across all populations. Every category one can imagine—gender, race, nationality, education level, income—possesses a fixed percentage of stupid people.

When it comes to investing, ALL investors, individual and professionals, are subject to making “stupid” decisions. As I discussed recently:

“A recent survey from Ally Invest showed much the same:

‘The bullish sentiment by investors, which doubled between Q1 and Q2 of this year, appears, in part, supported by the majority of respondents’ belief that interest rates will remain unchanged this year (67%) and the government will sign economic trade agreements that will help drive the markets higher (61%).

Other major market drivers cited by respondents include positive year-over-year earnings (26%), low unemployment rate (24%), lack of inflation (18%), and tax reform (15%).’

E*Trade also recently released survey data showing:

• Bullish sentiment returns. Bullishness rose 12 percentage points since last quarter to once again represent the majority of investors at 58 percent.
• Investors believe there’s more room for the bull market to run. Two-thirds of investors say they think the bull market has a year or more to go (66%), up seven percentage points from last quarter.
• The majority gave the US economy a passing grade. Investors who gave the economy an “A” or “B” grade rose 9 percentage points this quarter, to 64%.
• Volatility concerns remain. Investors who believe volatility will stay the same was up by 8 percentage points from Q1.

You get the idea. Just 8-weeks after panic selling lows in December of 2018, investors are once again “back in the pool.”

Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, then if I want to be accepted, I need to do it too.

In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets, the “herding” behavior is what drives market excesses during advances and declines.

As Howard Marks once stated:

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

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

Moving against the “herd” is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against those who are being “stupid.”

Law 3. A stupid person is a person who causes losses to another person or to a group of persons while himself deriving no gain and even possibly incurring losses.

Consistent stupidity is the only consistent thing about the stupid. This is what makes stupid people so dangerous. As Cipolla explains:

“Essentially stupid people are dangerous and damaging because reasonable people find it difficult to imagine and understand unreasonable behavior.“

Throughout history, investors are constantly drawn into investment strategies, promoted by a wide variety of “industry professionals,” which ultimately leads to losses in the end. This point was clearly made in a recent article by Jason Zweig entitled: “Whatever You Do, Don’t Read This Column.”

“Investors believe the darnedest things.

In one survey, wealthy individuals said they expect their portfolios to earn a long-run average of 8.5% annually after inflation. With bonds yielding roughly 2.5%, a typical stock-and-bond portfolio would need stocks to grow at 12.5% annually in order to hit that overall 8.5% target. Net of fees and inflation, that would require approximately doubling the 7% annual gain stocks have produced over the long term.

Individuals aren’t the only investors who believe in the improbable. One in six institutional investors, in another survey, projected gains of more than 20% annually on their investments in venture capital — even though such funds, on average, have underperformed the stock market for much of the 2000s.

Although almost nothing is impossible in the financial markets, these expectations are so far-fetched they border on fantasy.”

Cipolla is absolutely right, and despite the historical realities of investing, both the individual and the professional will ultimately suffer losses. As shown in the chart below, there is no evidence which shows markets can compound high levels of growth rates from current valuation levels. (For more detail on forward returns read “Valuations Matter”)

There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.

“Unless you have contracted ‘vampirism,’ then you do NOT have 90, 100, or more, years to invest to gain “average historical returns.” Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.

What drives those 12-15 year periods of flat to little return? Valuations.

Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals.”

Individuals who experienced either one, or both, of the last two bear markets, now understand the importance of “time” relating to their investment goals. Individuals that were close to retirement in either 2000, or 2007, and failed to navigate the subsequent market draw downs have had to postpone their retirement plans, potentially indefinitely.

But yet despite the losses incurred by both professionals and individuals, just a decade after the largest financial crisis since the “Great Depression,” individuals are piling on excessive risk once again under the guise “this time is different.” 

Talk about stupid.

Despite the mainstream media’s consistent drivel investors should just “passively index” and forget about actually managing the risk of catastrophic capital loss, the reality is that investors “buy high and sell low” for a reason.

“Greed” and “Fear” are far more powerful in driving our investment decisions versus “Logic” and “Discipline.” 

As Jason states:

“The traditional explanations for believing in an investing tooth fairy who will leave money under your pillow are optimism and overconfidence: Hope springs eternal, and each of us thinks we’re better than the other investors out there.

There’s another reason so many investors believe in magic: We can’t handle the truth.”

All of which leads us to:

Law 4: Non-stupid people always underestimate the damaging power of stupid individuals. In particular non-stupid people constantly forget that at all times and places and under any circumstances to deal and/or associate with stupid people always turns out to be a costly mistake.

Lot’s of “non-stupid people” are currently suggesting the next correctionary event will be mild, most likely no more than 20%. The idea is based upon the belief the Federal Reserve, and Central Banks globally, will quickly come to the rescue of a failing market and investors will quickly react by once again jumping back into the market.

However, as we have seen repeatedly throughout history, “stupid” people tend to do exactly the opposite during a crisis than what “non-stupid” people expect.

Then there are the “perennial bulls” who keep telling investors to “hang on, keep putting money in, you’re a long-term investor, right?” These are the ones who never see the bear market destruction until well after the fact and then simply say “well, no one could have seen that coming.” 

Non-stupid people are conservative. They analyze the risk of loss and conserve capital during declines. Make sure you are surrounding yourself with those that understand the “math of loss.” 

As Howard Marks stated above, sometimes being a contrarian is lonely.

When we underestimate the stupid, we do so at our own peril.

This brings us to the fifth and final law:

Law 5: A stupid person is the most dangerous type of person.

Following the “herd,” has always ended badly for investors. In every full-market cycle, there is an inevitable belief “this time is different” for one reason or another.

It isn’t. It has never been. And this time will not be different either.

However, what has always separated out the great investors from everyone else, is they have acted independently of the “herd.” They have a discipline, a strategy and a driving will to succeed.

They don’t “buy and hold.” They buy cheap and sell expensive. They avoid losses at all costs and they deeply understand the relationship of risk to reward.

They are the “non-stupid.”

These are the ones you want to follow.

Not the ones screaming at you on television telling you to “buy, buy, buy.”

Just remember that for every full-market cycle our job is to not only participate in the first-half of the cycle as prices rise, but to avoid the avoid the devastation during the second-half.

“Non-stupid” investors don’t spend a bulk of their time getting back to even.

“Getting back to even” is an investing strategy better left to the “herd.”

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

• As noted a couple of weeks ago, SPY tested, and failed, at the bottom of the uptrend line from both the 2017 post-election bounce and the 2016 lows.
• Currently, SPY is correcting the overbought condition but is not oversold as of yet.
• Also, as we noted two weeks ago, the “buy” signal in the lower panel was at a level which has always denoted at least short-term market tops. We recommended reducing risk.
• Despite the correction last week, the risk still outweighs further reward. As discussed in this past weekend’s newsletter, the bulls are betting against the odds given the fundamental and economic backdrop.
• Short-Term Positioning: Bullish
  • Last Week: Recommended taking profits
  • This Week: If you haven’t taken profits and rebalanced previously, do so on any rally next week.
  • Stop-loss adjusted to $275
• Long-Term Positioning: Neutral

Dow Jones Industrial Average

• As discussed last week, DIA was potentially setting up a double top which has now been established with the break below support at the the January highs.
• Market is working off the overbought condition and the current buy signal is being reversed.
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss adjusted to $250
• Long-Term Positioning: Neutral

Nasdaq Composite

• While QQQ broke out to all time highs, it has been a narrow push with MAGA stocks driving index higher (MSFT, AAPL, GOOG, AMZN). The break back below support raises some cautionary flags as we head into next week.
• As noted previously. “With the market and the underlying ‘buy signal’ extremely stretched to the highest levels we have seen in several years, an initial failure at these levels would not be surprising. The breakout to highs was not on inspiring volume.”
• That correctionary process is not complete yet.
• Support at $185 failed.
• Short-Term Positioning: Bullish
  • Last Week: Hold position, take profits, and rebalance holdings.
  • This Week: Same advice this week.
  • Stop-loss adjusted to $175
• Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

• SLY has fallen apart over the last week, as market participation has weakened.
• Currently on a modest “buy” signal, but that signal is deteriorating. SLY is oversold on a short-term basis, so a bounce next week to sell into is important.
• Short-Term Positioning: Bearish
  • Last Week: Hold
  • This Week: Sell on rally that fails to get above $69.
  • Stop adjusted to $66
• Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

• MDY failed at its support and at the downtrend resistance line. However, MDY did hold its 200-dma support this past week, but just barely.
• Mid-caps are on a buy signal, however, that signal is at more extended levels and while the extreme overbought levels has been reduced it is not entirely oversold yet.
• Support needs to hold this week.
• Short-Term Positioning: Neutral
  • Last Week: We had recommended adding 1/2 position, last Monday’s rout kept us from doing so.
  • This Week: Hold current positions with a tight stop at $340
• Long-Term Positioning: Bearish

Emerging Markets

• Trade wars are not good for emerging markets. Two weeks ago, EEM failed initial support. Last week, it crashed through critical support and stop levels.
• We specifically noted two weeks ago:”The current “buy” signal, and the market itself extremely overbought, look for a pullback to support at the tops of the previous consolidation which works off some of the overbought condition to add to holdings.”
• The failure at those support negates that recommendation.
• Short-Term Positioning: Bearish
  • Last Week: Hold current position.
  • This Week: We sold all holdings last week on violation of support.
  • Stop-loss violated.
• Long-Term Positioning: Neutral

International Markets

• EFA also broke below important support last week, which also negates previous recommendations.
• The good news is that EFA is holding its 200-dma for now.
• The downtrend from all-time highs remains and EFA did bounce off of oversold levels.
• The “buy signal” also remains extremely overbought in the short-term
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 position
  • This Week: Hold 1/2 position.
  • Stop-loss moved up to $64
• Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

• As noted last week, the rally in oil had gotten way ahead of itself in the face of building supplies. The correction continued again for a third week.
• There is support at $60 which held last week, and coincides with the important 200-dma.
• WTIC is not oversold yet and the “buy signal” is being worked off. Support must hold next week or we will be looking at the mid-$50’s pretty quickly.
• Advice remains, this is a good opportunity to scalp some profits and reduce risk currently.
• Short-Term Positioning: Neutral
  • Last Week: After taking profits, hold 1/2 position
  • This Week: Hold 1/2 position
  • Stop-loss adjusted to $60
• Long-Term Positioning: Bearish

Gold

• Gold did rally as expected last week and volatility picked up but failed at resistance at the 200-dma.
• Gold is close to oversold once again, but is close to registering a “sell signal.” Remain cautious on gold for now, but we are maintaining our position as a hedge against a potential pick up in volatility over the summer.
• Short-Term Positioning: Neutral
  • Last week: Hold positions.
  • This week: Hold positions
  • Stop-loss for whole position adjusted to $120
• Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

• Bonds rallied again this week as “trade war” rattled the equity markets sending money searching for “safety.”
• Currently on a buy-signal (bottom panel), bonds are now back to very overbought conditions and are testing the previous highs from earlier this year.
• Support held at $122 which now become extremely important support.
• Strong support at the 720-dma (2-years) (green dashed line) which is currently $118.
• Short-Term Positioning: Bullish
  • Last Week: Trimmed 1/4th of holdings to take profits.
  • This Week: Hold current positions and look to add exposure if support holds.
  • Stop-loss adjusted to $120
  • Long-Term Positioning: Bullish

U.S. Dollar

• With roughly 40-50% of corporate profits coming from exports, all commodities globally traded in dollars, and the dollar impact on the bond market, this is a key measure to watch. Trade war will have an impact across many sectors of the market and the dollar will likely tell the story.
• Currently, the dollar broke above previous resistance, has retested that previous resistance making it support, and has now registered a buy signal. The combination of these three catalysts suggests the dollar could rise toward $100 on the index.
• Short-Term Positioning: Bullish
  • Buy a full position at current levels
  • Target for trade is $101-102
  • Stop loss is set at $96

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• Market Review & Update
• Bulls Are Betting On A “Long Shot”
• Sector & Market Analysis
• 401k Plan Manager

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Market Review & Update

Over the last several weeks, we have been discussing the potential for a market correction simply due to divergences in the technical indicators which suggested near-term market risk outweighed the reward. Then, the White House reignited the “trade war” with China. To wit:

“The “Trade War” is not a good thing for markets or the economy as recently suggested by the President. David Rosenberg had an interesting point on this as well on Friday:

‘Tracing through the GDP hit from a tariff war on EPS growth and P/E multiple compressions from heightened uncertainty, the downside impact on the S&P 500 would come to 10%. I chuckle when I hear economists say that the impact is small- meanwhile, global trade volumes have contracted 1.1% over the year to February…how is that bullish news exactly?’

