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J. Brett Freeze and his firm Global Technical Analysis (GTA) provides RIA Pro subscribers Cartography Corner on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework. We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

GTA presents their monthly analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide

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July 2021 Review

E-Mini S&P 500 Futures

We begin with a review of E-Mini S&P 500 Futures (ESU1) during July 2021. In our July 2021 edition of The Cartography Corner, we wrote the following:  

In isolation, monthly support and resistance levels for July are:

o M4                4559.25

o M3                4374.50

o M1                4350.25

o PMH             4294.25

o Close            4288.50           

o M2                4224.25

o MTrend        4169.94     

o PML              4126.75       

o M5                4015.25

Active traders can use M3: 4374.25 as the pivot, maintaining a long position above that level and a flat or short position below it.

The price action in July mimicked the price action in June.  Figure 1 below displays both months, with prices indexed to one.  Is the dominant algorithm now being reset monthly?

Figure 1:

Figure 2 below displays the daily price action for July 2021 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  By the end of the second trading session, the market price was testing the first of our isolated resistance levels at M1: 4350.25.  It flirted with that level for the following two sessions before being rejected on July 8^th.  The market rolled back down during that session to PMH: 4294.25.  The following two trading sessions saw the market price rally sharply to our second isolated resistance level at M3: 4374.50.

After testing that level in the overnight session of July 13^th, the market rolled over.  Over the following four trading sessions, the market price declined 132.50 points (high-to-low), or -3%.  The decline stopped at our isolated support level at M2: 4224.25.

Just like in June, the market price immediately raced higher with the market-participants algorithms bulls successfully defending their positions (and intra-month shorts covering).  On July 23rd, the market price settled, solidly, above our isolated pivot at M3: 4374.50.  The final five trading sessions of July saw the market price consolidate, within a narrow range, above that level.

Figure 2:

U.S. Treasury 30-Year Yield

We continue with a review of the U.S. Treasury 30-Year Yield (“30Y”) during July 2021.  In our July 2021 edition of The Cartography Corner, we wrote the following:  

In isolation, monthly support and resistance levels for July are:

o M4                2.502

o PMH             2.330

o MTrend        2.236

o M1                2.236

o Close             2.086               

o PML              1.933         

o M3                1.909

o M2                1.708         

o M5                1.442

Active traders can use PMH: 2.330 as the upside pivot, maintaining a long position (yield perspective) above that level.  Active traders can use M3: 1.909 as the downside pivot, maintaining a short position (yield perspective) below that level.  

Figure 3 below displays the daily price action for July 2021 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The month of July consisted of five swings, three down and two up, approximately centered around our isolated downside pivot.

The first five trading sessions saw the 30Y race to our isolated downside pivot level at M3: 1.909.  On July 8^th, the 30Y traded five basis points through that level but settled above it.  The following three trading sessions saw the 30Y retrace most of the previous swing down.

On July 14^th, the 30Y began its second swing down.  This swing reached its nadir early in the session of July 20^th, reaching a low yield of 1.782, shy of our isolated support level at M2: 1.708.  The following two (plus) trading sessions saw the 30Y retrace most of the previous swing down.

The final six (plus) trading sessions saw the 30Y complete its third swing down.  The gradient of this descent was less than the first two.  The 30Y settled the month at 1.905, essentially on our isolated downside pivot.

Figure 3:

August 2021 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESU1).  The same analysis can be completed for any time-period or in aggregate.

Trends:  

o Daily Trend             4395.44        

o Current Settle         4389.50

o Weekly Trend         4358.81        

o Monthly Trend        4246.17        

o Quarterly Trend      3875.31

The relative positioning of the Trend Levels is bullish.  Think of the relative positioning of the Trend Levels like you would a moving-average cross.  In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures are “Trend Up”, having settled above Quarterly Trend for five quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures are “Trend Up”, settling nine months above Monthly Trend.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures are “Trend Up”, with six consecutive closes above Weekly Trend.

Support/Resistance:

In isolation, monthly support and resistance levels for August are:

o M4                4718.25

o M1                4550.75

o M3                4490.50

o PMH             4422.50

o Close            4389.50           

o M2                4321.25

o MTrend        4246.17     

o PML              4224.00       

o M5                4153.75

Active traders can use PMH: 4422.50 as the pivot, maintaining a long position above that level and a flat or short position below it.

High-Grade Copper

For August, we focus on High-Grade Copper Futures.  We provide a monthly time-period analysis of HGU1.  The same analysis can be completed for any time-period or in aggregate.

Copper prices are sensitive to cyclical industries, such as construction and industrial machinery manufacturing, as well as to political situations in countries where copper mining is government-controlled.  Copper is often referred to as “Doctor Copper” as it has a decent track record of predicting turning points in the global economy.  Following the price of copper is a worthwhile exercise to better understand the economic mindset of global investors.

Trends:  

o Daily Trend           4.5016           

o Monthly Trend      4.4852

o Current Settle       4.4825           

o Weekly Trend       4.3863           

o Quarterly Trend    3.8867

The relative positioning of the Trend Levels is transitioning from bullish to bearish.    Think of the relative positioning of the Trend Levels like you would a moving-average cross.  As can be seen in the quarterly chart below, copper is “Trend Up”, having settled five quarters above Quarterly Trend.  Stepping down one time-period, the monthly chart shows that copper is “Above Trend: 1 Months”.  We recently changed the logic in our labeling.  Although copper settled above Monthly Trend, it has not done so for at least three consecutive observations.  We still consider this to be “Consolidation”, however, we are trying to be precise with our description by acknowledging that it is above Monthly Trend.  Stepping down one time-period, the weekly chart shows that copper is “Trend Up”, having settled above Weekly Trend for four weeks.

One rule we have is to anticipate a two-period high (low), within the following four to six periods, after a Downside (Upside) Exhaustion level has been reached.  The signal was given the month of June to anticipate a two-month high within the next four to six months (now, three to five months).  That high can be achieved this month with a trade above 4.7070.

Support/Resistance:

In isolation, monthly support and resistance levels for August are:

o M4                5.1610

o M3                4.6760

o PMH             4.6275

o M1                4.5480

o MTrend        4.4852              

o Close             4.4825      

o M2                4.2390

o PML               4.1665      

o M5                 3.6260

Active traders can use M3: 4.6760 as the pivot, maintaining a long position above that level and a flat or short position below it.

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight into many different markets.  If you are a professional market participant and are open to discovering more, please connect with us.  We are not asking for a subscription; we are asking you to listen.

A few years ago, Paul Wallace penned an article entitled: “GDP Is A Grossly Defective Product.” The recent release of the Q2-2020 report reminded me of it as the media fawned over the 7.6% print.

“Yet despite its theoretical appeal, GDP is, in practice, a fallible measure. It is increasingly becoming one that could be described as a grossly defective product. 

While seemingly strong at the headline, the recent report leaves much to be desired when looking below the surface.

Estimates Missed By A Mile

The headline print of 6.35% was one of the most robust rates of “annualized” growth since the early 1980s. However, there are two significant takeaways from this data. First, while the growth rate is impressive, it is $5 trillion in Government spending during the recession that boosted growth. (Chart below is current through Q2 and estimated through Q4)

Secondly, the growth rate is substantially weaker than earlier estimates of more than 13% and a full percentage point lower than the Atlanta Fed’s GDPNow forecast of 7.6%. It also likely represents the peak of the economic recovery. (This is a topic we will address more next week.)

Over the next two quarters, the rates of economic growth will continue to weaken. Such will be due to the massive amounts of direct stimulus fading from the system.

By late 2022 the economic growth rate will likely set a new lower growth trend below 2%. Such will be weaker than the growth trends before the past two “real” economic recessions.

As is always the case, economists and analysts are always overly optimistic in their assessments. But, while being overly optimistic is undoubtedly a media preference, it leads to potential misallocations of capital by investors.

Yields Had It Right After All

As discussed in April, when estimates were for 13% GDP growth, bond yields signaled a peak of economic growth. To wit:

“As shown, the correlation between rates and the economic composite suggests current expectations of economic expansion are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.”

Since then, yields have continued to drop, along with the yield curve flattening. Historically, yields are a strong predictor of economic growth and inflation. However, as stated previously, disinflation is more likely than accelerating inflation. 

“With the base effects now exhausted, the cyclical, structural, and monetary considerations suggest inflation will decline by year-end. Thus, the ‘inflationary psychosis’ gripping the bond market already reversed as the realization of slower economic growth occurs.”

Of course, such is problematic for the Federal Reserve. The current program of $120 billion a month in monetary injections only maintains economic growth. But, unfortunately, those monetary interventions are not translating into “economic activity” either directly or indirectly.

“Each time the Fed has engaged in QE programs, the banks ‘hoard’ those reserves as the ‘risk/reward’ of loaning money into the economy is not justified. For example, in early 2020, as the economy was ‘shut down’ due to the COVID pandemic, companies tapped credit lines at their banks to ensure sufficient capitalization. After that initial surge in lending activity, banks reversed back into a more ‘protectionary’ mode.”

QE programs have NOT been effective at creating organic economic growth. However, they were effective at boosting asset prices and providing an illusory wealth effect. 

The Fed faces a challenge in trying to “taper” asset purchases. While there is more robust economic growth, a bubbling housing market, and falling unemployment, can they remove the economic “life support?” Some alternative measures suggest such may not be the case.

Alternative Measures Of Economic Growth

While mainstream economists suggest the economy is booming based on the more mainstream economic data, other data suggests such may not be the case.

It is important to note that America’s economic performance peaked in the late 1990s. Thus, the erosion in crucial economic indicators such as the rate of economic growth, productivity growth, job growth, and investment began well before the Great Recession.

A look at labor force participation, the proportion of Americans in the productive workforce peaked in 1997.

With fewer working-age men and women in the workforce, per-capita income continues to decline. Not surprisingly, median real household income remains muted well below the actual cost of living, with incomes stagnating across the bottom 80% of income earners. 

Moreover, stagnating income and limited job prospects have disproportionately affected lower-income and lower-skilled Americans, leading to household inequality.

Lastly, the U.S. lacks an economic strategy, especially at the federal and Governmental levels. The implicit strategy remains trusting the Federal Reserve to solve our problems through monetary policy. However, the rise in wealth inequality has fostered demands to transform the U.S. into a “socialistic” economy.

Neither strategy has ever solved the problems of those with the least who were promised the most.

Conclusion

As noted, the Federal Reserve is trapped. The Federal Reserve needs more substantial economic growth to justify raising interest rates. After all, the reason the Fed tightens monetary policy is to SLOW economic growth to mitigate the potential of surging inflationary pressures. The problem currently is that the Fed is discussing raising interest rates in an environment of weakening economic growth and disinflationary headwinds.

Currently, employment and wage growth remain weak, 1-in-3 Americans are on Government subsidies, and the majority of American’s are living paycheck-to-paycheck. Such is why Central Banks, globally, are aggressively monetizing debt to keep growth from stalling out. However, many analysts and economists have currently increased the odds of the Fed hiking rates by next year. The belief is that economic growth can continue to accelerate despite the tighter monetary policy.

Most of the analysis overlooks the level of economic growth at the beginning of interest rate hikes. The Federal Reserve uses monetary policy tools to slow economic growth and ease inflationary pressures by tightening monetary supply. For the last decade, the Federal Reserve has flooded the financial system to boost asset prices in hopes of spurring economic growth and inflation.

As stated, outside of inflated asset prices, there is little evidence of real economic growth as witnessed by an average annual GDP growth rate of just 1.1%.

While the mainstream media may indeed tout the “greatest economic growth rate in decades,” the pervasive weakness below the headlines will continue to erode projections.

The problem for investors is the inflation of assets prices far beyond what the actual economy can generate in terms of future revenue and earnings growth.

The re-alignment between overly bullish expectations and a “Grossly Defective Product” will likely be more painful than most expect.

S&P 500 Monthly Valuation & Analysis Review: 07-31-21

Also, read our commentary on why low rates don’t justify high valuations.

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J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long-term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.

In this 07-30-21 issue of “Market Rally Continues As Earnings Beat Estimates.”