Remember, at the beginning of 2018, with ‘tax cuts’ just passed, and earnings growing, the market was set back by 5% as an initial tariff of 10% was put into place. Fast forward to today, you have tariffs going to 25%, with no supportive legislation in place, earnings growth and revenue weakening along with slower economic growth. 

In the meantime, the bond market is screaming ‘deflation,’ and yields have clearly not been buying the 3-point multiple expansion from the December 24th lows.” 

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It was due to that analysis, and the trade war, that we made the following recommendations last week to our clients and RIA PRO subscribers. (Try NOW and get 30-days FREE)

“Continuing from yesterday’s discussion on the impact of ‘trade wars’ on various sectors has us beginning to reposition out of some the areas most susceptible to tariffs. Yesterday, we closed out our position in Emerging Markets, and sold 1/2 of our position in Basic Materials.

Today, on the bounce as laid out yesterday, we sold half of our position in XLI (industrials) and XLY (consumer discretionary) and added one-half position in XLRE (real estate) which should be defensive with lower interest rates.“

We still maintain a long-bias towards equity risk. But, that exposure is hedged with cash and bonds which remain at elevated levels. (If you haven’t taken any actions at all recently, read my previous newsletter for Portfolio Management Guidelines)

While the market got very oversold previously, we noted last weekend a bounce was likely. 

Unfortunately, that bounce was unable to hold above the 50-dma on Friday which negates the break above it earlier in the week. Importantly, the deeply oversold condition was somewhat reversed which now sets the market up for a potential retest of the 200-dma average over the next couple of weeks. A failure at that level and we have to start having a different conversation about portfolio allocation models. 

For now, the market is working a corrective process which is likely not complete as of yet. As we head into the summer months, it is likely the markets will experience a retracement of the rally during the first quarter of this year. As shown in a chart we use for position management (sizing, profit taking, sells) the market has just issued a signal suggesting risk reduction is prudent. (This doesn’t mean sell everything and go to cash.)

There is no “law” that says you have to be “all in” the market “all the time.” 

Every good gambler knows how to “size their bets” relative to the “hand they hold.” This is particularly the case when it certainly appears the “bulls are betting on a long shot.” 

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“Over the next couple of months, we will be able to refine our view further, but the important point is that since roughly 50% of corporate profits are a function of exports, Trump has just picked a fight he most likely can’t win.

Importantly, the reigniting of the trade war is coming at a time where economic data remains markedly weak, valuations are elevated, and credit risk is on the rise. The yield curve continues to signal that something has ‘broken,’ but few are paying attention.”

For the bullish narrative, the earnings growth story is going to become increasingly difficult to ignore. This is particularly the case given that just this past week economic data continues to show weakness. As shown in the following chart, global economic trade has collapsed to levels not seen since prior to the financial crisis. 

Of course, since almost 50% of corporate revenue and profits are generated from international activity, it is not surprising to see a problem emerging. 

As J. Brett Freeze, CFA discussed on Friday, dissected the key drivers of economic growth: Capital Expenditures.

The graph shows that when the economy is coming out of recession and optimism is budding, capital expenditures as a percentage of the economy are high. Conversely, as optimism wanes, and the economic cycle is long in the tooth capital expenditures peak, trend sideways and then drop sharply. (The data in the graph is normalized using six quarter moving averages and standard deviations as reflected on the Y-axis.)

The 1960s and the current period are unique in that those periods saw a sharp decline in capital expenditures that did not lead to a recession. We know the current episode is a result of a resurgence of corporate optimism due to the election of Donald Trump and importantly, the corporate tax cut that incentivized corporate spending. With much of the tax cut stimulus behind us, the temporary fiscal boost appears to be fading.    

Unsurprisingly, all of this data aligns with rising recession risks. 

(Important Note: The graph above is based on lagging economic indicators which are subject to huge negative revisions in the future. Therefore, high current risk levels should not be readily dismissed as the recession will have started before the data is revised to reveal the actual start date.)

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Here is my point.

If you had been living on Mars for the last 24-months and just reviewed the data above, you would, most logically, assume the market would be down, and probably significantly so.

That certainly isn’t the case, as noted above, with the markets just a couple of percentage points away from their all-time highs. So, despite the data, the resurgence of a “trade war” with China, rising delinquency rates and falling demand for loans, and weak outlooks by businesses, the bulls are certainly “betting on a long-shot” of an outcome that is currently well outside the current data. 

In that is the case, then what are the “bulls” betting on? My friend Patrick Hill sent me a good note on this issue.

“In watching Bloomberg, it seems the market is betting on:

1 – The Fed will lower interest rates.  The Fed Funds rate forecast shows at least once this year. Interestingly, historically, when the Fed begins lowering interest rates it has been in response to a recession, not a slowdown.

2 – The trade war will not be as bad as thought as Trump and Xi will meet at G20 and resolve everything. But that may not be the case given China’s positioning on Friday:

“The US has completely abandoned commercial principles and disregarded law. Its barbaric behavior against Huawei by resorting to administrative power can be viewed as a declaration of war on China in the economic and technological fields. It is time that the Chinese people throw away their illusions. Compromise will not lead to US goodwill.”

3 – Corporations can continue to churn out revenue growth as China stimulus will help out EM countries and US companies can sell to them

4 – Corporate debt at levels at record highs, and leveraged loans at twice the level of subprime debt in 2008, is of no real concern. 

5 – Corporate stock buybacks will continue to provide a bid to the market. (Of course, what happens when sales continue to fall.) Ned Davis research noted their research shows the S & P is up 19 % over what it would not be without buybacks. Buybacks have also made up about 80% of the “bid” to the market. 

6 – There is no concern that tariffs will push price inflation higher despite the fact that tariffs will lift costs on both consumers and businesses. 

7 – The Fed will respond to any weakness providing a permanent bid the market.

In other words, at the moment, data doesn’t matter to the markets – it is simply “hope” based momentum magnified with a “crap ton” of liquidity (Yes, that is a technical term.)

Doug Kass recently discussed the issue of the current disconnect.

“‘(Very) leveraged strategies involving yield enhancement, allocations based on risk assessment (risk parity) and other volatility targeting funds are contributing factors to a new and heightened regime of volatility that has recently intensified. And so does the popularity and proliferation of passive ETFs and the proliferation of CTA (extreme momentum-based) strategies, exaggerate short term price moves. (Even BlackRock’s Larry Fink has missed this important reason for the market’s sharp advance this year).

There is such a limited discussion of the enormous sums of money that are now being managed by Quants and Pseudo Quant hedge funds, algorithmic trading with MASSIVE leverage, all of which dominates the investing landscape.

The aforementioned strategies (based on momentum and the assessment of asset class risk), embraced by many, work until they don’t and when a trend changes (from up to down) massively levered products (like risk parity) are forced to delever and buy back volatility (to offset their short vol positions) – further exacerbating the move lower.

The problem, of course, is ‘uncovered’ when too many are on the same side of the boat.

A state of stability should not be as trusted as much today as in the past it will likely morph into more frequent episodes of instability – a series of ‘Minsky Moments.'” 

This is an important point, stability eventually breeds instability due to the buildup of “complacency.” The entire bullish “bet” currently is that despite a growing laundry list to the contrary, the markets will continue their advance simply waiting for the data to improve. 

Primarily, this belief is hinged on the idea the Fed will come to the rescue. The problem, as  noted previously:

“The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. In 2008, when the Fed launched into their ‘accommodative policy’ emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.”

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.

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

“The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the “norm” are negatively extended, confidence is hugely negative. In other words, there is nowhere to go but up.”

That is hardly the case currently as prices have become detached from both the economic and fundamental cycles of the market. The bulls are clinging to narratives to justify excessive valuations and deviations from the norm.

“We live in an investment world in which much of the silly, fairy tale narratives have little to do with the real world – a lot is basically “made up.”  It is that simple.” – Doug Kass, Real Money Pro

So, what are we doing now?

We realize that out clients have to make money when markets are rising, but that we also have to manage the risk of loss. 

It’s an incredibly tough job and doesn’t always work out the way we plan. But that is the essence of investing to begin with. 

With the recent market weakness, we are holding off adding to our equity “long positions” until we see where the market finds support. We have also cut our holdings in basic materials and emerging markets as tariffs will have the greatest impact on those areas. Currently, there is a cluster of support coalescing at the 200-dma, but a failure at the level could see selling intensify as we head into summer.

The recent developments now shift our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple. However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the current market environment.

Staples, while lagging the S&P 500, remain a sector where money is hiding. Staples remain on a buy signal but are extremely overbought and extended. Take profits and rebalance in portfolios.  The same goes for Utilities as well. 

We noted previously that Financials were underperforming but we would give the sector some room, Currently, financials are holding important support, but performance is weakening again as the yield curve inverts. If you haven’t done so, take profits and rebalance risk. 

We are overweight healthcare currently where relative performance is improving as a “risk off” rotation occurs. We remain slightly overweight in Healthcare again this week. 

 

Art and collectibles prices have exploded in the past decade as a result of the extremely frothy conditions created by central banks. Hardly a week goes by without news headlines being made about ugly, tacky, or just plain bizarre works of art fetching tens of millions, if not hundreds of millions, of dollars at auction houses like Sotheby’s and Christie’s (often sold to rich buyers in China or Hong Kong). Make no mistake: we’re currently experiencing a massive art bubble of the likes not seen since the Japan-driven art bubble of the late-1980s that ended disastrously. Two art market records were made in the past week: the $91.1 million “Rabbit” sculpture by Jeff Koons, which set the record for the highest amount paid for a piece of art by a living artist, and the sale of Monet’s ‘Meules’ painting for $110.7 million, which set a record for an Impressionist work.

The New York Post reports on the Koons sale –

A sculpture of a silver rabbit by artist Jeff Koons sold at Christie’s auction house in Manhattan Wednesday for $91.1 million, setting the record for the highest amount fetched for a piece of art by a living artist.

Koons’ “Rabbit” surpassed the previous record, which was set just last November when British painter David Hockney’s “Portrait of an Artist (Pool with Two Figures)” sold for $90.3 million. Both totals include the auction house fees.

Art dealer Bob Mnuchin, the father of Treasury Secretary Steven Mnuchin, made the winning bid for the Koons work, Bloomberg reported. Mnuchin made the purchase for a client, according to the report.

The sculpture, which stands just over 3 feet high, is made of stainless steel and based on an inflatable children’s toy, according to the auction house.

Reuters reports on the Monet sale –

One of the few paintings in Claude Monet’s celebrated “Haystacks” series that still remains in private hands sold at auction on Tuesday for $110.7 million, setting a record for an Impressionist work.

The oil on canvas, titled “Meules” and completed in 1890, is the first piece of Impressionist art to command more than $100 million at auction, said Sotheby’s, which handled the sale.

That also represents the highest sum ever paid at auction for a painting by Monet, the founder of French Impressionism and a master of “plein air” landscapes who died in 1926, aged 86.

“Meules” was one of 25 paintings in a series depicting stacks of harvested wheat belonging to Monet’s neighbor in Giverny, France.

The works are widely acclaimed for capturing the play of light on his subject and for their influence on the Impressionist movement.

Last month, I wrote about “bubble drunk” millennials in Hong Kong who paid $28 million for Simpsons art:

Today’s art bubble (like many other bubbles that are currently inflating) formed as a result of the Fed and other central banks’ extremely loose monetary policies after the Great Recession. In a desperate attempt to jump-start the global economy again, central banks cut and held interest rates at virtually zero percent for much of the past decade. The chart of the Fed Funds rate below shows how bubbles form when interest rates are at low levels:

In addition to holding interest rates at record low levels for a record length of time, central banks pumped trillions of dollars worth of liquidity into the global financial system in the past decade:

Assets around the world – from art to stocks to property – have been levitating on the massive ocean of liquidity that has been created by central banks. For example, the S&P 500 has soared 300% since its low in early-2009:

In order to understand today’s art bubble, it is helpful to learn about the art bubble of the late-1980s that ultimately crashed and burned. Throughout the 1980s, Japan had a bubble economy that was driven by debt and bubbles in property and stocks. Japan’s economy was seemingly unstoppable – almost everyone in the West was terrified that Japan’s economy and corporations would trounce ours while destroying our standard of living in the process. Of course, few people knew how unsustainable Japan’s economy was at that time.

As a result of hubris and the enormous amount of liquidity that was flowing throughout Japan’s economy in the late-1980s, Japanese businesspeople and corporations started to speculate in art, often bidding previously unheard of sums that Western art collectors would never have dreamed of paying. For example, Yasuda Fire and Marine Insurance paid a record $39.9 million for Vincent van Gogh’s “Sunflowers” at a London auction in 1987. Ryoei “wild fellow” Saito, Chairman of the Daishowa Paper Manufacturing empire, paid $160 million for the world’s two most expensive paintings – a Van Gogh and a Renoir. At the peak of the art market in 1990, Japan imported more than $4 billion worth of art, including nearly half of all Impressionist art that was on the market. Of course, the art market plunged along with Japan’s bubble economy in the early-1990s.

Unfortunately, today’s art bubble will burst just like the art bubble of the late-1980s. China, with its massive debt bubble, is currently playing the role that Japan played in the Eighties. While most people are probably not worried about the coming art market bust and won’t be directly affected by it, the point of this piece is to show how the art market acts like a barometer for the amount of froth there is in the global economy and financial markets. When the art market goes ballistic, that is typically a sign that the economic cycle is in its latter stages. We are fast approaching a time when art speculators will deeply regret paying $91.1 million for a steel rabbit sculpture and tens of millions of dollars for Simpsons art.

The recent running of the Kentucky Derby marks the time of year of horse racing’s prestigious Triple Crown and everything that goes along with it. Temperate spring weather, increasingly beautiful spring foliage, ostentatious hats, parties, and of course, the impressive physical prowess of the horses and the jockeys are all part of the season.

It is also a reminder of another race that has been going on, albeit with considerably less pageantry: The race to fund pension plans. This is a different kind of race because it is ongoing and because there aren’t distinct winners. There definitely are losers, however. It is also a race that has driven considerable interest in risky assets such as stocks and private equity.

In a sense, investors are accustomed to racing because it is something of a race to fund a retirement before it happens. The reality that many people wait too long to even start the race, and often don’t contribute enough money once they do start, only highlights the inherent challenges of the exercise.

There is yet another factor in the retirement equation that many investors have not bargained for though: The race has gotten harder over time due to low interest rates. This makes it even harder for investors to reach their retirement objectives and has created incentives for investors to increase risk. The Financial Times reported on how the process started over ten years ago in Japan, where the demographic challenges are even more urgent:

“Banks today offer only token interest rates of 0.1–0.45 per cent and ‘it is necessary to make money work harder’, says Tomoo Sumida, senior economist at Nomura Asset Management. ‘The baby-boomers will live for 20 years after they retire and there is no way they can support themselves without investing,’ says Mr Hirakawa at UBS’.”

The report confirmed that “the search for higher returns has begun” with cash and bank deposits declining as a share of overall household financial assets and stocks and other investments increasing share.

While the search for higher returns is understandable, it often belies the important consideration of risk. Financial assets, after all, are not utilities that consistently provide certain returns. While it is generally true that riskier assets produce higher returns than less risky assets over very long periods of time, they can also underperform for periods easily stretching to ten to twenty or more years. For many investors with comparable investment horizons, such as retirees and those nearing retirement, the historical average long-term returns of financial assets obscure the risk of falling short of their goals.

A better gauge for determining expected returns for stocks over a ten- to twenty-year investment horizon is to infer the returns implied by current prices and expected cash flows. John Hussman regularly performs this exercise and recently concluded that stock valuations “offer investors among the most offensive investment prospects in financial history.”

In his analysis, he also highlights an important difference between now and the tech boom in 2000 when valuations were also exceptionally high:

“An important aspect of current valuation extremes is that they are far broader than what was observed even at the 2000 market peak … Strikingly, the current multiple [median price/revenue ratio of S&P 500 component stocks) is far beyond what was observed at the 2000 peak.

With the exception of stocks in the very highest valuation decile, every other decile is more overvalued today than it was at the 2000 market peak.”

In other words, not only does investing in stocks provide the bleak prospect of low to negative returns over the next several years, but unlike in 2000 when only a few stocks were significantly overvalued, now almost everything is overvalued so there is nowhere to hide. The bottom line is that the chances of hitting retirement goals by searching for higher returns in stocks is extremely low.

The conditions of having under-saved for impending expenses while also confronting an interest rate environment that is adverse to accumulating wealth is one that is also starting to hit pension funds in the US hard. Even though such funds are typically managed by professional investors who can carefully evaluate risk, the reflex reaction of these institutional investors to search for higher returns has been extremely similar.

The only real difference is that the search for higher returns by institutional investors is even more vigorous, which is evidenced by many of them going even further out on the risk curve by increasing allocations to private equity. Grants Interest Rate Observer reports on one of the biggest players in the space in its April 5, 2019 edition:

“‘So, if I could give you a one-line exact summary of this entire presentation, it would be: We need private equity, we need more of it and we need it now,’ Ben Meng, GIG of the California Public Employees’ Retirement System, said at the pension plans’ Feb. 19 investment committee. ‘So, let’s talk about the first question. Why do we need private equity? And the answer is very simple, to increase our chance of achieving the seven-percent rate of return‘.”

Grants describes the decision-making logic:

“What’s a fiduciary to do? You can hardly meet a 7% investment hurdle with a 10- year Treasury yielding 2.5%, much less with a 10-year bund yielding negative 0.05%. The same low rates, of course, have decreased the cost of leverage and flattered the size of projected future cash flows—well and good for private equity’s cosmetic appeal.”

The case for private equity has more than just cosmetic appeal. The environment in which institutional funds make allocation decisions is culturally amenable to the strategy as Rusty Guinn reveals in a piece entitled, “Deals are my art form“:

“But if you want to understand, by and large, how big pools of capital make big decisions about how much of their plan will be allocated to private equity, venture capital, private real estate, hedge funds, alternative premia (and everything else), you must focus on the interactions that take place between the CIO office, the consultants and the board.

Asset owner boards are dominated by politicians, lawyers and businesspeople. Deal people. People for whom – like the Donald – The Deal is their art. Understanding the decision-making process of large pools of capital means understanding the deals! meme.”

In the challenging context of relatively high required returns, Guinn illustrates how the proclivity towards deal-making at the highest levels of institutional decision-making manifests itself:

“Consultants and some CIO offices that are targeting higher necessary returns are increasingly anchored to the asset classes that these assumption-driven models like. Why? Because every strategic asset allocation meeting for the last 5 years began, and every strategic asset allocation meeting for the next 10 years will begin with something akin to the following: Well, to meet our real return targets with these assumptions, we’d have to allocate 100% to either private equity or emerging markets! Ha ha ha! Of course, doing that would be imprudent, but…

Yeah, ‘but.’ Because by this time, the conversation has been framed. And in hundreds of rooms filled with truly smart, truly ethical, truly honest and well-meaning people infected with the deals! meme, private assets will not just feel like the understandable and straightforward strategy, they will look like the right and sensible and prudent thing to do as fiduciaries.”

While the high level of interest in private equity can be explained by the deal! meme and its cultural amenability, something else is going on to compel institutional investors to overcome its obvious shortcomings. And the critiques of private equity are widespread, harsh, and compelling.

For example, Grants quotes Daniel Rasmussen, who has written extensively on the subject. He asks, “Why would you, in aggregate, buy disproportionately levered companies at disproportionately high prices in a very late stage of a bull market?” He answers, “That doesn’t seem like a very good idea. But when you call it private equity and take away the mark to market, suddenly it is a thing that everybody wants.”

James S. Chanos, founder and managing partner of Kynikos Associates, L.P., also speaks out against private equity in Grants. He thinks the value proposition of private equity will start undergoing the same kind of scrutiny that has been applied to hedge funds the last five to ten years. Specifically, Chanos thinks asset allocators will start to question why they are increasing allocations to an asset class “that over the long run seems to be matching at best public-market indexes with reduced liquidity, higher fees after a monstrous rise in corporate valuations and a once-in-a-generation drop in interest rates.”

AQR Capital Management also recently published its own evaluation of private equity and also found the approach lacking in merit. The AQR report assesses, “Our estimates [of returns on private equity] display a decreasing trend over time, which does not seem to have slowed the institutional demand for private equity.” They too suspect that the “return-smoothing properties of illiquid assets in general” may be part of the appeal to certain investors.

John Dizard summarizes the value proposition of private equity in the Financial Times:

“If stock volatility is scary, lever up the portfolio with borrowed money, stop marking to market, and call it ‘private equity’. Problem solved.“

Whether it is individual investors increasing exposure to stocks or institutional investors increasing exposure to private equity, it is clear that the search for higher returns has evolved into a heated competition. The competition though, is based on a fallacy. When Guinn describes the pension conversation as being “framed”, he means that it is unduly and artificially constrained in its consideration of possible solutions.

Ben Inker from GMO elaborates on exactly this scenario by noting, “Risk is not merely a function of the volatility of the investment portfolio but also of the relationships between the investment portfolio, the liability, and the nonportfolio assets.” While changes can be made to the liability variable by renegotiating retirement benefits, Inker focuses on the importance of considering contributions:

“But most pension fund managers tend to stop there, failing to fully take into account the assets outside of the portfolio that are relevant to the overall problem – the potential of the fund sponsor to make additional contributions to the pension portfolio when needed.”

The appropriate allocation of financial assets to a retirement plan depends partly on the expected returns of those assets, but only partly. It also depends on the level of retirement benefits desired and on contributions (and asset volatility and investment horizon). As a result, undue focus on returns is a false choice. The bad news is that many institutional pension plans have little or no ability to reduce benefits or increase contributions. The good news is that individuals normally have a great deal more flexibility to manage through a low return environment.

Just how little flexibility many institutions have in regard to pension funding is illuminating. Grants captures this with the testimony by James P. McNaughton, assistant professor of management at the Kellogg School of Management, to a House of Representatives subcommittee dealing with the pensions crisis:

“While approximately 60% of multiemployer plans are currently certified in the green zone in recent PBGC reports, that number would drop to around 7% if discount rates were based on current corporate bond yields. In other words, on an annuity purchase basis, only 7% of plans have 80% of assets needed to purchase annuities for their participants.” 