• Market Rally Continues
• The Mirage Of Strong Earnings
• GDP Eclipses Pandemic Level
• Portfolio Positioning
• Sector & Market Analysis
• 401k Plan Manager

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

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Are you worried about the potential for a market correction, a surge in inflation, or are you unsure how to invest for your retirement? We can help. If you are not yet a client and would like to discuss your portfolio construction, please schedule a time to meet with one of our advisors below.

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Market Rally Continues

Last week, we discussed that as the market hit new highs, further upside was likely limited. To wit:

“While the upside remains somewhat limited, given the already substantial advance this year, the rally will alleviate downside concerns momentarily. However, with that said, the extremely low level of volatility this year is reminiscent of 2017. The reason is that “stability” is fragile. In other words, stability ultimately leads to instability.“

For more information on the “instability of instability,” read “The Next Minsky Moment.”

Not surprisingly, the market didn’t make much headway this past week, given the current extended and overbought conditions. For now, “buy signals” remain intact, which likely limits the downside over the next week. However, a retest of the 50-dma is certainly not out of the question.

With that said, we are entering into the two weakest trading months of the year. Stocktrader’s Almanac had a good note on why the rally could experience a “pause” over the next two months.

“For the past 33 years from 1988-2020 August and September are the worst two months of the year for DJIA, S&P 500, and NASDAQ. August is the worst for DJIA and S&P 500 and September is worst for NASDAQ.

Despite the persistence and resilience of this bull rally market internals and technicals are showing some signs of fatigue.“

• Advancing issues have barely outpaced decliners in recent weeks.
• New highs have been shrinking while new lows remain high.
• Technical indicators are struggling to break through resistance.
• Relative Strength, Stochastics and MACD are breaking down again.

“The timing of a pause coincides with the weak seasonal patterns mentioned above during the worst months of the year August and September (not to mention Octoberphobia) as well as the 4-Year Presidential Election Cycle.” 

6-Month Advances Are Rare

Given the bullish bias currently remains unfettered, and the Fed is still applying $120 billion a month in liquidity, there is no reason to be overly “bearish” at this juncture. Thus, while we are carrying slightly reduced exposure currently and have increased our “risk hedges” as of late, we remain nearly fully invested.

With our “money flow buy signals” triggered, such suggests there is support for stocks currently. Such means two things over the next week or so: 1) there is not a great deal of downside, and 2) there is not much upside either. Thus, a sideways consolidation and a pickup in volatility are likely. One concern is the “negative divergence” of money flows (bottom panel) against an advancing market. Such corresponds with the technical weakness we will discuss momentarily.

Therefore, given this backdrop, we increased portfolio hedges.

An additional “red flag” is the S&P 500 has had positive returns for 6-straight months. As shown in the 10-year monthly chart below, such streaks are a rarity, and when they do occur, they are usually met by a month, or more, of negative returns.

(It is also worth noting that when the 12-Month RSI is this overbought, larger corrective processes have occurred.)

While prices have advanced sharply, the bullish mantra remains that “earnings” support the increase. While that “rationalization” may seem to have merit, investors are paying more today for the same expected earnings from January of 2020.

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The Mirage Of Strong Earnings

The second-quarter earnings season started with a bang, with several companies reporting earnings “knocking the cover off the ball.”

“Overall, 24% of the companies in the S&P 500 have reported earnings to date for the second quarter. Of these companies, 88% have reported actual EPS above the mean EPS estimate. Another 1% have reported actual EPS equal to the mean EPS estimate, and 11% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above the 1-year (83%) average and above the 5-year (75%) average.” – FactSet

It is not surprising that stocks are rallying to new highs again this week with those kinds of numbers.

However, the longer-term problem for investors is that while the earnings were strong, they are only getting back to levels where they were supposed to be at the beginning of 2020. As shown, in January of 2020, the earnings estimate for the end of 2021 was $171/share. Currently, before estimates get downwardly revised, it is presently estimated that earnings will be just $174/share at the end of 2021.

As noted, the problem for investors comes down to valuations. For example, in January of 2020, investors were paying 19x for 2-year forward earnings. Today, they are paying 25x earnings for essentially the same dollar amount of earnings.

While it gets lost in the daily media, the reality is the price of the market is outpacing actual earnings growth. More importantly, when looking back historically, we see that earnings growth isn’t as strong as headlines suggest.

We certainly understand that valuations have very little importance in the short term. For now, all that matters is price momentum. However, as investors, it is essential to remember that valuations have great importance longer-term.

Sales Are Worse

Of course, such doesn’t even come close to premiums paid for each dollar of “actual sales” generated by the underlying companies. As we noted in “Priced For Perfection,” sales will decline this quarter, driving the price-to-sales ratio to historical levels. To wit:

Thought this was interesting.#Earnings are expected to hit $151 #reported this quarter

Q4-2020 = 94.13
Q1-2021 = 128.20
Q2-2021 = 151.17 est.

But here is revenue

Q4-2020 = 367.48
Q1-2021 = 364.05
Q2-2021 = 360.81

Anyone notice an issue relating to #Price/Sales

— Lance Roberts (@LanceRoberts) July 13, 2021

“Investors should not dismiss the above quickly. Revenue is what happens at the top line. Secondly, revenue CAN NOT grow faster than the economy. Such is because revenue comes from consumers, and consumption makes up 70% of the GDP calculation. Earnings, however, are what happens at the bottom line and are subject to accounting gimmicks, wage suppression, buybacks, and other manipulations.“

Currently, the price-to-sales (revenue) ratio is at the highest level ever. As shown, the historical correlation suggests outcomes for investors will not be kind.

Currently, there are more than 70 companies in the S&P 500 trading above 10x sales. That is 14% of the entire index, one of the highest levels ever on record. (How many of these companies do you own?)

A Lesson From 2000

Why is that important? For that answer, let’s revisit what Scott McNealy, then CEO of Sun Microsystems, said in 2000.

“At 10-times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10-straight years in dividends. That assumes I can get that by my shareholders. It also assumes I have zero cost of goods sold, which is very hard for a computer company.

That assumes zero expenses, which is hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that expects you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10-years, I can maintain the current revenue run rate.

Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those underlying assumptions are? You don’t need any transparency. You don’t need any footnotes.

What were you thinking?”

Of course, much of this is “forgotten history,” as many investors today were either a) not alive in 1999 or b) still too young to invest. However, for the newer generation of investors, the lack of “experience” provides no basis for the importance of “valuations” to future outcomes.

That is something only learned through experience.

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In Case You Missed It

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GDP Eclipses Pre-Pandemic Level

On Thursday, CNBC ran the following headline:

To wit:

“The U.S. economy is now larger than it was before the pandemic, but its growth rate may have peaked this year at a much slower pace than expected.” – Patti Dom, CNBC

Patti is correct; economic growth just peaked.

The problem with the 6.5% annualized rate is that it was more than 50% lower than the original estimates of 13.5%. More troubling was the report was even lower than the Atlanta Fed’s much-reduced 7.6% estimate.

What was missed by the mainstream media are two very critical factors.

1. The sharp decline in expected GDP growth rates suggests that “deflationary” pressures are present; and,
2. Given the relationship between economic growth and earnings, current estimates will be revised lower.

Over the next two quarters and fully into 2022, economic growth rates will decline back to 2% or less.

More importantly, the weaker than expected GDP report pushed the Market Capitalization / GDP ratio (inflation-adjusted) to a record high. But, again, given that revenues are a function of consumption (70% of the GDP calculation), earnings growth will weaken by default.

Lastly, while the economy is indeed larger than pre-pandemic, such is of little consolation. When you realize it took $8 Trillion in monetary stimulus (40% of the economy) to create $406 billion in growth from Q1-2020, it is a little underwhelming.

Next year, the fiscal impulse will become a drag.

Such will make it much harder to justify current valuations in a much slower economic growth environment.

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Portfolio Update (Party On Garth)

For now, as noted above, the markets remain bullishly biased, and there seems little to derail that mentality currently. The weaker than expected economic growth rate gave the markets reassurance the Fed won’t “taper” anytime soon.

In the meantime, we continue to maintain nearly full equity exposure in our portfolio models. However, the one change we have been quietly making over the last two months is increasing the duration of our bond portfolios. Such is because the recent peak in interest rates is more telling about the economy’s outlook and markets than many would like to admit. (See Why Bonds Aren’t Overvalued.)

While the markets are indeed in “Party On Garth” mode, the current extended, overbought, and bullish conditions provide the necessary backdrop for a short-term correction.

As discussed over the last couple of weeks, August and September tend to be weaker performance months. Therefore, with the bulk of earnings soon behind us, the focus will turn back to the economy and the Fed.

In the near term, the most significant risk for the market comes from the Federal Reserve at the Jackson Hole Summit this summer. If there is a change in their outlook to a more “hawkish” stance or more detailed “taper” discussions, the markets may react negatively.

Another immediate risk could be a failure to pass additional stimulus in Congress or a movement to “lockdowns” due to the virus.

In conclusion, it is simple enough to say “I have no idea” what could derail the markets. Such is why we analyze the risk each week and try to make prudent and informed decisions about portfolio exposures and risk management.

It’s the best we can do for you and our clients.

Have a great weekend.

By Lance Roberts, CIO

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Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members

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S&P 500 Tear Sheet

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Performance Analysis

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Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” are oversold. The current reading is 85.79 out of a possible 100.

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Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 83.58 out of a possible 100.

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Sector Model Analysis & Risk Ranges

How To Read This Table

• The table compares each sector and market to the S&P 500 index on relative performance.
• “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
• The risk range is a function of the month-end closing price and the “beta” of the sector or market.
• Table shows the price deviation above and below the weekly moving averages.

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Weekly Stock Screens

Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

Low P/B, High-Value Score, High Dividend Screen

Fundamental Growth Screen

Aggressive Growth Strategy

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Portfolio / Client Update

There isn’t much to update this week, as there was no need to make any changes. However, we did add one equity position for earnings season in the technology space (NVDA). We also increased the duration of our bond holdings by adding to our TLT position in both models.

Currently, the markets are significantly overvalued, extended, and deviated from long-term means. However, the psychology of the market remains exceedingly bullish, which trumps “logic” at this juncture.

As such, our job remains to create the necessary performance to meet your retirement goals. However, we must also be responsible and responsive to the underlying risk that could derail those goals. It is a tricky balancing act, and we work extremely hard at achieving those goals every day.

There will be a point where markets will change. But be assured that when they do, we will do the same as well.

Portfolio Changes

During the past week, we made minor changes to portfolios. In addition, we post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

“We are continuing to increase the duration of our bond portfolio in increments when we get pullbacks to support on 10-year Treasury Rates. This morning we added 1.5% to our position in TLT in both models, bringing it to 5%. We reduced our position in SHY to 7.5% to make room for the additional exposure in the fixed income sleeve.

We also initiated a 2% position in NVDA in the Equity Model. Both models are now around 50% equity exposure.” – 07/29/21

Equity Model

• Initiate at 2% position in NVDA
• Add 1.5% of the portfolio into TLT

ETF Model

• Add 1.5% of the portfolio into TLT

As always, our short-term concern remains the protection of your portfolio. Accordingly, we have shifted our focus from the election back to the economic recovery and where we go from here.

Lance Roberts, CIO

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THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors

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

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401k Model Performance Analysis

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

Have a great week!

The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You will find more detail on the model and the specific tickers below the charts.

Commentary 7-30-21

• The graphs below point to indecision in the markets. Maybe the best way to highlight this is the scatter plot comparing 20 day excess returns and current relative scores. The correlation is very low (R-squared = 22) as most relative scores are near fair value and the S&P 500 was little changed over the last four weeks. This low correlation reading comes after a long period of high R-squareds.
• The inflationary sectors, including energy, financials, and materials, led last week, while technology underperformed. That result is not surprising given many technology stocks got extended and earnings reports in some cases, despite being good, were not enough to justify recent price increases. Amazon’s weak market opening this morning on earnings disappointment will likely weigh on the discretionary sector due to its large contribution to the sector.
• Other than the NASDAQ, all factors and indexes remain slightly oversold versus the S&P. Emerging markets are deeply oversold but, as shown in the third graph below, it is not painting a pretty technical picture. EEM broke below key support at 52 and is below its 50 and 200-dmas. If you take advantage of its deeply oversold condition, do so with stop losses in place.
• All sectors, bonds, and factors/index are overbought on an absolute basis expect for energy and emerging markets. The S&P 500 is overbought but in the same range it has been over the past few weeks.
• On an absolute basis, staples and utilities, continue to see improving scores and are now both slightly overbought. Scores are based on many technical indicators and include various time frames. Scores can improve because the prior week showed strength, or because prior data, which was poor, is dropping out of technical calculations. For example, XLP was down 1 cent since last Friday, yet its score improved markedly this week.
• While the graphs point to indecision, none of the sector absolute scores are deep into overbought territory as we typically see at market peaks. There is a lot of tension in the equity markets so pay attention to your risk management levels.