This describes fairly clearly the predicament that pension fund managers are in. Only 7% of multiemployer plans are funded well enough to honor their promises with a very high likelihood of success. All the others are stuck between a rock and hard place: They can either try to renegotiate the promises by reducing pension benefits (which is difficult politically) or they can increase allocations to riskier assets and significantly increase the risk of losses.

Such incredibly poor funding levels reveal a number of important things about the investment landscape. For one, the response by many institutions to chase returns, increase leverage, and obscure volatility has all the makings of desperation. As Grants points out, “If you expect big, perhaps unreasonable, things from your p.e. allocation, it’s because you need them. You want to believe.” It sounds more like someone down on their luck going to a loan shark than it does a high-quality decision-making process.

As it happens, some private equity funds even seem to be playing the role of loan shark. The Financial Times reports that despite the increasingly problematic value proposition of private equity and the pressure on fees almost everywhere, some funds are actually raising their performance fees in what appears to be a form of surge pricing:

“Investors seem to have a weak hand when it comes to negotiating terms. Large institutions — under pressure to seek yield in a low interest rate environment — do not complain about terms because they fear being cut back or being excluded from a popular fund.”

This raises an interesting possibility that also reflects on today’s investment environment. Typically, large institutional investors have been considered “smart money”. As a result, other investors look to them for information content, clamoring to benefit from whatever they are doing. When institutional investors go progressively further out on the risk spectrum, it sends a signal that that might be a “smart” thing to do.

But what if the “smart money” isn’t so smart anymore? It’s not to suggest that the people running institutional funds are any less intelligent but rather that they are more desperate. They aren’t chasing returns so much because they think it is a great investment decision but because they believe they have to do something, and they don’t have a choice. Insofar as this is the case, their search for higher returns signals an increasingly desperate race that is likely to end badly. It is one that should be avoided, not emulated.

John Dizard sums it up well, barely containing his revulsion:

“Prof Siegel and his followers have been telling people what they want to hear, though he no doubt believes it himself. I believe the collective opinions, policies and investment decisions based on the high equity return cult will lead to social, economic and political disaster.“

This suggests another important thing about the investment landscape. The pension funding crisis is a very big and interconnected issue that will affect everyone. There is already talk of legislation to rescue multiemployer pension plans that fail. Any effort to do so will set a dangerous precedent of redistributing tax income to bail out mismanaged plans. John Mauldin expects there to be pain and describes how it will likely affect incomes: “As with the federal debt, some portion of this unfunded pension debt is going to get liquidated in some manner. Any way we do it will hurt either the pensioners or taxpayers.”

In a similar sense, Grants describes (in its August 10, 2018 letter) how the pension funding crisis will likely affect risk assets:

“The fancy prices that the p.e. firms pay for listed companies (or the neglected and undermanaged subsidiaries thereof) contribute to the lift in public-market equity averages. The returns that p.e. has earned, and—it is hoped—will earn again, support an immense structure of debt. Unwarranted expectations concerning p.e. returns raise false hopes for deeply underfunded pension funds. In short, private equity is everybody’s business.”

So, this season for horse racing serves as a useful reminder that the race to fund pension plans is on but promises to be a much uglier affair. As such, it also serves as a reminder for investors to carefully align the risks of their assets with their investment horizons. Otherwise, they may end up chasing returns in a thankless race.

Just a week ago, I was still fairly comfortable with the bullish argument. Note that I did not say that I was a bull, or a bear, or any other market animal. What I saw on the charts, and yes, from the fundamental side, was still supportive of higher prices in the near-term.

My argument to readers/listeners was that the S&P 500 hit a very likely, and yes, logical, place where those looking to cash out might do so.

That’s a fancy way to say the index hit resistance. And naturally, the next step was to look for a likely place for this pullback to find support.

Could it be the 38.2% Fibonacci from the December low? That would be roughly an 8% decline from peak prices in May. Hmmm… that seems a bit hefty for a garden variety pullback. That’s more like a correction if we are to believe the concocted cutoffs pushed by the media (10% is a correction, 20% is a bear market). I prefer to call then farkakteh cutoffs. (I like that this word was in MS-Word’s spell check).

So what’s next? Well, Monday morning as the Dow is down 500 or so on the latest on-again, off-again trade talks with China, the S&P is down about 4% from its peak. That seems reasonable for a pullback. No, I am not calling a bottom here, just looking for likely places that might occur.

Lo and behold, there is support there from October, November and December interim highs. But when emotions rule – more than usual – these are but mere suggestions of support. I certainly would not buy based solely on that.

One thing that caught my eye over the past week was that these opening morning dumps have mostly been reversed as the days wore on. Again, no forecast of that but if it happens yet again then we have to admit that there is still a good desire to buy stocks, despite the news.

Market breadth really did not deteriorate much. Not too much money flowed out of the major ETFs. And gold is not moving higher. All things that right now are not so bad for stocks.

But keeping with money flows, each peak over the past year has been trending lower, even though prices made similar or higher highs.  That’s not great.

My conclusion? It is close to decision time. The pullback is still in line with a rising trend from December and is still above the 200-day average. But I need some sort of signal that the upside reversal is at hand because I also see a downside bowtie crossover perhaps a few days away. If that happens, then I will have to re-evaluate my stance.

Myopia

As a long-time glasses and contact lens wearer, I am quite qualified to define this word. It means being able to see what’s right in front of me but not what’s out there farther away.  You may call it “nearsighted.” As a side note, I’ve had cataract surgery on both eyes and no longer need any corrections. I won’t say it has helped my market forecasting but I am quite happy with the results, otherwise.

Anyway, we often zero in on the S&P 500 as the go-to index we use in prognosticating. As some now look for a potential triple top here (I disagree with that characterization, but that is for another time), the same pattern is not evident in other major indices. The Dow is close to having three similar peaks. NYSE composite? No. Russell 2000? No. Transports? No. And even my “four horsemen” sectors (tech, housing, retail and financial) are not even close to this formation.

Therefore, it is hard for me to say that “the market” hit resistance and fell away. Yes, the S&P 500 is the big daddy of market cap but it is also rather at the mercy of international trade. And right now, everyone seems to have their panties in a bunch over China. Without getting sucked into the politics, the Chinese stock market looks a lot weaker than the domestic market and that tells me they have a weaker hand to play.

The numbers here still look pretty good (yeah, fundamental dabbling). And as long as Congress is in full gridlock mode, that is usually pretty good for stocks, too.

Therefore, I am hopeful but waiting for a sign that the buyers are back for real. If not, this is not a falling knife I’m willing to catch.

When we embarked on our Value Your Wealth series, we decided to present it using a top-down approach. In Parts One and Two, we started with basic definitions and broad analysis to help readers better define growth and value investment styles from a fundamental and performance perspective. With this basic but essential knowledge, we now drill down and present investment opportunities based on the two styles of investing.

This article focuses on where the eleven S&P sectors sit on the growth-value spectrum. For those that invest at a sector level, this article provides insight that allows you to gauge your exposure to growth and value better. For those that look at more specialized funds or individual stocks, this research provides a foundation to take that analysis to the next level.

Parts One and Two of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Sector Analysis

The 505 companies in the S&P 500 are classified into eleven sectors or industry types. While very broad, they help categorize the S&P companies by their main source of revenue. Because there are only eleven sectors used to define thousands of business lines, we must be acutely aware that many S&P 500 companies can easily be classified into several different sectors.

Costco (COST), for instance, is defined by S&P as a consumer staple. While they sell necessities like typical consumer staples companies, they also sell pharmaceuticals (health care), clothes, TVs and cars (discretionary), gasoline (energy), computers (information technology), and they own much of the property (real-estate) upon which their stores sit.

Additionally, there is no such thing as a pure growth or value sector. The sectors are comprised of many individual companies, some of which tend to be more representative of value and others growth.

As we discussed in Part Two, we created a composite growth/value score for each S&P 500 company based on their respective z-scores for six fundamental factors (Price to Sales, Price to Book, Price to Cash Flow, Price to Earnings, Dividend Yield, and Earnings Per Share). We then ranked the composite scores to allow for comparison among companies and to identify each company’s position on the S&P 500 growth-value spectrum. The higher the composite score, the more a company is growth oriented and the more negative the score, the more value-oriented they are.  

The table below summarizes the composite z-scores by sector.  To calculate this, we grouped each company based on its sector classification and weighted each company’s z-score by its market cap. Given that most indexes and ETFs/Mutual funds are market cap weighted, we believe this is the best way to arrange the sector index scores on the growth-value spectrum. 

Data courtesy Bloomberg

As shown, the Financial, Energy, and Utility sectors are the three most heavily weighted towards value.  Real-estate, Information Technology, and Consumer Discretionary represent the highest weighted growth sectors.

While it might be tempting to select sectors based on your growth-value preferences solely using the data in the table, there lies a risk. Some sectors have a large cross-section of both growth and value companies.  Therefore they may not provide you the growth or value that you think you are buying. As an example, we explore the communications sector.

The communications sector (represented by the ETF XLC) is a stark combination of old and new economy stocks. The old economy stocks are traditional media companies such as Verizon, Fox, CBS and News Corp. New economy stocks that depend on newer, cutting edge technologies include companies like Google, Facebook, Twitter, and Trip Advisor. 

As one might expect, the older media companies with more reliable earnings and cash flows are priced at lower valuations and tend to be defined as value stocks by our analysis. Conversely, the new economy companies have much higher valuations, are short on earnings, but come with the prospect of much higher growth potential.

The scatter plot below offers an illustration of the differences between growth, value and market capitalization within the communications sector. Each dot represents the intersection of market capitalization and the composite z-score for each company. The table below the scatter plot provides fundamental and performance data on the top three value and growth companies.

Data courtesy Bloomberg

As shown in the graph, the weighted average z-score (the orange circle) for the communications sector leans towards growth at +0.19. Despite the growth orientation, we deem 58% of the companies in the communications sector as value companies.

The following table compares the weighted average z-score for each S&P sector along with the variance of the underlying companies within the sector and the percentage of companies that are considered value and growth. We use standard deviation on the associated composite z-scores to determine whether companies are close together or far apart on the growth/value spectrum.  The lower the standard deviation, the more similar the companies are in terms of growth or value

Data courtesy Bloomberg

Again here, weightings, market capitalization, and the influence of individual stocks within a sector are important to understand The industrial sector, as shown above, has a score of +0.232, which puts it firmly in growth territory. However, Boeing (BA), due to its large market cap and significant individual growth score skews this sector immensely. Excluding BA, the weighted average composite score of the industrial sector registers as a value sector at -0.07. Again this highlights the importance of understanding where the growth and or value in any particular sector comes from.

Takeaways

The graph below shows the clear outperformance of the three most heavily growth-oriented sectors versus the three most heavily value-oriented. Since the beginning of the post-financial crisis, the three growth companies grew by an average of 480%, almost three times the 166% average of the three value companies.

This analysis provides you a basis to consider your portfolio in a new light. If you think the market has a few more innings left in the current expansion cycle, odds continue to favor a growth-oriented strategy. If you think the economy is late-cycle and the market is topping, shifting towards value may provide much-needed protection.  

While we believe the economic and market cycles are late stage, they have not ended. We have yet to receive a clear signal that value will outperform growth going forward. At RIA Advisors, growth versus value is a daily conversation, whether applied to sector ETF’s, mutual funds or individual stocks.  While we know it’s early, we also know that history has been generous to holders of value, especially after the rare instances when growth outperformed it over a ten-year period as it has recently.