Graphs (Click on the graphs to expand)

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Users Guide

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change trend. When the scatter plot in the sector graphs has an R-squared greater than .60 the signals are more reliable.

The first set of four graphs below are relative value-based, meaning the technical analysis is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

• Staples XLP
• Utilities XLU
• Health Care XLV
• Real Estate XLRE
• Materials XLB
• Industrials XLI
• Communications XLC
• Banking XLF
• Transportation XTN
• Energy XLE
• Discretionary XLY
• S&P 500 SPY
• Value IVE
• Growth IVW
• Small Cap SLY
• Mid Cap MDY
• Momentum MTUM
• Equal Weighted S&P 500 RSP
• NASDAQ QQQ
• Dow Jones DIA
• Emerg. Markets EEM
• Foreign Markets EFA
• IG Corp Bonds LQD
• High Yield Bonds HYG
• Long Tsy Bonds TLT
• Med Term Tsy IEI
• Mortgages MBB
• Inflation TIP
• Inflation Index- XLB, XLE, XLF, and Value (IVE)
• Deflation Index- XLP, XLU, XLK, and Growth (IWE)

In a recent interview with Business Insider, Paul Krugman’s delusion was evident as the difference between economic theory and reality was on full display.

However, such is always the difference between economists who spent their lives in the “ivory towers” of academia instead of those who created businesses, jobs, and prosperity.

While many economists attempt to make economic theory a science, it is still a function of human psychology and behaviors. For example, the theory is that if the price of beef rises too much, consumers will switch to chicken. However, in practice, individuals often make other choices instead.

Most economists, Krugman included, believe the economy is about to come roaring back to life with economic growth rates that will surpass anything seen in this current century. Such may well indeed be the case momentarily as massive stimulus and spending flow through the system. However, what happens then?

After 12-years of monetary interventions, we now have plenty of evidence to determine if Paul’s view of the world is indeed what he claims it be.

Wages Will Recovery With The Economy

“So there’s basically not much of a downside to having a very rapid economic recovery. If you’re an ordinary American, you can say, ‘look, the odds are that by this time next year, jobs will be plentiful, things will be looking pretty good. Inflation might be a bit higher, but your income will be more than keeping up with it.'” – Paul Krugman

It is correct there will be inflationary pressures if we indeed do have a rapid economic recovery. However, Krugman’s mistake is in stating that wages for “ordinary Americans” will rise commensurately. Since 2007, the inflation-adjusted wage growth for the bottom 80% of Americans has not grown.

We can look at the wage growth of the bottom 80%, compared to economic growth, and see that wage growth has not come close to keeping up with economic growth.

Furthermore, since 1990, wage growth has failed to keep up with the rising cost of the standard of living for the bottom 80% of Americans. The chart below shows the gap between wages, savings, and living costs through the end of 2020. It requires roughly $4000 in debt annually to “fill the gap” between incomes, savings, and the cost of living.

Given that it takes a “full-time” job to support a family, it is increasingly difficult to look at the chart below and suggest that we are anywhere near full employment.

Of course, when Government Transfers make up more than 40% of real disposable incomes, it only further undermines Krugman’s view of American prosperity.

Interestingly, given all government spending was done through debts and deficits, Krugman sees no evidence of any problems.

No, Debt Is A Problem

“We’ve learned two lessons from the past dozen years. The U.S. economy can in fact run a lot hotter than we thought. It is, in fact, okay to have nice things. We can have full employment and it doesn’t mean that that hyperinflation is around the corner. And, the debt doesn’t seem to be a problem at anything near current levels.”

As noted above, we haven’t seen anything close to true “full employment” since Bill Clinton was President. But such also corresponds with the tipping point to where debts and deficits became corrosive to economic growth. As shown, despite continued increases in debt, economic growth has continued to deteriorate, the wealth gap widened, and the calls for socialism rose.

I am not sure how Krugman can conclude that debt at current levels has no consequence. Such is particularly an issue where it now takes more than $5 in debt to create $1 of economic growth.

As we discussed in “Sugar Rush:”

“While the economy may have ‘appeared’ to grow during this period, economic growth would have been ‘negative’ without debt increases. The chart below shows what economic growth would be without the increases in Federal debt.”

Such is why, after more than a decade of monetary and fiscal interventions totaling more than $43 Trillion and counting, the economy remains on “life support.”

(It required roughly $12 in support to generate $1 of economic growth.)

While the claims of a robust economy rely heavily upon a surge in consumer spending, as noted above, it is a mirage of the increase in “social benefits.”

No Historical Evidence

“I’m worried that they’re excessively paid for. In principle, they’re supposed to be fully paid for. But take what we knew about the economy in 2019. We were really kind of in secular-stagnation land with low neutral real rates. We had full employment then, it was only thanks to extremely low interest rates and persistent deficit spending. What the doctor ordered is some sustained moderate deficit spending.”

Uhm…we did that.

After 12-years of “Zero Interest Rate Policies,” and successive rounds of trillions of dollars in monetary interventions, there has been little to show for it.

The only thing we can attribute to 12-years of the most progressive and aggressive monetary experiments in history is a massive surge in the “wealth gap.” The top 10% of income earners own ~90% of the entirety of equity assets.

I am not sure that doing more of the same is going to generate a different result.

Pulling Forward Consumption Isn’t Sustainable.

The problems that both Keynesian and Modern Monetary Theories run into is three-fold:

1. Debts and deficits have an economically negative impact longer-term.
2. Low-interest rates do not promote economic activity but actually detracts from it due to a lack of incentives.
3. Providing short-term incentives does not increase productive economic activity.

The “trap’ that economists, along with the Fed, have fallen into is that “stimulus” only pulls forward “future consumption.” Yet, as we saw after the initial CARES act, as soon as financial supports evaporated, so did economic growth.

The hope over the last decade was the economy would eventually “catch fire” and grow organically. Such would allow Central Banks to reverse monetary supports. However, such has never occurred. Each time Central Banks reduce monetary supports, the economy stalls or worse.

After 12-years it is clear “something has gone wrong.” Despite perennial hopes of “higher growth rates,” such has not been the case. Instead, the only thing that has grown is the debt and deficits which continue to erode economic solvency.

While the U.S. economy will indeed exit the recession in 2021, it may be a statistical result rather than an economic recovery leading to broader prosperity.

The most significant risk of the latest stimulus package is a surge in inflationary pressures, undermining the stimulus’s benefit. That concern will manifest itself as a stagflationary environment where wages remain suppressed while costs of living rise.

Due to the debt, demographics, and monetary and fiscal policy failures, the long-term economic growth rate will run well below long-term trends. Such will only continue to widen the wealth gap, increase welfare dependency, and socialism usurping the “golden goose” of capitalism.

It’s important to understand the Medicare Set Aside mistakes that can affect future Medicare coverage and benefits. In this blog, we will cover:

• What a Medicare set aside is
• How the allocations get determined
• What the common Medicare set aside mistakes are

Be thankful that “Medicare Set Aside” is not familiar terminology because it means you avoided a worker’s compensation or personal liability settlement due to an injury that can last a lifetime. But if you have, we’re going to cover the basics of what you need to know. Would you mind subscribing to our weekly newsletter in which we talk about how to preserve and grow your wealth?

What is a Medicare Set Aside?

A Medicare set aside (MSA) is simply an account or trust that holds settlement proceeds. Medicare recipients who receive greater than $25,000 for a personal injury settlement or reasonably expect to enroll in Medicare within 30 months of a settlement of more than $250,000 need to consider Medicare Set Aside. Most likely, in the latter instance, an injured party will receive Social Security Disability Insurance benefits or Supplemental Disability Income after a 24-month waiting period. The 1980 legislation was to protect Medicare Trust Funds from several types of ongoing medical and liability claims. It also deemed Medicare the secondary insurance payer in those cases. The action was to shift costs from Medicare to private sources of payment. Consequently, money received due to a settlement gets segregated and spent for ongoing medical issues related to the liability. Medicare becomes the primary insurance payer once the segregated funds become exhausted. A workers’ compensation insurance company may partner with Medicare to request approval for the amount placed in the Set Aside Account. However, this union is not as copacetic as it sounds.

Two broad types of MSAs

Commonly, MSAs get established for Workers’ Compensation claims (WCMSA). In addition, they are used for personal liability settlements (LMSA). The sources of the liabilities may differ, but accounts get established to ensure Medicare is the secondary payer of future claims. Again, the requirement of MSAs is only for Medicare recipients or those eligible after a 30-month waiting period. In addition, recipients reimburse the federal government for medical expenses paid by Medicare before a settlement.

How are MSA Allocations determined?

The crucial first step is to hire a qualified attorney for representation in a Workers’ Comp or personal liability claim. A personal injury professional with a track record in Medicare Set-Asides and secondary payer compliance is an absolute necessity. As a first step, one can look to the Special Needs Alliance. The SNA is a national organization of law professionals with significant experience in disability and elder law. Trying to do this without proper legal support is where Medicare set aside mistakes occur. An MSA expert may be part of the team because there are many moving parts to consider, including the difficulty of extrapolating future medical costs from current records. Per Synergy Settlement Services, a company that specializes as analyst and connection to Centers for Medicare and Medicaid Services:

The professional hired to perform the allocation determines how much of the injury victim’s future medical care is covered by Medicare and then multiplies that by the remaining life expectancy to determine the suggested amount of the set-aside. Medicare does not necessarily accept the allocation recommendation. If an MSA gets submitted to CMS for review/approval, Medicare could require more or less to be set aside than the amount suggested in the MSA allocation.

What about for Workers Comp?

CMS maintains specific standards for creation and adherence to WCMSA guidelines and provides copious guides and instructions. However, as an administrator (could be self-administered) for allocated funds, whether lump sum or paid in an annuity structure, ongoing compliance is an ominous task. We’ll discuss this more later in the blog.

What about personal injury or liabilities?

CMS does not provide clear-cut guidelines, nor is there anything codified into law regarding personal injury or liabilities (LMSAs), making them more challenging to navigate. Attorneys and administrators may start with Workers’ Compensation rules. However, there’s increasing confusion in the application and more art than science regarding the assessment of future benefits required.

Medicare set aside mistakes to avoid

Here are the most common Medicare set aside mistakes we have seen people make.

1. 1. Don’t go it alone. Find an elder-law attorney specializing in MSAs, especially LMSAs, due to the level of complexity and lack of formal rules (although CMS’ Workers’ Compensation tenets act as a guideline).
   2. Is there a need for a professional administrator? Most likely, an administrator gets hired to project future medical costs and the proper long-term allocation of funds. Keep in mind, if CMS rejects a proposed allocation, there is no system in place for appeal. Allocation services costs are usually a flat rate anywhere from $1,800 to $3,000 on average. In my opinion, it’s worth the expense. Unfortunately, it will take time and due diligence to find the right one, especially in a personal liability case. Perhaps, your attorney is an excellent place to start.
   3. The settlement is just the beginning of the journey. Ongoing management until funds are exhausted another long-term responsibility. CMS offers guidelines for the self-administration of WCMSAs. However, one needs to consider how time-consuming self-administration can be. In addition, mistakes can lead to running out of money prematurely or the risk to the future entitlement of Medicare benefits.
   4. Compliance can be a demanding task: annual filings, immaculate recordkeeping of expenses, adherence to Medicare’s pricing schedule for medications.
   5. You can hire a professional administrator for ongoing responsibilities for a flat fee. They’ll establish the FDIC-insured account to hold the segregated funds and file reports with CMS as fiduciaries. Most importantly, they’ll help you avoid Medicare benefits mistakes.

Medicare Set Aside mistakes and benefits can be navigated through partnership with professional administration and qualified legal representation.

Stay on top of your financial health – not just Medicare benefits!