At the beginning of this year, I was at dinner with my wife. Sitting at the table next to us, was a young financial advisor, who was probably in his mid-30’s, meeting with his client who appeared to be in his 60’s. Of course, the market had just experienced a 20% correction from the previous peak and the client was obviously concerned about his portfolio.

“Don’t worry, there is always volatility in the market, but as you can see, even bear markets are mild and on average the market returns 8% a year over the long-term.” 

Here is the chart which shows the PERCENTAGE return of each bull and bear market going back to 1900. (The chart is the S&P 500 Total Return Inflation-Adjusted index.)

Here is the narrative used with this chart.

“The average bear market lasts 1.4 years on average and falls 41% on average.-The average bull market (when the market is rising) lasts 9.1 years on average and rises 476% on average.”

While the statement is not false, it is a false narrative.

“Lies, Damned Lies, and Statistics.”– Mark Twain

Here are the basics of math.

• If the index goes from 100 to 200 it is indeed a 100% gain.
• If the index goes from 200 back to 100, it is only a 50% loss.
• Mathematically it would seem as if an investor is still 50% ahead, however, the net return is actually ZERO.

This is the error of measuring returns in terms of percentages as it masks the real damage done to portfolios during a decline. To understand the real impact of bull and bear markets on a portfolio, it must be measured in POINTS rather than percentages.

The chart above exposes the basic realities of math, loss, and time. What becomes much more apparent is that bear markets tend to destroy most or all of the previous advance and has done so repeatedly throughout history.

Importantly, what was not being discussed between the advisor and his 60-something client was simply the risk of “time.”

There are many financial advisors, commentators, experts, and social media gurus who have never actually “been invested” during a real “bear market.” While the “theory of ‘buy and hold'” sounds good, kind of like MMT, in practice it is an entirely different issue. The emotional stress of loss leads to selling even by the most “die hard” of individuals. The combined destruction of capital and the loss of time is the biggest issue when it comes to individuals meeting their retirement goals.

The following chart the real, inflation-adjusted, total return of the S&P 500 index.

Note: The green lines denote the number of years required to get back to even following a bear market. It is worth noting the entirety of the markets return over the last 118-years occurred in only 4-periods: 1925-1929, 1959-1968, 1990-2000, and 2016-present)

That comment corresponds to the next chart. As noted, there have currently been four, going on five, periods of low returns over a 20-year period.

As discussed last week:

“Unless you have contracted ‘vampirism,’ then you do NOT have 90, 100, or more, years to invest to gain “average historical returns.” Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.

What drives those 12-15 year periods of flat to little return? Valuations.

Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals.”

In other words, the most important component of your investment success depends more on WHEN you start rather than IF you start.

That brings me to my second point of that nagging problem of “time.” 

Time Is An Unkind Companion

While it is nostalgic to use 100+ years of market data to try and prove a point about the benefits of “buy and hold” investing, the reality is that we “mere mortals” do not have the life-span required to achieve those returns.

“Despite the best of intentions, a vast majority of the ‘bullish’ crowd today have never lived through a real bear market.”

I have been managing money for people for a very long time. The one simple truth is that once an individual has lost a large chunk of their savings, they are very reluctant to go through such an experience a second time. This is particularly the case as individuals get ever closer to their retirement age.

Let’s remember that our purpose of investing is to:

 “Grow savings at a rate which maintains the same purchasing power parity in the future and provides a stream of living income.” 

Nowhere in that statement is a requirement to “beat a benchmark index.” 

For most people, a $1 million account sounds like a lot of money. It’s a big, fat round number. The problem is that the end number is much less important than what it can generate. The table below shows $1,000,000 and what it can generate at varying interest rate levels.

30-years ago, when prevailing rates were substantially higher, and living standards were considerably cheaper, a $1,000,000 nest egg was substantial enough to support retirement when combined with social security, pensions, etc.

Today,  that is no longer the case.

Since most investors only have 20 to 30-years to reach their goals, if that period begins when valuations are elevated, the odds of success falls dramatically.

This is why “time” becomes such an important determinate of success.

In all of the analysis that is done by Wall Street, “life expectancy” is never factored into the equations used when presenting the bullish case for investing. Therefore, in order to estimate future inflation-adjusted total returns, we must adjust the formula to include “life expectancy.” 

RTR =((1+(Ca + D)/ 1+I)-1)^(Si-Lfe)

Where:

• Ca = Capital Appreciation
• D = Dividends
• I = Inflation
• Si = Starting Investment Age
• Lfe = Life Expectancy

For consistency, we will assume the average starting investment age is 35. We will also assume the holding period for stocks is equal to the life expectancy less the starting age. The chart below shows the calculation of total life expectancy (based on the average of males and females) from 1900-present, the average starting age of 35, and the resulting years until death. I have also overlaid the rolling average of the 20-year total, real returns and valuations.

Importantly, notice the level of VALUATIONS when you start investing has everything to do with the achievement of higher rates of return over the investable life expectancy of an individual. 

There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.

As shown in the chart box below, I have taken a $1000 investment for each period and assumed a real, total return holding period until death. No withdrawals were ever made. (Note: the periods from 1983 forward are still running as the investable life expectancy span is 40-plus years.)

The gold sloping line is the “promise” of 6% annualized compound returns. The blue line is what actually happened with invested capital from 35 years of age until death, with the bar chart at the bottom of each period showing the surplus or shortfall of the goal of 6% annualized returns.

In every single case, at the point of death, the invested capital is short of the promised goal.

The difference between “close” to goal, and not, was the starting valuation level when investments were made.

This is why, as I discussed in “The Fatal Flaws In Your Retirement Plan,” that you must compensate for both starting period valuations and variability in returns when making future return assumptions. If you calculate your retirement plan using a 6% compounded growth rates (much less 8% or 10%) you WILL fall short of your goals. 

The Next Bear Market Will Be The Last

After two major bear markets since the turn of the century, a vast majority of “baby boomers” are woefully unprepared for retirement. Dependency on social welfare is at record highs, individuals are working far longer into retirement than at any other point in history, and after a decade long bull market many investors have only just recently gotten back to where they were 10-years ago.

It is from this point, given valuations are once again pushing 30x earnings, that we review the expectations that individuals facing retirement should consider.

• Expectations for future returns and withdrawal rates should be downwardly adjusted due to current valuation levels.
• The potential for front-loaded returns going forward is unlikely.
• Your personal life expectancy plays a huge role in future outcomes. 
• The impact of taxation must be considered.
• Future inflation expectations must be carefully considered.
• Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
• The yield chase over the last 10-years, and low interest rate environment, has created an extremely risky environment for investors. Caution is advised.
• Expectations for compounded annual rates of returns should be dismissed in lieu of variable rates of return based on current valuation levels.

Importantly, chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely realize.

For the majority of individuals today facing, or in, retirement the two previous bear markets have left many further away from retirement than they ever imagined.

The next one will destroy those goals entirely.

Investing for retirement, should be done conservatively, and cautiously, with the goal of outpacing inflation, not the market, over time. Trying to beat some random, arbitrary index that has nothing in common with your financial goals, objectives, and most importantly, your life span, has tended to end badly for individuals.

You can do better.

We are adding a new monthly review of important commodities which may provide clues as to both the strength and direction of the markets and the economy.

CRB Index

• If the economy was as strong as headlines suggest, the commodity index should be rising as demand for commodities grows. This was clearly apparent in mid-2017 as 3-major hurricanes and 2-massive wildfires devastated the U.S. requiring demand for raw materials.
• This same story will be evidence in the following economically sensitive commodities as well.
• A break below $178 will likely signal a test of fairly long-term lows below $170
• No trade yet for $CRB

Copper

• Copper, often called “Dr. Copper” because of its sensitivity to economic demand has remained weak as the rolloff of demand from natural disasters continues.
• Still correcting its recent overbought condition and close to a sell signal suggests copper may well continue to weaken.
• No position currently.
• A break below $2.50 will likely suggest a test of $2.00 amidst a pickup in economic weakness.

Lumber

• Lumber is looking to retest lows of the last 3-yeas, and like the CRB, it is clear the demand spike, and subsequent economic input from natural disasters, is over.
• Lumber is close to triggering a “sell signal.”
• A break below $300 will suggest both accelerating economic weakness and substantially lower lows.
• No position currently.

Soybeans

• One look at this chart and you can understand why American farmers are filing for bankruptcy.
• With global demand slowing, the acceleration of the decline is becoming apparent. It is unlikely even a trade agreement with China at this point will repair the damage.
• Soybeans are oversold BUT on an important sell signal.
• There is a trade to $875 only. But the downside risk outweighs the reward.
• Stops must be set at $800

Live Cattle

• Demand for beef is on the decline and I am pretty sure “Beyond Meat” is NOT the culprit.
• Given the cost of meat, cattle is a decent indicator of economic strength.
• Cattle are oversold here BUT on an important “sell” signal.
• No trade currently, but watch the message live cattle are sending.

Lean Hogs

• Hogs are current performing better than live cattle and support is holding at $6.00
• However, Hogs are overbought on the short-term and are carrying a very elevated “buy” signal.
• If economic weakness is increasing, then look for a break back down to previous lows.
• No position currently, but watch the $6.00 level for the next signal.

US Dollar Index

• With roughly 40-50% of corporate profits coming from exports, all commodities globally traded in dollars, and the dollar impact on the bond market, this is a key measure to watch. Trade war will have an impact across many sectors of the market and the dollar will likely tell the story.
• Currently, the dollar is breaking out of previous resistance and has now registered a buy signal. The combination of these two catalysts suggests the dollar could rise toward $100 on the index.
  
• With the dollar flirting with a “buy signal,” a stronger dollar looks to be the play as the “trade war” attracts foreign dollars into U.S. Treasuries.
• Be long the dollar with an initial target of $100.

10-Year Interest Rates

• As noted above, the stronger dollar and the “trade war” are driving foreign investors into the “safety” of the U.S. Dollar.
• Rates just broke below the previous lows of 2.4% and suggests a potential test of 2.1% may be in the works.
• Add to long-bond positions and increase duration slightly in portfolios. (7-10 years).
• Rates are oversold so a buy towards 2.5% would likely be an ideal entry point to add exposure.

Gold

• Gold held important support at $1270 and is wrestling to climb above its 50-dma.
• Gold is threatening to trigger a short-term sell signal so support at $1270 needs to hold for the time being.
• Hold positions but be patient in adding exposure until the 50-dma is broken above.
• Maintain at stop-loss at $1250

Oil – Black Gold

• The rally in oil from the 2018 lows appears to be complete.
• The good news is that oil is holding support at the 50-dma which has finally crossed back above the 200-dma.
• Stay long oil and energy-related investment for now BUT be critically mindful that oil is ultimately negatively impacted by both a weaker economy and strong dollar.
• Stops must be set at $58.
• That signal has been triggered and VTR is not yet oversold.
• We blew through our initial $60 target so cover 1/2 of the position immediately.
• Stop is now moved to $62
• Position can be re-shorted on a failed rally to $61.50

For the last several years, there has been a tremendous amount of activity and hype in the tech startup arena. In addition to the tens of thousands of startups that been founded in recent years, there are over three-hundred new “unicorn” startups that have valuations of $1 billion or more. Most of these unicorns came of out virtually nowhere and amassed tremendous valuations despite hemorrhaging cash, which is a tell-tale sign of a bubble. The recent announcement of a new Silicon Valley stock exchange for “hot startups, particularly those that are money-losing” is an indication of the amount of hubris and hype there is in the startup arena right now –

The U.S. Securities and Exchange Commission approved the creation of the Long-Term Stock Exchange, or LTSE, a Silicon Valley-based national securities exchange promoting what it says is a unique approach to governance and voting rights, while reducing short-term pressures on public companies.

The LTSE is a bid to build a stock exchange in the country’s tech capital that appeals to hot startups, particularly those that are money-losing and want the luxury of focusing on long-term innovation even while trading in the glare of the public markets.

The stock exchange was proposed to the SEC in November by technology entrepreneur, author and startup adviser Eric Ries, who has been working on the idea for years. He raised $19 million from venture capitalists to get his project off the ground, but approval from U.S. regulators was necessary to launch the exchange.

The tech startup bubble formed as a result of the Fed and other central banks’ extremely loose monetary policies after the Great Recession. In a desperate attempt to jump-start the global economy again, central banks cut and held interest rates at virtually zero percent for much of the past decade and pumped trillions of dollars worth of liquidity into the global financial system. The chart of the Fed Funds rate below shows how bubbles form when interest rates are at low levels:

Loose global monetary policy led to an explosion of venture capital activity over the past several years:

Trillions of dollars worth of central bank-created liquidity has been sloshing around the globe looking for a home and a portion of it found its way into unicorn companies that are worth billions of dollars each:

Today’s unicorns are equivalent to dot-com companies in 1999 and will have the same fate, unfortunately. Though some of the unicorns will survive and become successful in the longer-run like Amazon and eBay, there is going to be a tremendous shakeout that is going to slash valuations and weed out the Pets.coms and Webvans. Thousands, if not tens of thousands, of tech startups are going to fold when this bubble bursts. The abysmal performance of two recent high-profile unicorn IPOs, Lyft (down nearly 50% since its IPO) and Uber, may be a sign that air is starting to come out of the unicorn bubble. It will be interesting to see if the Long-Term Stock Exchange will be able to go live before the unicorn bubble bursts.

This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.  

How often do you think about what the dollar bills in your wallet or the pixel dollar signs in your bank account are? The correct definitions of currency and money are crucial to our understanding of an economy, investing and just as importantly, the social fabric of a nation. It’s time we tackle the differences between currency and money and within that conversation break the news to you that deficits do matter, TRUST me.

At a basic level, currency can be anything that is broadly accepted as a medium of exchange that comes in standardized units. In current times, fiat currency is the currency of choice worldwide. Fiat currency is paper notes, coins, and digital 0s and 1s that are governed and regulated by central banks and/or governments. Note, we did not use the word guaranteed to describe the role of the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the currency that it will retain its value and the TRUST that others will accept it in the future in exchange for goods and services.

Whether its yen, euros, wampum, bitcoin, dollars or any other currency, as long as society is accepting of such a unit of exchange, trade will occur. When TRUST in the value of a currency wanes, commerce becomes difficult, and the monetary and social prosperity of a nation falters. The history books overflow with such examples.

Maslow and Currency

Before diving into the value of a currency, it is worth considering the role it plays in society and how essential it is to our physical and mental well-being. This point is rarely appreciated, especially by those that push policies that debase the currency.

Maslow created his famous pyramid to depict what he deemed the hierarchy of human needs. The levels of his pyramid, shown below, represent the ordering of physiological and psychological needs that help describe human motivations. When these needs are met, humans thrive.

Humans move up the pyramid by addressing their basic, lowest level needs. The core needs, representing the base, are physiological needs including food, water, warmth and rest. Once these basic needs are met, one then seeks to attain security and safety. Without meeting these basic physiological and safety needs, our psychological and self-fulfillment needs, which are higher up the pyramid, are difficult to come by. Further, as we see in some third-world countries, the social fabric of the nation is torn to shreds when a large part of the population cannot satisfy their basic needs.

In modern society, except for a few who live “off-the-grid,” fiat currency is the only means of attaining these necessities. Possession of currency is a must if we are to survive and thrive. Take a look back to the opening paragraphs and let’s rephrase that last sentence: possession and TRUST of currency is a must if we are to survive and thrive.

It is this most foundational understanding of currency that keeps our economy humming, our physical prosperity growing and our society stable. The TRUST backing the dollar, euro, yen, etc. is essential to our financial, physical and psychological welfare.

Let’s explore why we should not assume that TRUST is a permanent condition.

Deficits Don’t Matter…. or Do They?

Having made the imperative connection between currency and TRUST and its linkage to trade and commerce along with our physical and mental well-being, we need to explore the current state of the United States government debt burden, monetary policy, and the growing belief that deficits don’t matter.

Treasury debt never matures, it is rolled over. Yes, a holder of a maturing Treasury bond is paid in full at maturity, however, to secure the funds to pay that holder, the government issues new debt by borrowing money from someone else. Over time, this scheme has allowed deficits to expand, swelling the amount of debt outstanding. Think of this arrangement as taking out a new credit card every month to pay off the old card.

The chart below shows U.S. government debt as a percentage of GDP. Since 1967 government debt has grown annually 2% more than GDP.

Data Courtesy: St. Louis Federal Reserve

Continually adding debt at a faster rate than economic growth (as shown above) is limited. To extend the ability to do this requires declining interest rates, inflation and a little bit of financial wizardry to make debt disappear. Fortunately, the U.S. government has a partner in crime, the Federal Reserve.

As you read about the Fed’s methods to help fund deficits, it is important to consider the actions they routinely take are at the expense of the value of the currency. This warrants repeating since the value of the currency is what supports TRUST in the currency and allows it to retain its functional purposes.

The Fed helps the government consistently run deficits and increase their debt load in three ways.

1. The Fed stokes moderate inflation.
2. The Fed manages interest rates lower than they should be.
3. The Fed buys Treasury and mortgage securities (open market operations/QE) and, as we are now witnessing, monetizes the debt.

Inflation

Within the Fed’s charter, Congress has mandated the Fed promote stable prices. To you and me, stable prices would likely mean no inflation or deflation. Regardless of what you and I think, the Fed interprets the mandate as an annual 2% rate of inflation. Since the Fed was founded in 1913, the rate of inflation has averaged 3.11% annually. That rate may seem inconsequential, but it adds up. The chart below illustrates how the low but consistent rate of inflation has debased the purchasing power of the dollar.

Data Courtesy: St. Louis Federal Reserve

$1 borrowed in 1913 can essentially be paid off with .03 cents today. Inflation has certainly benefited debtors.

Interest Rate Management

For the better part of the last decade, the Fed has imposed price controls that kept interest rates below what should be considered normal. Normal, in a free market economy, is an interest rate that compensates a lender for credit risk and inflation. Since Treasury debt is considered “risk-free,” the predominant risk to Treasury investors is earning less than the rate of inflation. As far as “risk-free”, read our article: The Mind Blowing Concept of Risk-Free’ier.

If the yield on the bond is less than inflation, as has recently been the case, the purchasing power and wealth of the investor declines in the future.

The table below highlights how U.S. Treasury real rates (yields less CPI) have trended lower over the past forty years. In fact, over the last decade, negative real rates are the norm, not the exception. When investors are not properly compensated by the U.S. Treasury, the onus of government debt is partially being put upon investors. We have the Fed to thank for their Fed Funds (FF) policy of negative real rates.

Data Courtesy: St. Louis Federal Reserve

Fed Balance Sheet

The Fed uses its balance sheet to buy and sell U.S. Treasury securities to manage the money supply and thus enforce their interest rate stance. In 2008, their use of the balance sheet changed. From 2008 through 2013, the Fed purchased nearly $4 trillion of Treasury and mortgage-backed securities in what is called Quantitative Easing (QE). By reducing the supply of these securities, they freed up liquidity to move to other assets within the capital markets. The action propped up asset prices and helped keep interest rates lower than they otherwise would have been.

Since 2018, they have reversed these actions by reducing the size of their balance sheet in what is called Quantitative Tightening (QT). This reversal of prior action essentially makes the benefits of QE temporary. However, if they fail to reduce it back to levels that existed before QE was initiated, then the Fed permanently monetized government debt. In plain English, they printed money to extinguish debt.

As we write this article, the Fed is in the process of ending QT. Based on the Fed schedule as announced on March 20, 2019, the balance sheet will permanently end up $2.28 trillion larger than from when QE was initiated. To put that in context, the balance will have grown 269% since 2008, as compared to 48% economic growth.

Data Courtesy St. Louis Fed

The methods the Fed employs to manage policy as described above, all involve using their balance sheet to alter the money supply and help the Treasury manage its deficits. We can argue the merits of such a policy, but we cannot argue a basic economics law; when there is more of something, it is worth less. When something of value is created out of thin air, its value declines.

At what point is debt too onerous, deficits too large and the Fed too aggressive such that TRUST is harmed? No one knows the answer to that question, but given the importance of TRUST in a fiat currency regime, it would be wise to avoid actions that could raise doubt. Contrary to that guidance, current fiscal and monetary policy throws all TRUST to the wind.

Prelude to Part 2

As deficits grow and government debt becomes more onerous, the amount of Fed intervention must become greater.  To combat this growing problem, both political parties are downplaying deficits and pushing the Fed to do more. In part 2 we will explore emerging fiscal mindsets and what they might portend. We will then define money, and with this definition, show why the difference between currency and money is so important. 

The global economy is apparently facing a significant problem. Inflation’s gone missing! Central bankers can’t seem to stoke it no matter how deftly they act. Neither lowering interest rates to zero (and less) nor endless amounts of Quantitative Easing (QE) appear to make any difference. This, we’re told, is a problem that is equally as serious as it is perplexing. However, this position puzzles me. What if it’s not inflation that’s lacking, but rather our understanding of it? More importantly, might this disconnect have significant ramifications for investment portfolios?

In my opinion, there are two ways in which inflation is misunderstood. The first stems from misapplying a commodity-based monetary standard practice to a fiat convention. The second potential error is placing too much importance on unit prices as an economic signal. It’s possible, I think, that both had a hand in producing the 40-year secular decline in interest rates.

Inflation Is A Currency Phenomenon

Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The Merriam-Webster dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.” Here, we can see that inflation is a relative term. It compares the value of goods and services to money.

While these definitions are commonplace today, they are in fact modern redefinitions. Inflation was first used to describe the value of (paper) currency compared to a monetary standard, not to goods and services. Emperors clipping coins didn’t devalue money per se. The standard, which was typically defined as some unit weight of commodity metal, remained constant. Rather, they merely lessened the monetary value of each coin in circulation. Hence, it took more currency to purchase the same goods and services. The same held true for paper currencies convertible into gold. Lowering exchange rates reduced their purchasing power. This was inflation. To clarify Dr. Friedman’s definition, inflation is not a monetary phenomenon, it’s a currency phenomenon!

Inflation Was Lost In Translation

Today, however, we operate under a fiat monetary standard. There is no physical definition of a dollar apart from the currency itself. A dollar is simply what someone else is willing to accept for it in trade. Given that governments create the fiat currencies used in commerce (currencies, not money!), it follows that monetary authorities would require some metric to assess if the quantity produced is optimal.

Enter the modern—and in my view, flawed—concept of inflation. It’s determined by tracking the change of the average price of a basket of goods. There are many different indices with many different mixes of goods and services, with many different kinds of adjustments made. Inflation’s use in monetary policy is to provide policymakers with an objective signal with respect to the amount of currency in circulation.

“In the earlier definition, inflation is something that happens to the circulating media at a given price level; in the later definition, an inflating currency is defined to exist when it produces a rise in the general price level, as suggested by the quantity theory. What originally described a monetary cause came to describe a price effect.” [Emphasis is mine.]

Michael F. Bryan, On the Origin and Evolution of the Word Inflation

The attempt to bring objectivity to an arbitrary, fiat system is valiant. It is, however, flawed. Put aside the issues of measurement and representation of the popular indices (hedonic adjustments anyone?). Defining monetary value in terms of tangible goods and services ignores the most fundamental fact about human wealth and prosperity creation; and it’s hiding in plain sight.