Avoiding Medicare set aside mistakes and optimizing your Medicare benefits are a few aspects of your overall financial health. The ins and outs of Medicare overall can be a challenge to grasp. The greatest Medicare mistake is to let annual enrollment go ignored. Healthcare insurance and coverage require ongoing due diligence by older Americans significantly as costs increase every year and seniors can’t afford to leave benefits on the table. Could you benefit from speaking with someone who is an expert in Medicare and other financial topics that may impact your wealth? Set up a time to talk with us if so.

In this past weekend’s newsletter, I discussed the issue of the markets next “Minsky Moment.” Today, I want to expand on that analysis to discuss how the Fed’s drive to create “stability” eventually creates “instability.”

In 2007, I was at a conference where Paul McCulley, who was with PIMCO at the time, discussed the idea of a “Minsky Moment.”  At that time, this idea fell on “deaf ears” as markets were surging higher amidst a real estate boom. However, it wasn’t too long before the 2008 “Financial Crisis” brought the “Minsky Moment” thesis to the forefront.

So, what exactly is a “Minskey Moment?”

Economist Hyman Minsky argued that the economic cycle is driven more by surges in the banking system and credit supply. Such is different from the traditionally more critical relationship between companies and workers in the labor market. Since the Financial Crisis, the surge in debt across all sectors of the economy is unprecedented.

Importantly, much of the Treasury debt is being monetized, and leveraged, by the Fed to, in theory, create “economic stability.” Given the high correlation between the financial markets and the Federal Reserve interventions, there is credence to Minsky’s theory. With an R-Square of nearly 80%, the Fed is clearly impacting financial markets.

Those interventions, either direct or psychological, support the speculative excesses in the markets currently.

Bullish Speculation Is Evident

Minsky’s specifically noted that during periods of bullish speculation, if they last long enough, the excesses generated by reckless, speculative activity will eventually lead to a crisis. Of course, the longer the speculation occurs, the more severe the problem will be.

Currently, we see clear evidence of “bullish speculation” from:

• Due to commission-free trading and mobile apps, retail trading has exploded.
• A surge in IPO’s
• A record increase in SPAC’s
• Investors paying record multiples and prices for money-losing companies
• Option contract speculation has seen record increases
• Margin debt at new highs and near-record annual increases.
• A widely accepted belief “this time is different,” due to the “Fed Put.”
• Record M&A activity

But, again, these issues are not new. In one form or another, they have all been present at every prominent market peak in history.

Notably, what fosters these periods of exuberance in markets is “stability.” In other words, there are periods of exceptionally low volatility in markets, which breed overconfidence and speculative appetites.

However, these periods of exceptionally low volatility are also a problem.

The Instability Of Stability

Hyman Minsky argued there is an inherent instability in financial markets. As noted, an abnormally long bullish cycle spurs an asymmetric rise in market speculation. That speculation eventually results in market instability and collapse. 

We can visualize these periods of “instability” by examining the Volatility Index versus the S&P 500 index. Note that long periods of “stability” with regularity lead to periods of “instability.”

Given the volatility index is a function of the options market, we can also view these alternating periods of “stability/instability” by looking at the daily price changes of the index itself.

A “Minsky Moment” is the reversal of leverage following prolonged bullish speculation. The build-up of leverage is the direct result of the complacency occurring from low-volatility market regimes.

One way to look at “leverage,” as it relates to the financial markets, is through “margin debt,” and in particular, the level of “free cash” investors have to deploy. So, for example, in periods of “high speculation,” investors are likely to be levered (borrow money) to invest, which leaves them with “negative” cash balances.

Critically, while “margin debt” provides the fuel to support the bullish speculation, it is also the accelerant for “crisis” when it occurs. 

The Dependency Of The Fed

The dependency on maintaining “stability” is the most significant problem facing the Fed.

Currently, the Fed has created a “moral hazard” in the markets by inducing investors to believe they have an “insurance policy” against loss. Therefore, investors are willing to take on increasing levels of financial risk. This level of speculative risk-taking gets shown in the current yields of CCC-rated bonds. These are corporate bonds just one notch above “default” and should carry very high yields to compensate for that default risk.

As noted, with the entirety of the financial ecosystem more heavily levered than ever, the “instability of stability” is now the most significant risk.

The Paradox

The “stability/instability paradox” assumes that all players are rational. Therefore, such rationality implies avoidance of destruction. In other words, all players will act rationally, and no one will push “the big red button.”

The Fed is highly dependent on this assumption as it provides the “room” needed, after more than 12-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that have built up in the system.

The Fed is dependent on “everyone acting rationally.”

Unfortunately, that has never been the case.

Throughout history, as noted above, the Fed’s actions have repeatedly led to adverse outcomes despite the best of intentions.

• In the early 70’s it was the “Nifty Fifty” stocks,
• Then Mexican and Argentine bonds a few years after that
• “Portfolio Insurance” was the “thing” in the mid -80’s
• Dot.com anything was a great investment in 1999
• Real estate has been a boom/bust cycle roughly every other decade, but 2006 was a doozy
• Today, it’s ETF’s and “Passive Investing,” and levered credit.

Another measure of “exuberance” is the deviation from the long-term moving averages. As shown, the market pushing an extreme deviation from the 4-year moving average, with the 12-month relative strength index (RSI) in very overbought territory.

The problem with “monthly charts” is they are slow to mature. The current period of exuberance could last another 12-18 months, potentially even longer. The extended period of “stability” will lead investors to “dismiss” the warning as “wrong” given it did not immediately result in a correction.

As Howard Marks once quipped:

“Being early is the same as being wrong.”

Therefore, while investors must manage portfolios in the near term to generate returns, it is undoubtedly a warning you should not dismiss entirely.

Rates Are Also Sending A Warning

The risk to this entire market remains a credit-related event.

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. That is, until suddenly, and often without warning, it all goes “pear-shaped.”

We wrote in early 2020, just before the Covid crisis, that yields would approach zero.

“While yields going to zero certainly sounds implausible at the moment, just remember that all yields globally are relative. If global sovereign rates are zero or less, it is only a function of time until the U.S. follows suit. This is particularly the case if there is a liquidity crisis at some point.

It is worth noting that whenever Eurodollar positioning has become this extended previously, the equity markets have declined along with yields. Given the exceedingly rapid rise in the Eurodollar positioning, it certainly suggests that ‘something has broken in the system.’” 

It wasn’t long after that yields approached zero in the depth of the economic shutdown.

With risk elevated, the Fed continues to supply liquidity at the rate of $120 billion a month. The sole goal, of course, is to maintain “stability.” Importantly, with inflation pushing 5%, and economic growth expected to surpass 4%, interest rates should be at a corresponding level.

However, interest rates are warning that “something is not quite right” in the financial system. Previously, when rates have risen from lows and peaked, such has preceded periods of “market instability.”

Will this time be different.

Maybe.

But history suggests it won’t be.

Conclusion

Only those that risk going too far can possibly find out how far one can go.” – T.S. Eliot

All of this underscores the single most significant risk to your investment portfolio.

In extremely long bull market cycles, investors become “willfully blind” to the underlying inherent risks. Or rather, it is the “hubris” of investors that they are now “smarter than the market.”

Yet, the list of concerns remains despite being completely ignored by investors and the mainstream media.

• Growing economic ambiguities in the U.S. and abroad: peak autos, peak housing, peak GDP.
• Excessive valuations that exceed earnings growth expectations.
• The failure of fiscal policy to ‘trickle down.’
• Geopolitical risks
• Flattening of yield curves amid surging economic growth.
• Record levels of private and public debt.
• Exceptionally low junk bond yields

For now, none of that matters as the Fed seems to have everything under control.

The more the market rises, the more reinforced the belief “this time is different” becomes.

Yes, our investment portfolios remain invested on the long side for now. (Although we continue to carry slightly higher levels of cash and hedges.)

However, that will change, and rapidly so, at the first sign of the “instability of stability.” 

When will the next “Minsky Moment” arrive? We don’t know.

What we do know is that by the time the Fed realizes what they have done, as always, it will be too late.

Earnings up, multiples down. Such seems to be a straightforward rationale for why investors should pile into markets as it enters a “new phase.” 

Such was the suggestion made recently by Yahoo! Finance anchor Myles Udland.

“The stock market is entering a new phase. Investors right now are faced with a simple question: how much? How much do they want to pay for earnings growth that continues to blow away expectations but might also be peaking?”

It’s a good question. 

With wealth investors expecting to earn 17% average annual returns, there currently does seem to be little concern about valuations.

“According to a new survey from Natixis that surveyed households that have over $100,000 in investable assets in March and April of 2021. Those same investors report they expect to earn 17.3% above inflation in 2021, which, while high, may be understandable.“

However, to assess “how much,” we need to understand what it means when the media makes comments about “forward earnings” and “future multiples.”

Not A New Cycle

We need to start by dispelling the myth that begins the article. The market is “not” entering a “new phase.” Yet, in a rush to pitch the bullish case for stocks, the media has continued to suggest the March 2020 decline was a “bear market cycle.” Such would support the idea a new “bull market cycle” has started.

However, as discussed in “Confusing Bear Markets & Crashes,” March was a “correction” within a “bull market cycle.” To wit:

“As Sentiment Trader notes, the 20% rule is arbitrary. The question is, after a decade-long bull market, which stretched prices to extremes above long-term trends, is the measure still valid? “

If a 20% decline is arbitrary, what measures accurately define a “bull” or “bear” market? To answer that question, let’s clarify the premise.

• A bull market is when the price of the market is trending higher over a long-term period.
• A bear market is when the previous advance breaks, and prices begin to trend lower.

The chart below provides a visual of the distinction. When you look at price “trends,” the difference becomes both apparent and valuable.

This distinction is vital for investors, particularly when discussing the starts of “new market cycles.”

• “Corrections” generally occur over short time frames, do not break the prevailing trend in prices, and are quickly resolved by markets reversing to new highs.
• “Bear Markets” tend to be long-term affairs where prices grind sideways or lower over several months as valuations are reverted.

The decline in March did not meet any of the criteria necessary to be classified as a “bear market.” 

• The decline was unusually swift and did not break the prevailing bullish price trend. 
• The recovery to new highs occurred quickly; and,
• Valuations did not revert from previously elevated levels.

Stocks Are Eating Earnings

As noted, the correction in March did not revert the overvaluation in the markets that existed in February of 2020. While earnings declined, the price advance was so fast it kept valuations elevated throughout the “economic shutdown.” Thus, while valuations did not get more expensive, they did not get cheaper either.

“The chart, which came from Credit Suisse equity strategist Jonathan Golub, showed that while stock prices had been in rally mode for months, the market wasn’t getting more expensive.” – Myles Udland

In other words, the rise in prices “ate the recovery” in earnings. If this had been a “real bear market,” investors would have shunned stocks keeping prices depressed as earnings recovered, thereby lowering valuations.

That is also another characteristic of “bull market correction” and a “real bear market.” Following a “bear market,” investors do not rush back into the riskiest of assets. 

Most importantly, you don’t see investors piling into leverage at the beginning of a new “bull market cycle.”

The Problem With Lower Forward Valuations

However, here is the “ugly truth” of “forward valuations.” Let’s start with Myles’s analysis as a baseline.

“Right now, the S&P 500 currently trades at roughly 22x forward earnings. You might hear this referred to as the market’s multiple or its valuation. The terms are roughly interchangeable. And we say roughly because there are always exceptions. 

So a simple way of thinking about the earnings multiple for the market is how much you need to pay as an investor for $1 of earnings power.” – Myles Udland

The S&P 500 recently traded at 4,353. According to the latest data from S&P, earnings estimates for the index at the end of 2022 are $189. Divide the index level by the expected annual earnings for the index, and you get the earnings multiple. In this case, 4,353 divided by 189 is 23.03. So, for every $23.03 you put into the S&P 500, you can expect to get back $1 in earnings based on today’s estimates.

Read that again.

23-Years To Get Your Money Back

While investors take this to mean the market will be cheaper in the future, therefore using that rationalization to “buy stocks,” such is not the case.

The correct way to interpret valuations of 23x earnings is to realize two things. 

For earnings in the future to catch up with the market’s current price, price returns over the next 18-months must be ZERO. 

If stocks continue to appreciate during the period, valuations can decline if earnings growth is faster than the price of appreciation. However, such does not necessarily resolve the overvaluation of the market.

Secondly, and to Myles’s last point, while it may seem like a “bargain” to pay $23 for each $1 of earnings, that is not precisely what that means. Here is the math:

“If you pay $23 for $1 in earnings, and the company distributes that $1 of earnings to you each year, it will only take you 23-years to get your money back.“

All of a sudden, that doesn’t sound like such a good deal.

Valuations Are Astronomical

In 2013, valuations on stocks were around 19x trailing earnings. While certainly expensive, valuations had not yet eclipsed previous “bull market” excess of 23x earnings. As shown below, even if we assume no increase in the index price, the market will remain well above 20x earnings over the next two years assuming analyst estimates are correct.

I recently quoted Carl Swenlin on earnings. As Carl noted, there is nothing normal with GAAP earnings. But, of course, today, most companies report “operating” earnings which obfuscate profitability by excluding all the “bad stuff.” 

The following table shows the expectations for reported earnings growth:

• 2020 (actual) = $94.13 / share
• 2021 (estimate) = $161.62  (Increase of 71.69% over 2020)
• 2022 (estimate) = $189.48  (Increase of 101.29% over 2020)

The chart below uses these earnings estimates and assumes NO price increase for the S&P 500 through 2022. Such would reduce valuations from 41x earnings currently to roughly 22x earnings in 2022. (That valuation level remains near previous bull market peak valuations.)

However, as stated above, investors always bid up prices as earnings increase. With earnings expected to double over the next two years, if we reduce wealthy investor return assumptions to just 15% annually, the picture changes. Instead of valuations declining, the increase in price keeps valuations hovering near 27x earnings.

Potentially Disappointing Outcomes

Given that markets are already trading well above historical valuation ranges, such suggests that outcomes will likely not be as “bullish” as many currently expect.

“Historically, price has usually remained below the top of the normal value range (red line); however, since about 1998, it has not been uncommon for price to exceed normal overvalue levels, sometimes by a lot. The market has been mostly overvalued since 1992, and it has not been undervalued since 1984. We could say that this is the ‘new normal,’ except that it isn’t normal by GAAP (Generally Accepted Accounting Principles) standards.” – Carl Swenlin

The hope, as always, is that earnings will rise to justify the over-valuation of the market. However, when earnings are rising, so are the markets.

Most importantly, analysts have a long and sordid history of being overly bullish on expectations of growth which fall well short. Such is particularly the case today. Much of the economic and earnings growth was not organic. Instead, it was from the flood of stimulus into the economy, which is now evaporating.

Conclusion

While Myles’ analysis is typical for mainstream media, it is essential always to consider the context in which it gets structured.

Throughout history, overvaluations of markets have never been resolved by earnings catching up with the price. Secondly, the two-fold problem of the temporary nature of the stimulus and inflation leaves the market vulnerable to a downshift in earnings expectations over the next couple of quarters. As noted, Wall Street has ratcheted up expectations to try and justify current prices.

However, a bit of analysis suggests that over-estimating earnings will lead to a price correction when it becomes realized. While that is something we do not expect immediately, we think markets will likely wake up to this reality in the last half of the year.

While monetary interventions allow market participants to ignore the reality of the economic ties to the market, such does not preclude hair-raising volatility and significant declines, as we saw in March 2020.

In 2021 and 2022, earnings are likely to come in once again lower than analyst’s exuberant estimates. But such shouldn’t be a surprise since they are never accurate historically. More importantly, if the Fed backs off, whether by its design or due to inflation, slower economic growth, or massive debt overhead, rich valuations will matter.

The risk of disappointment is high. And so are the costs of investing based on analysis without all of the facts.

In this 07-23-21 issue of “Bulls Buy The Dip But Is The Risk Really Over?”

• Bulls Buy The Dip & The Next Minsky Moment
• Trading Sardines
• The Fed Is Deflationary
• Portfolio Positioning
• Sector & Market Analysis
• 401k Plan Manager

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

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Are you worried about the potential for a market correction, a surge in inflation, or are you unsure how to invest for your retirement? We can help. If you are not yet a client and would like to discuss your portfolio construction, please schedule a time to meet with one of our advisors below.

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Bulls Buy The Dip

Last week, we discussed that as the market hit new highs and the index returned to more extended and overbought conditions, a correction was likely. To wit:

“Analysts have set a very high bar for the markets to hurdle, given already lofty valuations. With indices already well-stretched above their historical means, there is much room for disappointment. With the currently very overbought short-term market, a 3% to 10% correction this summer remains likely.”

Well, between Friday and Monday, the market did sell-off by 3% to touch the 50-dma. However, at that point, “dip buyers” emerged to chase the market back to new highs. While this does indeed negate any short-term bearish action, it is worth noting two things (shown below):

• The volume of the rally was extremely light; and,
• The sell-off was too shallow to reverse the underlying technical concerns.

The good news is that the lack of real progress over the last couple of weeks did work off most of the “money-flow sell signal,” which preceded the selloff. If the market can continue to maintain its more bullish posture, this should reverse our signals as early as next week.

While the upside remains somewhat limited, given the already substantial advance this year, it will alleviate downside concerns momentarily. However, with that said, the extremely low level of volatility this year is reminiscent of 2017. The reason is that “stability” is fragile. In other words, stability ultimately leads to instability.

Economist Hyman Minsky argued that during long periods of bullish speculation, the excesses generated by reckless, speculative activity eventually lead to a crisis. Of course, the longer the speculation occurs, the more severe the crisis will be.

The Next Minsky Moment

Minsky argued there is an inherent instability in financial markets. He postulated that abnormally long bullish cycles would spur an asymmetric rise in market speculation. That speculation would eventually result in market instability and collapse. Thus, a “Minsky Moment” crisis follows a prolonged period of bullish speculation, which is also associated with high amounts of debt taken on by both retail and institutional investors.

One way to view “leverage” is through “margin debt,” and in particular, the level of “free cash” investors have to deploy. In periods of “high speculation,” investors are likely to take on excess leverage (borrow money) to invest, which leaves them with “negative” cash balances.

While “margin debt” provides the fuel to support the bullish speculation, it is also the accelerant for the reversal when it occurs. Periods of low volatility, and steadily rising prices, lead to market complacency. As noted, the last period where we saw similar levels of low volatility was 2017.

Of course, that low-volatility period in 2017 didn’t last long. The “Minsky Moment” arrived in 2018 and lasted through 2020 as price swings punctuated the markets. While this current low-volatility regime can certainly last a while longer, it is likely naive to believe the next “Miskey Moment” will be any less punishing than the last.

The last time I wrote about a “Minsky Moment,” here was my conclusion.

“Professor Minsky taught that markets have short memories and they repeatedly delude themselves into believing “this time is different.” Sadly, judging by today’s market exuberance, once again Minsky is likely to be proven correct.

All that is missing is the catalyst to start the ball rolling.

An unexpected recession would more than likely do to trick.”

That was February 2020, one month before the recession began.

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Trading Sardines

“In ‘Margin of Safety,’ Seth Klarman tells a story about the market craze in sardine trading. One day, the sardines disappeared from their traditional habitat off of the Monterey, California, shores. Due to their scarcity, commodity traders bid up the price of sardines. Prices soared.

Eventually, along comes a gentleman who decides to treat himself and opens up a can of sardines and eats them. He immediately gets ill and tells the seller the sardines are no good. The seller quickly responds, ‘You don’t understand. These are not eating sardines; these are trading sardines!'” – Doug Kass

On Monday, the market sold off over fears of the “Delta variant.” (Someone ate the sardines.) On Tuesday, as the market touched the 50-dma, computer algorithms furiously “traded sardines.”

Such is not an investor’s market. Rather, it is a market fraught with speculative frenzy as investors fear “missing out” more than “losing capital.”

In the short term, speculation seems “normal.” However, as the price advances, the underlying valuations become an inherently more significant drag on outcomes. Currently, those valuations exceed levels rarely witnessed in history. (Table courtesy of Tavi Costa of Crescat Capital)

If you are a long-term investor, it is becoming more critical to understand the risk you are undertaking. Likewise, if you are a trader, it is essential to determine what type of trader you are. As Doug concluded:

“In terms of trading, more than ever, it’s important to remember that there are two kinds of traders:

• Those who are humble.
• Those who are going to be humbled.

Remember those words because, despite the appearance of the many talking heads in the business media who regal in the reversal of Monday’s losses and consecutive winning trades. The stock market is likely to grow more difficult and narrow in the months ahead.”

The Fed’s Power

Over the past few years, Michael Lebowitz and I have written many articles discussing the perils of excessive monetary policy. These perils range from slower economic growth, excessive speculation, the formation of asset bubbles, and wealth inequality. The last point is most important.

Wealth inequality is the catalyst behind the calls for socialism, the increase in riots, and racial tensions. When individuals cannot make “ends meet,” they begin to lash out at those who are prospering at their expense. Such is not new but rather a consequence of similar periods of inequality throughout history. Notably, the wealth gap is directly related to the Federal Reserve monetary interventions.

The speculative retail frenzy in the financial markets is further evidence of the Fed’s monetary mistake of creating “Moral Hazard.“ As Charles Mackay noted in his book on “The Madness Of Crowds:“

“Essential is the understanding of the role psychology plays in the formation and expansion of financial manias. From the 1711 ‘South Sea Bubble’ to the 2000 ‘Dot.com crash,’ all bubbles formed from a similar ‘panic’ by investors to chase ongoing speculation.”

On Thursday, Michael Lebowitz and I discussed the ongoing problems of the Fed’s monetary interventions in much greater detail. This discussion includes 10-clips from various Fed members, Jeremy Grantham, Mohammed El-Erian, and Howard Marks, to support our views.

The problem for the Fed, as discussed, is they have now inflated multiple asset bubbles from which they cannot extricate themselves. If they try and “taper” monetary policy, the markets panic. With the entirety of the financial ecosystem more heavily levered than ever, the Fed’s most significant risk is the “instability of stability.” 

Ultimately, the Fed can choose to reverse monetary policy and navigate the fallout. Or, some exogenous event will eventually do it for them.

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In Case You Missed It

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The Fed Is Deflationary

On Thursday, Mish Shedlock penned an excellent post on Lacy Hunt and the inflation argument. While I suggest reading it in its entirety, the following except supports our recent views on why “Monetary Policy Is Not Expansionary.”

“When debt is already at extreme levels, a further increase in debt leads to an increase in the risk premium on which a borrower will default suggesting that the bank or other lender will not be repaid.

In terms of the impact on monetary activities, a drop in the LD ratio means that more of bank deposits are being directed to the purchase of Federal, Agency and state and local securities in lieu of private sector loans. The macroeconomic result is that funds are shifted to sectors that are the least productive engines of economic growth and away from the high multiplier ones.” – Dr. Lacy Hunt

The shift in “risk preference” by banks is evident. Each time the Fed engages in QE programs, banks “hoard” those reserves as the “risk/reward” of loaning money into the economy is not justified. 

As we repeatedly stated previously, disinflation is more likely than accelerating inflation. 

With the base effects now exhausted, the cyclical, structural, and monetary considerations suggest inflation will decline by year-end. Thus, the “inflationary psychosis” gripping the bond market is already reversed as the realization of slower economic growth and disinflation occurs.

Given that wages are not keeping up with inflation currently, consumers’ ability to continue expanding their consumption “sans stimulus” will become problematic.

Given we already see cracks in the housing and auto markets, there is likely a deflationary “payback” coming much sooner than expected.

As Mish concludes

“QE sponsors bubbles and central banks are addicted to it.”

The problem with addictions is the eventual “withdrawal.”

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Portfolio Update

We have not made tremendous changes to our portfolio models as of late. We still maintain a nearly fully allocated equity allocation in our models along with a bond portfolio that remains fairly short-duration.

As we have been recommending over the last couple of weeks, we have followed our basic rules of portfolio risk management. We took actions to:

• Take profits in positions that rose sharply and exceeded our portfolio allocation sizing limits.
• Reduce positions that were underperforming but still maintain strong fundamental underpinnings.
• Rebalance sector allocations to aligns with our portfolio benchmarks as needed.

About three weeks ago, we noted that we started to increase the duration of our bond portfolios, expecting a peak in economic activity. Over the last week, the bond market came to agree with our views, and that increased duration provided a hedge against equity risk. So on Thursday, we increased our duration again as the 10-year Treasury rate touched and held the 200-dma.