Deflation Is The Hallmark Of Prosperity And Progress

There’s no surer way to scare a macroeconomist than to utter the word “deflation.” This euphemism for falling prices conjures up thoughts of economic depression, breadlines, unemployment, and poverty. Thus, deflation must be avoided at all cost it is thought. This fear has apparently short-circuited the critical thinking mechanism of some very bright people. None seem to realize that, by our modern definition, deflation is the hallmark of prosperity and progress.

Just think for a moment. The dramatic fall in general prices is a corollary to wealth. Affordability yields abundance, comfort, and joy. Who doesn’t want more and better goods and services at an exponentially cheaper cost? (Well, macroeconomists I suppose, but I bet most are compartmentalized on this subject.)

One study demonstrates this very fact by scaling food costs to the value of unskilled labor. It found that prices exponentially fell for basic needs.

1. The time price (i.e. nominal price divided by nominal hourly wage) of our basket of commodities fell from 47 hours of work to ten … .
2. The unweighted average time price fell by 79 percent … .
3. Put differently, for the same amount of work that allowed an unskilled laborer to purchase one basket of the 42 commodities in 1919, he or she could buy 7.6 baskets in 2019 … .
4. The compounded rate of ‘affordability’ of our basket of commodities rose at 2.05 percent per year … .
5. Put differently, an unskilled laborer saw his or her purchasing power double every 34 years … .”

Marian L. Tupy, Unskilled Workers and Food Prices in America (1919-2019)

This becomes more starkly apparent if you remove money from the equation altogether. Consider this: Go back far enough and everyone was a subsistence farmer (or hunter/gatherer). In other words, virtually 100% of an entire population’s time and effort was spent on producing the basic necessities for survival. Today, less than 5% of those in developed countries work in agriculture. The other 95% produce everything else that improves our lives.

Source: Our World in Data

Now that’s some massive deflation, at least according to our modern definition! Were these horrible times? Hardly so! Deflation, it turns out, is present throughout all prosperous periods of human history. Of course no one called this deflation because, quite frankly, it’s not. True inflation is a currency phenomena. It has nothing to do with the value of goods and services.

Using the modern inflation concept in monetary policy simply makes no sense. Deflation is desirable. It’s inflation we should fear. A rise in general prices can only result from wealth destroying shortages or the imposition of unnatural competitive barriers (i.e. regulation and tariffs). The invisible hand ensures just this.

Inflation’s Usage Is Misplaced

Putting this aside for a moment, macroeconomists apply inflation inconsistently. It can connotes both economic growth (good) and monetary debasement (bad). What I find most bizarre though, is for exactly 2.0% inflation to be monetary panacea despite its arbitrary origin.

“’It was almost a chance remark,’ [former Reserve Bank of New Zealand Governor] Mr. Brash said in a recent interview. ‘The [2% inflation target] figure was plucked out of the air to influence the public’s expectations.’”

Neil Irwin, Of Kiwis and Currencies: How a 2% Inflation Target Became Global Economic Gospel

Furthermore, the importance that macroeconomists place on unit prices is misplaced in my view; that is if one is interested in monitoring economic conditions.

Inflation in macro is assumed to be information-laden. To practitioners, it signals tightening economic conditions such that prices rise. Falling prices, on the contrary, indicate excess “slack”; that resources are under-utilized and a cause for alarm. Perhaps most silly is the belief that price declines prevent consumers from spending. If this were truly the case few would own TVs and other consumer electronics; the Industrial Revolution would have stopped dead in its tracks.

Lost on these economists is that prices are just one tiny piece of the economic machinery. Companies change them for a whole slew of reasons. In fact, not only should prices fluctuate, they do because they are effects.

Getting Micro With The Macro

While on the surface this inflation perspective appears logical, it lacks a basis in reality. For inflation to carry significance, prices should be of paramount concern to businesses. After all, macroeconomics is merely the aggregation of the micro. Analyzing commercial activities reveals that this is simply not the case.

Consider this: Businesses seek to maximize profit (or cash flow). Profits are a function of both revenues and expenses. While important, prices are just one component of the profit algorithm.

Profit ($) = price ($ per unit) x volume (units) – costs ($)

From this equation it should be abundantly clear that a company’s fortune rests upon more than unit prices. In fact, profits might rise despite prices falling. This routinely happens when companies expand capacity or increase productivity (i.e. lower unit costs). Lower prices facilitate higher volumes which can increase efficiency. This combination often leads to greater profits, which is the ultimate goal .

True, falling prices might indicate a lack of demand. But often times they times don’t. The same applies for the economy writ large.

Profound Investment Implications

In summary, I find the treatment of inflation to be flawed in two ways. First, defining monetary stability in terms of goods and services is inconsistent with its original conception. Inflation simply has no relevance in a fiat currency regime due to the lack of an objective standard. Secondly, the fixation on unit prices for assessing macroeconomic health seems disconnected from microeconomic realities.

Today’s lack of inflation is not a problem; it’s prosperity. So long as markets and people are left free to create and work, deflation will likely persist. We should expect (and welcome) inflation target undershoots in spite of policymakers concocting all sorts of crazy theories and policies in order to stoke it. (Thank goodness!)

The investment implications are potentially profound. What if these misunderstandings underpin the secular decline in interest rates? If so, it seems likely that markets will continue to incorrectly process the incoming inflation data given how institutionalized inflation is in investment frameworks. This should present profitable opportunities for the rest of us. Perhaps the undershooting of inflation targets—and other related trends—will persist as the growth we’re enjoying continues. In that case, I, for one, look forward to disappointing inflation readings for years to come … for both my wallet’s and investment portfolio’s sake.

In 2009, I shared 2 words on Facebook that I felt would shape the future of our social and economic discussions:

Socialism & Nationalism.

Not trying to be a smarta**, however, I told you so.

A shallow economic recovery (one of the weakest post-WW2), since the Great Recession, intervention by the Fed and persistent greed from U.S. corporations that place shareholders and senior executives above all else, have blossomed dissatisfaction with the very heart of our system.

In 2012, I outlined in my book Random Thoughts of a Money Muse, how I believed the financial crisis would permanently alter the focus of C-Suite executives and corporate boards. My thought was publicly traded companies would operate in a state of permanent recession regardless of business cycle, and lastingly consider employees as ‘excess baggage,’ thus seek to reduce headcount whenever possible. I also wrote that wage growth would remain stagnant and employees would bear a greater burden of healthcare costs through high-deductible insurance plans.

No, I’m no psychic. My personal corporate employment experience post-financial crisis forced me on a path of painful self-discovery. Creative pay cuts, cancerous morale where motivational speak sounded more like threat of unemployment (BE THANKFUL you have a job), crushing sales targets, outright lies to the frontlines meant to keep clients in an imploding proprietary product, compelled me to re-shape my views about the company and jumpstart additional research into corporate behavior. At a contentious arbitration, I vocalized how I went from the custodian of the clients’ dreams to custodian of shareholder dreams. That’s not what I signed up for. I am and always will be a fiduciary and advocate for clients first.

Jonathan Tepper wrote in his eye-opening tome “The Myth of Capitalism:” Today, votes for Sanders, Trump and Brexit are the expression of discontent by the “Newly Poor.” They feel the system is rigged against them and future is not as bright as the past.

Historian Will Durant warned that societies fall apart when inequality is too severe.”

The market now pays attention to extreme views which reinforces my belief that socialism has crept into conventional thought. There was a time when markets would ignore outlier political sentiments. The recent example of healthcare stocks trashed in fear of Medicare for all initiatives tells me the market, as a leading indicator, believes our capitalist structure is being questioned. The cracks are beginning to spring leaks.

Here are 4 charts that outline how the private sector has helped to nurture the seed of socialism in our American soil.

Surprisingly, Warren Buffett believes that stock buybacks represent an excellent use of capital. A passionate believer in value has now been converted into a momentum-growth market participant. There was a time in our history that stock buybacks were illegal. Considered stock price manipulation (which it is). So, what’s changed? Today, it’s a prevalent form of financial engineering. Corporations purchase shares in the open market, artificially boost EPS, decrease float and ultimately drive stock prices higher. Not coincidentally, CEO compensation lives and dies by stock share price.

If you’re investing periodically in index or other mutual funds in a 401(k) or another type of company defined-contribution plan, stock buybacks have indeed been a tailwind to your net worth.

Unfortunately, while we enjoy a light breeze at our financial backs as retail investors, the richest 10% of households control 84% of the total value in stocks as outlined in a 2017 NBER Working Paper penned by NYU professor Edward N. Wolff – “Household Wealth Trends In The United States, 1962-2016: Has Middle Class Wealth Recovered?”

The richest households have experienced a full gale force of appreciation in risk assets thanks primarily to record stock buybacks and unorthodox central bank policies such as quantitative easing and persistently low short-term interest rates. In addition, less than 42% of small businesses – those with two to 99 employees – offer any kind of retirement benefits which means their employees may not participate in market returns at all.

Keep in the mind, the wealth of the bottom 90% of the population is in primary residences. Houses with mortgages which require income to make payments. In other words, to many Americans, rising household incomes and the appreciation of home prices, not the possibility of future gains in the stock market, fuel the faith in prosperity envisioned by the American dreamers. House prices rose post-Great Recession. However, wealth grew more vigorously at the top of wealth distribution than in the middle, due to the increase in stock prices.

Which leads me to chart #2.

Abigail Disney, the grandniece of Walt Disney was on CNBC in April lamenting over Disney CEO Bob Iger’s $65.6 million 2018 paycheck, calling it “insane.” Her tweet from April 21^st has been retweeted 12,958 times and liked by over 42,000.

Let me very clear. I like Bob Iger. I do NOT speak for my family but only for myself. Other than owning shares (not that many) I have no more say in what happens there than anyone else. But by any objective measure a pay ratio over a thousand is insane. https://t.co/O34OjXd6rr

— Abigail Disney (@abigaildisney) April 21, 2019

According to the Economic Policy Institute which examines trends in CEO compensation, in 2017, the average CEO of the 350 largest U.S. firms received $18.9 million in total compensation – a 17.6% increase over 2016. Worker compensation remained flat.

From the EPI:

“The 2017 CEO-to-worker compensation ratio of 312-to-1 was far greater than the 20-to-1 ratio in 1965 and more than five times greater than the 58-to-1 ratio in 1989 (although it was lower than the peak ratio of 344-to-1, reached in 2000). The gap between the compensation of CEOs and other very-high-wage earners is also substantial, with the CEOs in large firms earning 5.5 times as much as the average earner in the top 0.1 percent.”

Listen, CEOs, senior managements, deserve big pay and incentives. I get it.  However, one needs to ponder whether they’re worth 312 to 1. I don’t think so. What do you think? Is Abigail Disney correct to rail about Iger’s pay package?

Ironically, in March, Disney World increased ticket prices by 23%. A one-day ticket will now set us back a lofty $159. What is a middle-class family going to do? Will they pay up? Probably. Despite consistent price hikes every year, park attendance continues to hit new records. As customers we just deal with the financial hit, shift items around in the budget, use credit, to make memories with our children.

Profligate compensation and price disparities not only raise the ire of those with socialist interest. Believers in the capitalist system consider them questionable, too.

What about the current state of household income? Sentier Research known for its thorough analysis of trends in household income, reported in March that median household income is now 3.5% higher than back in January 2000. Stagnation in household incomes finally broke after 18 years, which is good news.

However, the long-term financial distress to middle class wage earners may take decades to recover. The lingering financial vulnerability has done tremendous damage to the confidence in the American system, especially among post-Baby Boomer generations who feel their lives may never be as prosperous as their parents.