By the end of this year, we expect that we will likely see treasury rates fall below the 1% level once again as the markets realize artificial short-term economic growth is not the same as real growth.

However, in the short term, we remain focused on our equity exposure. After next week, the bulk of the S&P 500 will have reported earnings. Such leaves the market vulnerable to August and September’s seasonally weak tendencies.

The #market continues to follow it's #seasonal #pattern for the summer months. With #talk of #taper create the #selloff in #August?
Chart via #GoldmanSachs. pic.twitter.com/fz0weYKs8D

— Lance Roberts (@LanceRoberts) July 22, 2021

As we have noted over the last several weeks, it has been an exceptionally long period without a 5% correction, or more, in the market. While such does not mean it “MUST” occur, the probabilities of such an occurrence outweigh the possibilities it won’t.

Have a great weekend.

By Lance Roberts, CIO

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Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members

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S&P 500 Tear Sheet

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Performance Analysis

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Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” are oversold. The current reading is 88.81 out of a possible 100.

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Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 75.50 out of a possible 100.

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Sector Model Analysis & Risk Ranges

How To Read This Table

• The table compares each sector and market to the S&P 500 index on relative performance.
• “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
• The risk range is a function of the month-end closing price and the “beta” of the sector or market.
• Table shows the price deviation above and below the weekly moving averages.

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Weekly Stock Screens

Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

Low P/B, High-Value Score, High Dividend Screen

Fundamental Growth Screen

Aggressive Growth Strategy

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Portfolio / Client Update

From the main body of this week’s newsletter:

“We have not made tremendous changes to our portfolio models as of late. We still maintain a nearly fully allocated equity allocation in our models along with a bond portfolio that remains fairly short-duration.

As we have been recommending over the last couple of weeks, we have followed our basic rules of portfolio risk management. We took actions to:

• Take profits in positions that rose sharply and exceeded our portfolio allocation sizing limits.
• Reduce positions that were underperforming but still maintain strong fundamental underpinnings.
• Rebalance sector allocations to aligns with our portfolio benchmarks as needed.

“About three weeks ago we noted that we started to increase the duration of our bond portfolios expecting a peak in economic activity. Over the last week, the bond market came to agree with our views and that increased duration provided a hedge against equity risk. On Thursday, we increased our duration again as the 10-year Treasury rate touched and held the 200-dma.

We expect that by the end of this year, we will likely see treasury rates fall below the 1% level once again as the markets realize artificial short-term economic growth is not the same as real growth.

However, in the short term, we remain focused on our equity exposure. After next week, the bulk of the S&P 500 will have reported earnings. Such leaves the market vulnerable to further corrective action as we move into the seasonally weak summer months of August and September.“

Portfolio Changes

During the past week, we made minor changes to portfolios. In addition, we post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

“This morning we added 1% DUK to the equity model bringing the exposure to Utilities to 2%. This action aligns the Equity Model with the ETF Model in terms of Utility exposures.” – 07/22/21

Equity Model

• Buy 1% of the portfolio in DUK

“We are adding to our existing TLT (20-year Treasury Bond) holding today to increase our exposure on this recent pullback in rates. With economic growth likely to have peaked, we feel there is more downside pressure on yields to come by year-end. Given we are very underweight our benchmark in bonds, the minor addition of duration moves us in the right direction.” – 07/21/21

Equity & ETF Models

• Increase TLT from 2.5% of the portfolio to 3.5%.

“This morning we are reducing exposure slightly in portfolios particularly in the Nasdaq-related areas which is extremely overbought relative to the S&P 500 index. As has been the case with our actions as of late, we continue to tweak exposures to reduce overall risk while still maintaining our core positions.” – 07/20/21

Equity Model 

• Reduce ADBE by 1% of the portfolio
• Sell 1% of AAPL as it has run well ahead of earnings.
• Reduce UPS by 1% of the portfolio
• Sell down AMLP from 3.5% to 2% of the portfolio.

ETF Model

• Reduce XLV by 1% of the portfolio. 
• Reduce XLK by 1% of the portfolio. 

As always, our short-term concern remains the protection of your portfolio. Accordingly, we have shifted our focus from the election back to the economic recovery and where we go from here.

Lance Roberts, CIO

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THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors

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

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401k Model Performance Analysis

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

Have a great week!

The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You will find more detail on the model and the specific tickers below the charts.

Commentary 7-23-21

• The same themes from the last few weeks continue. Growth sectors remain overbought versus the S&P 500, while cyclical sectors are generally underperforming. Healthcare and Technology continue to be the two hottest sectors. Realestate (XLRE) gave up 3% to the S&P 500, which pushed its relative score back toward fair value. It was the most overbought sector in the prior week.
• The third graph below shows each sectors excess returns versus the S&P 500. Of note, the most current 10 day period shows that staples and utilities are finally green. Conversely, energy has had a few abysmal weeks versus the market. Looking at the longest time frame, 240 trading days (approximately 1 year), staples and utilities are still down signficantly versus the market. Financials and transportation stocks have the largest gains over that period. If we look back to February 19th, the pre-pandemic peak, only utilities and energy are still lower over that period.
• The factor/index relative value graphs also show that growth, in particular the NASDAQ (QQQ), are the only equity factor/index trading with a positive relative score. All of the factors/indexes with negative scores became a little less oversold over the last week.
• On the absolute series of charts, the cyclical inflationary sectors all improved on the week and are back to, or near fair value. Technology continues to move deeper into overbought territory. This coming week will feature earnings reports for many of the technology companies. Even if they report strong earnings, they may have lackluster gains given their run up over the past month. Technology is now over 2 standard deviations above its 200 dma and about 1.5 above its 20 and 50 dmas.
• The absolute factor/index graph shows that everything has a higher score this week versus last week except for emerging markets (EEM). EEM is sitting on its 200 dma and about 1 standard deviation below its 50 and 20 dmas.
• The S&P continues to hover in modestly overbought territory as do all of the bond sectors.

Graphs (Click on the graphs to expand)

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Users Guide

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change trend. When the scatter plot in the sector graphs has an R-squared greater than .60 the signals are more reliable.

The first set of four graphs below are relative value-based, meaning the technical analysis is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

• Staples XLP
• Utilities XLU
• Health Care XLV
• Real Estate XLRE
• Materials XLB
• Industrials XLI
• Communications XLC
• Banking XLF
• Transportation XTN
• Energy XLE
• Discretionary XLY
• S&P 500 SPY
• Value IVE
• Growth IVW
• Small Cap SLY
• Mid Cap MDY
• Momentum MTUM
• Equal Weighted S&P 500 RSP
• NASDAQ QQQ
• Dow Jones DIA
• Emerg. Markets EEM
• Foreign Markets EFA
• IG Corp Bonds LQD
• High Yield Bonds HYG
• Long Tsy Bonds TLT
• Med Term Tsy IEI
• Mortgages MBB
• Inflation TIP
• Inflation Index- XLB, XLE, XLF, and Value (IVE)
• Deflation Index- XLP, XLU, XLK, and Growth (IWE)

It’s now official that the recession of 2020 was the shortest in history. 

According to the National Bureau of Economic Research, the contraction lasted just two months, from February 2020 to April 2020. However, during those two months, the economy fell by 31.4% (GDP), and the financial markets plunged by 33%. Both of those declines, as shown in the table below, are within historical norms.

Here it is graphically. The chart shows the historical length of each recession and the corresponding market decline.

However, while the effects of the “recession” were all within historical norms, the recession itself was not. 

Let me explain.

A Non-Standard Recession

The statement from the NBER is as follows:

“In determining that a trough occurred in April 2020, the committee DID NOT conclude that the economy has returned to operating at normal capacity. The committee decided that any future downturn of the economy would be a new recession and not a continuation of the recession associated with the February 2020 peak. The basis for this decision was the length and strength of the recovery to date.”

As I said, the recession was non-standard. Conventionally, the NBER defines a recession as two consecutive quarters of negative GDP growth. Notably, while the recession did technically meet the criteria after GDP fell 5% in Q1, recessions tend to last more than three months historically.

The difference was the massive interventions of 20% of GDP beginning in Q2, which created an “artificial growth surge” in the economy by pulling forward consumptive activity. That led to an explosive recovery in GDP in Q3 of nearly 30%.

It is essential to note that the NBER stated that any subsequent downturn would get labeled as a “new” recession. That view accounts for the recovery driven by massive interventions even though that growth is not sustainable.

As such, the “next recession” may not be as far off as many currently expect.

Why Recessions Are Important

Our discussion must begin with a basic concept: “recessions” are not a “bad thing.” 

It is a given you should never mention the “R” word. People immediately assume you mean the end of the world: death, disaster, and destruction. But, unfortunately, the Federal Reserve and the Government also believe recessions “are bad.” As such, they have gone to great lengths to avoid them.

However, what if “recessions are a good thing,” and we just let them happen?

“What about all the poor people that would lose their jobs? The companies that would go out of business? It is terrible to think such a thing could be good.”

Sometimes destruction is a “healthy” thing, and there are many examples we can look to, such as “forest fires.”

Wildfires, like recessions, are a natural part of the environment. They are nature’s way of clearing out the dead litter on forest floors, allowing essential nutrients to return to the soil. As the soil enrichens, it enables a new healthy beginning for plants and animals. Fires also play an essential role in the reproduction of some plants.

Ask yourself this question: “Why California has so many wildfire problems?” 

Is it just bad luck and negligence? Or, is it decades of rushing to try and stop fires from their natural cleansing process as noted by MIT:

“Decades of rushing to stamp out flames that naturally clear out small trees and undergrowth have had disastrous unintended consequences. This approach means that when fires do occur, there’s often far more fuel to burn, and it acts as a ladder, allowing the flames to climb into the crowns and takedown otherwise resistant mature trees.

While recessions, like forest fires, have terrible short-term impacts, they also allow the system to reset for healthier growth in the future.

No Tolerance For Recessions

Following the century’s turn, the Fed’s “constant growth mentality” not only exacerbated rising inequality but fostered financial instability. Rather than allowing the economy to perform its Darwinian function of “weeding out the weak,” the Fed chose to “mismanage the forest.” The consequence is that “forest fires” are now more frequent.

Deutsche Bank strategists Jim Reid and Craig Nicol previously wrote a report that echos this analysis.

“Actions are taken by governments and central banks to extend business cycles and prevent recessions lead to more severe recessions in the end.” 

Prolonged expansions had become the norm since the early 1970s, when President Nixon broke the tight link between the dollar and gold. The last four expansions are among the six longest in U.S. history .

Why so? Freed from the constraints of a gold-backed currency, governments and central banks have grown far more aggressive in combating downturns. They’ve boosted spending, slashed interest rates or taken other unorthodox steps to stimulate the economy.” – MarketWatch

But therein also lies the problem.

The Darwinian Process Of Recessions

As we discussed in our series on “Capitalism,” if allowed to operate, is a “Darwinian System.” As with Darwin’s theory of evolution, corporate evolution has the same essential components as biological evolution: competition, adaptation, variation, overproduction, and speciation. In other words, as an economic system, companies either adapt, evolve, and survive or become extinct. 

However, in 2008, the Government and Federal Reserve began a process of “bailing” out companies that should have been allowed to go “bankrupt.”  The consequence of that process is the failure to enable the system to “clear itself” of the excess debt, which diverts capital away from productive uses.

I have illustrated the continual increases in debt used to create minimal economic growth. Specifically, since 2008, the Federal Reserve and the Government have pumped more than $43 Trillion into the economy. But, in exchange, that debt generated just $3.5 trillion in economic growth, or rather, $12 of monetary stimulus for each $1 of growth. Such sounds okay until you realize it came solely from debt issuance.

As Ruchir Sharma previously penned:

“Modern society looks increasingly to government for protection from major crises. Whether recessions, public-health disasters or, as today, a painful combination of both. Such rescues have their place. Few would deny that the Covid-19 pandemic called for dramatic intervention. But there is a downside to this reflex to intervene, which has become more automatic over the past four decades. Our growing intolerance for economic risk and loss is undermining the natural resilience of capitalism and now threatens its very survival.”

Such is an important concept to comprehend. 

Just as poor forest management leads to more wildfires, not allowing “creative destruction” to occur in the economy leads to a financial system that is more prone to crises.

Structural Fagility

Given the structural fragility of the global economic and financial system, policymakers remain trapped in the process of trying to prevent recessions from occurring due to the extreme debt levels. Unfortunately, such one-sided thinking ultimately leads to skewed preferences and policymaking.

As such, the “boom and bust” cycles will continue to occur more frequently at the cost of increasing debt, more money printing, and increasing financial market instability.

It is clear the Fed’s foray into “policy flexibility” did extend the business cycle. However, those extensions led to higher structural budget deficits. The cancerous byproduct of increased private and public debt, artificially low-interest rates, negative real yields, and inflated financial asset valuations is problematic.

However, these policies have all but failed to this point. From “cash for clunkers” to “Quantitative Easing,” economic prosperity worsened. Pulling forward future consumption, or inflating asset markets, exacerbated an artificial wealth effect. Such led to decreased savings rather than productive investments.

The Fed’s “Moral Hazard”

A growing body of research shows that constant government stimulus is a significant contributor to many of modern capitalism’s most glaring ills. Wealth inequality is the most obvious.

However, another more important but not noticeable side effect is that it keeps alive heavily indebted “zombie” firms. 

When a company is “kept alive,” it comes at the expense of startups, which typically drive innovation. All of this leads to lower productivity which is the prime contributor to the slowdown in economic growth and a shrinking pie for everyone. (See chart above.)

By not allowing “recessions” to perform their natural “Darwinian” function of “weeding out the weak,” it creates a macroeconomic problem. As previously noted by Axios:

“Zombie firms are less productive, and their existence lowers investment in, and employment at, more productive firms. In short, a side effect of central banks keeping rates low for a long time is it keeps unproductive firms alive. Ultimately, that lowers the long-run growth rate of the economy.”

If “recessions” are allowed to function, the weak players will fail. Stronger market players would acquire failed company assets. Bond-holders would receive some compensation for their debt holdings. Shareholders, the ones who accepted the most risk, would get wiped out.

Furthermore, assuming capitalism was allowed to function, investors would require appropriate compensation for the risk when loaning money to companies. As such, credit-related investors would get compensated for their risk rather than the current state of abnormally low yields for junk-rated debt.

The consequence, of course, is that since the “Darwinistic process” of a recession did not occur, and the macroeconomic system is even more fragile than previously, the next downturn could happen sooner than later.

The Next Recession

While the interventions certainly salvaged the economy from a more prolonged recessionary event, they also made the economy more fragile. Furthermore, by dragging forward future consumption, the interventions only gave the appearance of economic activity. As excess stimulus fades and assuming interventions don’t repeat, the economy will return its pre-covid growth trend of 2% or less.

Such should not be a surprise given that economic growth is roughly 70% consumption. With wage growth well below inflationary pressures, consumption will get impacted by higher prices.

With Treasury yields dropping and the yield curve reversing, these are early warning signs that economic growth is indeed slowing.

While the NBER declared the 2020 recession the shortest in history, such does not preclude another recession from occurring sooner than later.

All the excesses that existed before the last recession have only worsened since then.

• Excess Debt
• High Stock Market Valuations
• Investor Complacency
• Financial System Fragility
• Weak Economic Underpinnings
• Declining Monetary Velocity
• Low Interest Rates Detering Productive Activity
• Financial Liquidity Required To Keep Asset Prices Elevated

Given the dynamics for an economic recession remain, it will only require an unexpected, exogenous event to push the economy back into contraction.

Such is why the NBER is clear in saying they will classify the next downturn as a separate recession.

If you are quick to dismiss the idea, remember no one expected a recession in 2020 either.

But we did warn you about it in 2019.

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The “Fear Of Missing Out” has infected retail and hedge funds alike as they ramp up exposure to chase performance.

We have previously discussed the near “mania” of retail investors taking on exceptional risk in various manners. From increasing leverage, engaging in speculative options trading, and taking out personal loans to invest, it’s all evidence of overconfident investors.

However, that “risk appetite” is not relegated to retail investors alone. Professional managers, institutions, and hedge funds are “all in” as well.

Money Flows Are Huge

The evidence of “professional investor” exuberance is the massive inflows of capital. The first half of 2021 outpaced every year since the Financial Crisis lows.

That surge in inflows came from a rotation of foreign investors. The inflows are a function of expectations for more robust economic growth in the U.S. relative to their home country. The divergence in performance between the “Rest Of The World” and the U.S. represents the performance chase.

One issue is the extreme overbought and deviated conditions of the U.S. market. Such conditions, when coupled with a deterioration of participation of stocks, remain a concern. (Bottom panel)

A Mental Formation

Nonetheless, given the $120 billion a month in “Quantitative Easing” by the Federal Reserve, it is not surprising to see the “performance chase” in action. As noted in “Market Will Soon Reach 4500,” it all comes down to the “psychology” of QE:

“The key to navigating Quantitative Easing! and Fed policy in general is to recognize that their effect on the stock market relies almost entirely on speculative investor psychology. See, as long as investors get inclined to speculate, they treat zero-interest money as an inferior asset, and they will chase any asset with a yield above zero (or a past record of positive returns). Valuation doesn’t matter because investors psychologically rule out the possibility of price declines in the first place.” – John Hussman

In other words, “Quantitative Easing” is a mental formation. Therefore, the only thing that alters the effectiveness of the Fed’s monetary policy is investor psychology itself.

Such was a point we made in the “Stability/Instability Paradox.”

“With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the ‘instability of stability’ is now the most significant risk.”

Given professional managers are subject to “career risk,” they get forced to “chase performance.”

Hedge Funds Are All In

Hedge fund managers are now extremely long “risk” exposure.

As stated, that “career risk” has professional managers chasing performance after suffering a rough start to the year. The need to make up lost ground, or risk losing assets to better-performing managers, rises with the market. Per the Wall Street Journal:

“Client notes from both Morgan Stanley and Goldman Sachs show fundamental stock-picking manager had negative alpha in the first half of the year.

Part of the challenge for professional stock pickers is that markets are heavily rotational. Markets this year whipped back and forth between growth and value stocks. Such makes it difficult for managers to find winning trades.”

Sentiment Trader had an excellent piece of data to this point:

“The latest estimate of Hedge Fund Exposure shows that funds are nearly 40% net long stocks, a quick rise from almost being flat a month ago. Over the past few years, after such large allocation increases, the S&P gave any further gains back.”

“After any day since 2003 when Exposure was below zero, the S&P 500 returned an annualized 15.2%, versus only 1.4% when Exposure was above 25% as it is now. If we look at the period after the first reading above 35% the medium-term returns were unimpressive.“ – Sentiment Trader

The point is that when professionals investors get “sucked” into performance chasing, it warrants being more “risk” aware.

As Bob Farrell once quipped:

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

Smart Vs Dumb Money

None of this should be of any surprise. After more than a decade of monetary interventions, the psychology of QE is now thoroughly ingrained. The problem eventually is that with investors very “long” the market, there will be few “buyers” when it comes time to sell.

The chart below combines investor positioning from both retail and professional investors. While there is room for investors to get even more exposed to “risk,” such levels have historically not lasted long or ended well.

As discussed in “There Is No Way, This Doesn’t End Badly,” virtually every measure of fundamental analysis suggests the markets are expensive.

“10-year forward returns are below zero historically when the price-to-sales ratio is at 2x. There has never been a previous period with the ratio climbing to near 3x.”

However, in the short term, investors are trapped by the “fear of missing out.” While there is plenty of logic for sitting out of an overvalued, exuberant and stretched market, there is a consequence to “missing out.” While a bear market does indeed destroy capital, not participating in a bull market has an equal impact on ending results. 

It’s a terrible choice.

Conclusion

A correction is coming. I have no idea when or what will cause it.

However, the markets are currently in a very long advance without a 5% correction or more. So when it occurs, for whatever reason, it will “feel” worse than it is. That is due to the high level of complacency investors have developed in this market.

While we are only expecting a correction in the near term, you cannot dismiss a “real bear market” either.

It may not be today, next month, or even next year. But there is one truth in a market with all the signs of exuberance.

“Bull markets are built on optimism and die on exuberance.”

All bull markets die eventually. We never know the cause in advance. Ignoring history won’t make the damage any less catastrophic.

Historically, we find that when both valuations and prices have extended well beyond their intrinsic long-term trendlines, subsequent reversions BEYOND those trend lines have ensued.

Every Single Time.

Importantly, these reversions have wiped out a decade or more in investor gains. Think about this. If the next correction begins in 2022 and ONLY reverts to the long-term trendline, investors will reset portfolios to levels not seen since 2008.

A decade of gains will get wiped out.

Such tends to have a very negative impact on an individual’s retirement plans.

If you think that can’t happen, talk to anyone who was thinking about retiring in 2000 or 2008. I am sure they have an interesting story to share with you.

Knowledge vs. experience. When it comes to investing, such is what separates long-term success from failure.

Amid a “market mania,” retail investors believe they have “knowledge” as every investment they make seems to be successful. As the bubble inflates, continued success breeds over-confidence to the point where it is widely believed “this time is different.”

I previously discussed Charles Mackay’s book “Extraordinary Popular Delusions And The Madness Of Crowds.” As noted, that book was an early study in crowd psychology. To wit:

“Essential is the understanding of the role psychology plays in the formation and expansion of financial manias. From the 1711 ‘South Sea Bubble’ to the 2000 ‘Dot.com crash,’ all bubbles formed from a similar ‘panic’ by investors to chase ongoing speculation.”

For anyone who has lived through two “real” bear markets, the imagery of people trying to “daytrade” their way to riches is familiar. The recent surge in “Meme” stocks like AMC and Gamestop as the “retail trader sticks it to Wall Street” is not new.

It wasn’t long after the turn of the century that those with “knowledge” learned the stern “lessons of experience.”

Moore’s Law

There is a fable that explains how little we understand exponential moves.

“A king promised the inventor a reward for inventing the game of chess. The inventor asked for one single grain of rice on the first square of the chessboard, two on the second, four on the third, and so on.

The king thought this request was inexpensive to fulfill but he failed to understand the exponential law of compounding. Once the 64th square was reached, it required 18 quintillion grains. That amount exceeded the total production of the kingdom. Instead of getting his reward, the inventor was killed for fooling his king.”

For some context to the current market exuberance, look at the chart below.

The chart often gets put into a log scale to reduce the skewness towards large numbers. However, a non-log chart provides a better visual for this explanation. Pay attention to the exponential growth trend line.

In 1965, Gordon Moore postulated that the number of transistors on a microchip doubles every two years, though the cost of computers gets halved. “Moore’s Law” suggests this growth is exponential. 

Along the way, Wall Street adopted this tenet to apply to the stock market, assuming that price trends will go on forever. Notably, the longer a trend goes on, the more permanent it seems to be.

“But for some reason, human beings always extrapolate current trends whether it is population growth or stock market rallies. We know from statements at historical tops like 1929, 1987 or 2000 that anyone, from politicians to investors at the time, believe that the trend will go on for ever and that the world has made a paradigm shift.

Many markets and investments are now going up exponentially and very few forecast an end to this euphoric state.” – Egon Greverz

Knowledge Vs. Experience

It isn’t just rising index prices that denote the existence of a “market mania.” It is also the “speculative” actions of investors which are coincident with manias that suggest one is present.

• Due to commission-free trading and mobile apps, retail trading has exploded.
• A surge in IPO’s
• A record increase in SPAC’s
• Investors paying record multiples and prices for money-losing companies
• Option contract speculation has seen record increases
• Margin debt at new highs and near-record annual increases.
• A widely accepted belief “this time is different,” due to the “Fed Put.”

Again, these issues are not new. In one form or another, they have all been present at every prominent market peak in history. While all of this seems to be very common “knowledge,” it is the “experience” that links it together.

“Here is a simple chart that vividly illustrates my view.” – Doug Kass

“At times, the markets can be quite exciting. During the halcyon periods of prosperity and abetted by many (like the financial media who have no dog in the hunt) – traders who act like gamblers are encouraged to ‘play the trend’ and, increasingly do so en masse and as a ‘community.’ 

History proves this all ends badly and will result (as it did in the early and late 2000s) with an exodus of individual traders/investors out of the markets.

Most of these traders will fail to survive the current market cycle and will not be around in the next cycle.” – Doug Kass

Go back to the S&P 500 index chart above. Note that when the index trades well above the exponential trend line, the outcome was not good.