Chart #3 is an eye-opener, courtesy of Lance Roberts.

There is a marked deterioration in the willingness of corporations to share their prosperity with employees. The gaps of profits to employees and corporate unwillingness to share the wealth have never been so wide.

Lance’s analysis helped me to personally understand what I experienced at my former employer post-Great Recession. I lived these charts. I’m certain many readers have experienced the same. In my opinion, the interminable focus on shareholders over employees is one of the reasons extreme or outlier political views have become more widely accepted.

Last, The New School’s Schwartz Center for Economic Policy Analysis has undertaken eye-opening research which dives deep into the reality of U.S. retirement readiness. Teresa Ghilarducci, the Director of SCEPA along with her team, has been banging the drum hard over retirement inequality among lifetime earnings quintiles.

Low and moderate wage earners have experienced a dramatic deterioration in retirement wealth due to the death of pensions. However, there’s damage in every quintile which proves to me how defined contribution plans such as 401ks have failed a majority of Americans as primary retirement savings vehicles regardless of the impressive bull run in markets over the last 10 years.

Two major stock market derails along with a decade to break even after the financial crisis, lack of financial literacy, poor savings skills, oh, and the ability to tap plan account balances for loans and down payments for primary residences (which I believe is fiscally irresponsible), have proven that defined contribution plans should have remained a compliment to pensions as originally envisioned, not a replacement.

Per SCEPA’s analysis, among workers in the bottom fifth of the earnings distribution, the share of those with no retirement wealth increased from 45% to 51% between 1992 and 2010.

Workers are grouped below into five tiers of lifetime earnings. The share of total retirement wealth held by the top fifth of earners held steady from 1992 to 2010 at around half of all retirement assets. The lowest-earning quintile, meanwhile, held only 1 percent of retirement wealth in 2010, down from 3%.

Even WITHIN quintiles, the top 10% of savers held 10-20 times the retirement wealth of the bottom 10%.

Retirement inequality can compel workers to vote their dissatisfaction for mainstream political candidates within their respective parties.

Read The New School Policy Note here.

Corporate America has prospered enough to benefit both shareholders and employees. They have failed to do so. Shortsightedness and outright greed have allowed outlier political views to prosper enough for markets to pay attention.

Capitalism will always prevail over socialism. The proof is in the prosperity and growth we enjoy in America when compared to all other nations.

However, the C Suite’s bastardized definition of capitalism isn’t the answer. Nor is cloying regulation and massive Federal Reserve intervention appropriate responses.

If these conditions persist, be prepared for continued unwelcomed surprises to emanate from voting booths across America.

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 let’s get to the sector analysis.

AAPL – Apple Computer

• Two weeks ago, we took 20% of our position off the table to lock in some profit and protect capital.
• Currently AAPL has retraced back to the 50% Fibonacci level and is holding support.
• We would like to see a consolidation around support to add back into our holding.
• Stop is set at $170

CHCT – Community Healthcare

• Defensive Utility and Real Estate stocks continue to get a bid during turmoil.
• CHCT continues to sit near highs and is overbought currently.
• Look for a pullback to support at $33-34 to add to the position.
• Stop-loss is moved up to $32

CMCSA – Comcast Corp.

• CMCSA, despite the recent rout in the market, continues to hold up well.
• The position is overbought and deviated from support.
• Take profits and hold position long for now. Look for a pullback to support to add to the position.
• Stop-loss remains at $39

COST – CostCo Wholesale

• After almost giving up on COST last year, the company has performed well as defensive position continues to outperform during market volatility.
• With the position overbought, but on a buy signal, we are looking for a pullback to support to add to our holdings.
• Our stop is set at $220

DUK – Duke Energy

• DUK has pulled back to support with the recent selloff in the market and needs to hold currently.
• With the position not oversold and triggering a sell-signal we are monitoring the holding closely.
• While we like Utilities here with respect to defensive positioning, DUK is performing less well than its cohorts in the portfolio.
• Stop-loss is set at $86 for now.

JPM – JP Morgan Chase

• After a sharp spurt higher last month, JPM is pulling back to support.
• With JPM still on a buy signal, we can look to add to the position if support holds at $107.50
• Our stop-loss is moved to $105

MDLZ – Mondelez International

• After MDLZ broke out of its long consolidation, the price has remained elevated and extremely overbought.
• After taking profits we are looking for an entry point to add back to the position. There simply isn’t one right now so we will be patient and watch.
• We are moving our stop-loss up to $46

PEP – Pepsico, Inc.

• Like MDLZ – consumer staples continue to attract money flows from their more defensive positioning.
• Nonetheless, PEP is extremely overbought and needs to have a correction to add to the position.
• Our stop-loss is moved to $118

PPL – PPL Corp.

• PPL is another defensive Utility position to offset market risk in the short-term.
• PPL is also one of the few utility companies which trades at a discount to fair value.
• Stop loss is currently set at $30

XOM – Exxon Mobil

• Give me credit! Or rather, Americans keep taking on more of it. V has held up well with the recent market swoon.
• However, V remains extremely overbought and extended. We are looking for a better opportunity to add to the holding in the future.
• Stop-loss is set at $145.

In June of 2018, as the initial rounds of the “Trade War” were heating up, I wrote:

“Next week, the Trump Administration will announce $50 billion in ‘tariffs’ on Chinese products. The trade war remains a risk to the markets in the short-term.”

Of course, 2018 turned out to be a volatile year for investors which ended in the sell-off into Christmas Eve.

As we have been writing for the last couple of weeks, the risks to the market have risen markedly as we head into the summer months.

“It is a rare occasion when the markets don’t have a significant intra-year correction. But it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occur early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity.”

“With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. Again, this is why we discussed taking profits and rebalancing risk in our portfolios last week.”

Well, that certainly didn’t take long. As of Monday’s close, the entirety of the potential 5-6% decline has already been tagged.

The concern currently, is that while the 200-dma is critical to warding off a deeper decline, the escalation of the “trade war” is going to advance the timing of a recession and bear market. 

Let me explain why.

The Drums Of “Trade War”

On Monday, we woke to the “sound of distant drums” beating out the warning of escalation as China retaliated to Trump’s tariffs last week. To wit:

“After vowing over the weekend to “never surrender to external pressure,” Beijing has defied President Trump’s demands that it not resort to retaliatory tariffs and announced plans to slap new levies on $60 billion in US goods.

• CHINA SAYS TO RAISE TARIFFS ON SOME U.S. GOODS FROM JUNE 1
• CHINA SAYS TO RAISE TARIFFS ON $60B OF U.S. GOODS
• CHINA SAYS TO RAISE TARIFFS ON 2493 U.S. GOODS TO 25%
• CHINA MAY STOP PURCHASING US AGRICULTURAL PRODUCTS:GLOBAL TIMES
• CHINA MAY REDUCE BOEING ORDERS: GLOBAL TIMES
• CHINA ADDITIONAL TARIFFS DO NOT INCLUDE U.S. CRUDE OIL
• CHINA RAISES TARIFF ON U.S. LNG TO 25% EFFECTIVE JUNE 1

China’s announcement comes after the White House raised tariffs on some $200 billion in Chinese goods to 25% from 10% on Friday (however, the new rates will only apply to goods leaving Chinese ports on or after the date where the new tariffs took effect).

Here’s a breakdown of how China will impose tariffs on 2,493 US goods. The new rates will take effect at the beginning of next month.

• 2,493 items to be subjected to 25% tariffs.
• 1,078 items to be subject to 20% of tariffs
• 974 items subject to 10% of tariffs
• 595 items continue to be levied at 5% tariffs

In further bad news for American farmers, China might stop purchasing agricultural products from the US, reduce its orders for Boeing planes and restrict service trade. There has also been talk that the PBOC could start dumping Treasuries (which would, in addition to pushing US rates higher, also have the effect of strengthening the yuan).”

The last point is the most important, particularly for domestic investors, as it is a change in their stance from last year. As we noted when the “trade war” first started:

The only silver lining in all of this is that so far, China hasn’t invoked the nuclear options: dumping FX reserves (either bonds or equities), or devaluing the currency. If Trump keeps pushing, however, both are only a matter of time.”

Clearly, China has now put those options on the table, at least verbally.

It is essential to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. As you can see, there is a high correlation between fluctuations in the Yuan and treasury activity.

One way for China to both penalize the U.S. for tariffs, and by “the U.S.” I mean the consumer, is to devalue the Yuan relative to the dollar. This can be done by either stopping the process of sanitizing transactions with the U.S. or by accelerating the issue through the selling of U.S. Treasury holdings.

The other potential ramification is the impact on interest rates in the U.S. which is a substantial secondary risk.

China understands that the U.S. consumer is heavily indebted and small changes to interest rates have an exponential impact on consumption in the U.S.. For example, in 2018 interest rates rose to 3.3% and mortgages and auto loans came to screeching halt. More importantly, debt delinquency rates showed a sharp uptick.

Consumers have very little “wiggle room” to adjust for higher borrowing costs, higher product costs, or a slowing economy that accelerates job losses.

However, it isn’t just the consumer that will take the hit. It is the stock market due to lower earnings.

Playing The Trade

Let me review what we said previously about the impact of a trade war on the markets.

“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”

While the markets have indeed been more bullishly biased since the beginning of the year, which was mostly based on “hopes” of a “trade resolution,” we have couched our short-term optimism with an ongoing view of the “risks” which remain. An escalation of a “trade war” is one of those risks, the other is a policy error by the Federal Reserve which could be caused by the acceleration a “trade war.” 

In June of 2018, I did the following analysis:

“Wall Street is ignoring the impact of tariffs on the companies which comprise the stock market. Between May 1st and June 1st of this year, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.”

The red dashed line denoted the expected 11% reduction to those estimates due to a “trade war.”

“As a result of escalating trade war concerns, the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners will be greater than anticipated. In a nutshell, an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.”

Fast forward to the end of Q1-2019 earnings and we find that we were actually a bit optimistic on where things turned out.

The problem is the 2020 estimates are currently still extremely elevated. As the impact of these new tariffs settle in, corporate earnings will be reduced. The chart below plots our initial expectations of earnings through 2020. Given that a 10% tariff took 11% off earnings expectations, it is quite likely with a 25% tariff we are once again too optimistic on our outlook.

Over the next couple of months, we will be able to refine our view further, but the important point is that since roughly 50% of corporate profits are a function of exports, Trump has just picked a fight he most likely can’t win.

Importantly, the reigniting of the trade war is coming at a time where economic data remains markedly weak, valuations are elevated, and credit risk is on the rise. The yield curve continues to signal that something has “broken,” but few are paying attention.

With the market weakness yesterday, we are holding off adding to our equity “long positions” until we see where the market finds support. We have also cut our holdings in basic materials and emerging markets as tariffs will have the greatest impact on those areas. Currently, there is a cluster of support coalescing at the 200-dma, but a failure at the level could see selling intensify as we head into summer.

The recent developments now shift our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple. However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the current market environment.

Assuming that you were astute enough to buy the 2009 low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals. 

If you went to cash now, the odds are EXTREMELY high that you will outpace investors who remain invested in the years ahead. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs, the decline will destroy most, if not all, of the returns accumulated over the last decade.

China understands that Trump’s biggest weakness is the economy and the stock market. So, by strategically taking actions which impact the consumer, and ultimately the stock market, it erodes the base of support that Trump has for the “trade war.”

This is particularly the case with the Presidential election just 18-months away.

Don’t mistake how committed China can be.

This fight will be to the last man standing, and while Trump may win the battle, it is quite likely that “investors will lose the war.” 

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