“Reversions to the mean” happen all the time on Wall Street.

The Benefit Of Experience

Investors all start with knowledge. However, what “bear markets” teach is “experience.” Such is why every great investor in history has a defined set of “investment rules” they follow.

To understand why the “rules” are essential, one must first understand the definition of “risk” related to investing. Howard Marks previously penned a great piece on this concept.

“If I ask you what’s the risk in investing, you would answer the risk of losing money.

But there actually are two risks in investing: One is to lose money, and the other is to miss an opportunity. You can eliminate either one, but you can’t eliminate both at the same time. So the question is how you’re going to position yourself versus these two risks: straight down the middle, more aggressive or more defensive.

What is critical about the “rules” is not what they tell us but how they came to be.

How do you avoid getting trapped by the devil? I’ve been in this business for over forty-five years now, so I’ve had a lot of experience.

In addition, I am not a very emotional person.In fact, almost all the great investors I know are unemotional. If you’re emotional then you’ll buy at the top when everybody is euphoric and prices are high. Also, you’ll sell at the bottom when everybody is depressed and prices are low. You’ll be like everybody else and you will always do the wrong thing at the extremes.”

It is not surprising with markets surging off the March lows, the Fed flooding the system with liquidity, and the mainstream media trumpeting the news, individuals are swept up at the moment.

However, this is the point where a “can’t lose proposition” tends to be a loser.

A Man With Experience

There is an old WallStreet axiom which states:

“A man with money meets a man with experience. The man with the experience leaves with the money, while the man with money leaves with experience.”

Such is the truth about markets and investing.

Experience tends to be a brutal teacher, but through experience, we learn how to build wealth successfully over the long term.

As Ray Dalio once quipped:

“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.”

Such is why every great investor in history, in different forms, has one basic investing rule in common:

“Don’t lose money.” 

The reason is simple; if you lose your capital, you are out of the game.

Many young investors with “knowledge” today will eventually gain a lot of “experience” by giving back most of their gains. 

It is one of the oldest stories on Wall Street.

We’re not in Kansas anymore. The S&P 500 racked up another fine quarter with an 8.55% return, which brought the first half of the year to 15.25%. It has been easy to fill in the blanks with apparent reasons for the continued appreciation: Strong economic growth, easy financial conditions, the receding threat of Covid-19, etc. Still, it is hard to imagine the abyss the market was staring into just sixteen months ago.

This paradoxical combination of frightening crashes and eye-watering rebounds has come to dominate market behavior over the last several years. This pattern also differs noticeably from the past when markets traced out the business cycle more closely. The challenge for investors is to find a mental model that can help navigate this unfamiliar territory.

We’re Not In Kansas Anymore

As value investors are well aware, valuation does not make an excellent timing tool. Still, it is closely associated with future returns and therefore has proved helpful for long-term positioning. Since the financial crisis, however, not only has value underperformed consistently, but other investment tools have lost effectiveness as well. John Hussman recently described:

“In market cycles across a century of market history, there was always a ‘limit’ to speculation. The points where overvalued, overbought, overbullish syndromes were so extreme that an air pocket, or panic, or crash would regularly follow. However, quantitative easing made those ‘limits’ utterly unreliable.”

So, if past guidelines to theoretical limits have become ineffective, what guidelines should investors turn to? As it turns out, authors Tim Lee, Jamie Lee, and Kevin Coldiron pursued a similar course of inquiry in their book, The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis. For example, they wanted to know.

“Why have stock markets, over the past 25 years, experienced huge rises and crashes? Why did the US stock market, in particular, quadruple over the years following the 2007–2009 global financial crisis even though US economic performance was at best so-so?”

The Rise Of Carry

These are excellent questions indeed. The answer that best fits the evidence is the market has become one giant carry trade. To appreciate that conclusion and understand the implications. First, however, it helps to be clear about what a carry trade is.

“Carry trades make money when ‘nothing happens.’ In other words, they are financial transactions that produce a regular stream of income or accounting profits. Still, they subject the owner to the risk of a sudden loss when a particular event occurs or when underlying asset values change substantially. The ‘carry’ is the income stream or accounting profits the trader earns over the transaction’s life. In this sense, carry trades are closely related to selling insurance, an activity that provides a steady premium income but exposes the seller to occasional large losses.”

As it happens, carry is “a naturally occurring phenomenon” and “is not in itself wholly bad.” As the authors fairly note,

“The return that carry traders earn is, at least in part, compensation for providing liquidity to markets and for assuming risk.”

One of the unique elements of carry trades over the last twenty years or so is the increasingly active role of central banks. By dampening volatility, central banks have reduced the risk to traders and speculators putting on carry trades. That course of monetary policy has “helped carry returns become supernormal returns” and has “supercharged” the phenomenon of carry in the process.

Characteristics Of Carry

When we examine the characteristics of carry trades, it is easy to see their stamp on market behavior. Critical features include:

“Leverage, liquidity provision, short exposure to volatility, and a ‘sawtooth’ return pattern of small, steady profits punctuated by occasional large losses.”

Perhaps the “sawtooth” pattern of returns is most notable – and pernicious – for investors. When markets seem reasonably calm and safe, something comes from nowhere to throw markets into a spin. Likewise, just as soon as it looks like markets will completely seize up, the skies magically clear, and it is smooth sailing again. This kind of progression of bubbles and crashes is what the authors refer to as a “carry regime.”

One of the fascinating characteristics of a carry regime is “a progressive de-anchoring of the structure of market prices from fundamental economic reality.” In other words, stock prices become driven by a financial market structure more than business and economic fundamentals. Such is precisely why valuation has been ineffective and why other conventional market metrics have also performed poorly. Thus, the carry regime is a financial phenomenon, not an economic one.

Another aspect of the current carry regime gets based in US markets. Such is because there is “greater liquidity and breadth of financial instruments in the US markets.” As such, the S&P 500 index “is at the center of the global carry trade.” Therefore, the carry regime outside the US is “more fragile,” and why emerging markets get hit hard when things turn south.

Carry Is About Power

Finally, carry is about power in a meaningful sense.

When markets go down, only those with strong balance sheets or close government connections survive. During the financial crisis, all major banks (except Lehman Brothers) got backstopped by the Fed. When volatility spiked in February 2018 in the Volmageddon event, retail investors in the XIV ETF got wiped out. 

“Long term, this leads to three critical outcomes. First, it makes prospering in financial markets less about competence and more about insider status. Insiders with weak balance sheets can survive crashes thanks to central bank action. Second, it reinforces wealth inequality by truncating losses for already wealthy investors who benefit from action to suppress volatility. Lastly, the distinction between economic recessions and financial market downturns becomes increasingly blurry. Recessions no longer cause severe asset price declines or bear markets; they are a function of the asset price declines.”

To sum up, then, carry trades are naturally occurring phenomena but have become supercharged due to central bank interventions that artificially moderate volatility. Insofar as central banks stay the course on interventions, a carry regime develops, which is comprised of a running series of carry bubbles and carry crashes. Because the drivers are financial, conventional economic and market-based metrics and decision tools lose effectiveness.

Adapting

One of the adaptations some investors have made is to “Buy the dip.” While this strategy is painfully simplistic, it has also been amazingly effective. While such robotic behavior may not seem worthy of earning excess returns, in a carry regime buying the dip provides liquidity and therefore does earn excess returns.

There are two problems with managing through carry regimes, though. One is carry crashes can occur suddenly and without warning. The authors describe,

“In the world of extreme carry, high financial asset prices do not guarantee that the economy is ‘good for now.’ The carry crash can occur suddenly—at the point when leverage has reached too great an extreme to be sustainable.”

Longer Than Logic Would Suggest

Another problem is carry regimes can last longer than one might guess, although they can’t last forever. Part of the reason is “The carry regime in itself is fundamentally deflationary over the long run, primarily because it exists in an economic environment of very high, and burdensome, debt levels.” Relatedly, a carry regime directs the course of the economy by “creating a pattern of economic growth driven by consumption and capital allocation driven by speculation, as opposed to a more healthy economy driven by the investment of the economy’s savings in future growth potential.” In other words, it is parasitic.

Over the long run, the carry regime de-anchors stocks from fundamentals, facilitate debt accumulation, weakens growth, and increases economic risk. It will end. But what will cause it to end, and what will follow in its stead?

When push comes to shove, and central bankers get forced to decide between tanking the economy by withdrawing monetary support or throwing the machinery into full inflationary gear, the authors assume the latter will happen. In their words:

“Governments together would implement extreme measures that would be outside the bounds of current law but gets deemed imperative to ‘save the world.’”

Indeed, this could include direct monetization of government spending.

Conclusion

In summary, the carry regime provides remarkable explanatory power to market behavior over the last twenty years or so. For example, it helps explain the sawtooth progression of bubbles followed by crashes, and it helps explain why the value style has underperformed.

As long as the carry regime persists, the easiest path to success is buying the dips. It is essential to note in doing so. However, one must have money to survive carry crashes and be on the lookout for the end of the regime.

It is also helpful to highlight the potential this environment has to wrong-foot all kinds of investors. Many investors will be comfortable riding out the carry crashes of the sawtooth pattern to ever-higher market highs. That will end when it all comes collapsing down once the carry regime fails. Others may prefer to buy the dips of the sawtooth. But they need a regular supply of capital to do so. Even then, it will be just as vulnerable to the outcome of the carry regime.

Still, other investors will prefer to sit out the carry regime or to remain underinvested through it. This strategy is notable for avoiding much of the potential for permanent losses of capital. However, it requires a great deal of patience. Further, since the carry regime will most likely end with inflation, appropriately sizing inflation hedges is a challenge.

The carry regime does not provide the kind of markets most of us would prefer to invest in, but we still need to contend with it nonetheless. At least by understanding its characteristics and developing an appropriate mental model. Then you can have a fighting chance to make the most of the market exposure you accept.

The CPI Measures Inflation and Other Widely Believed Economic Nonsense

The Fed, mainstream media, and others have a spotlight on the CPI and that’s the wrong spotlight.

Chart Discussion

In the chart above I plot the Case-Shiller national home price index, the Case-Shiller 10-city index, the CPI, Owners’ Equivalent Rent (OER), and the BLS Rent Index. 

I have produced this chart previously, but this month I added the BLS Rent Index. 

OER is the mythical price one would pay if one rented their own house from themselves, unfurnished and without utilities. 

Prior to the year 2000, housing, rent, OER, and the CPI all moved in sync. In 2000, home prices disconnected from the CPI, OER, and rent. 

In 2012 another disconnect developed in which both rent and OER also disconnected from the CPI.

If we plotted actual medical prices (not the BLS measures of them), we would see that the cost of healthcare disconnected from the CPI as well.  That happened because the CPI does not include prices paid on behalf of consumers (i.e. Medicaid, Medicare, or your group plan where you work). 

The two enormous bubbles (you do see them don’t you?) are the direct result of the Fed sponsoring bubbles. 

Debate Over the CPI

CPI Is Understated

I made the statement that the real CPI is understated. Actually, that’s not phrasing things properly.

More accurately, the CPI is a piss poor measure of inflation.  Which led to the comment “Housing prices lead rent, no?” 

There is no CPI "conspiracy". Rather it's just a piss poor measure of inflation.

PCE + Housing is a start and can easily be measured – resales of same house.

Housing used to be in the CPI. And it used to track rent. Then we had huge bubbles, ignored – with consequences.

— Mike "Mish" Shedlock (@MishGEA) July 13, 2021

Slaves to the CPI

The Fed and economists in general are slaves to CPI despite the facts

• The CPI does not measure inflation
• Consumer prices do not properly measure price inflation
• The entire notion we need 2% inflation while ignoring asset bubbles that allegedly do not represent inflation is downright idiotic. 

Measured Price Inflation MPI

A better measure of inflation can be calculated by substituting actual home prices for OER in the CPI. 

To satisfy the purists who say that home prices are a capital expense, let’s not call the result “consumer” inflation but rather MPI measured Price Inflation.

I called it Case-Shiller CPI but will change the name next month to better reflect what it really is and to stop futile discussion of the word “consumer”.   

Those who want the CPI can have it. As an inflation measure, especially as used by the Fed, it’s proven useless anyway. 

The nice thing about Case Shiller is the index measure actual resales of the same house over time. We can debate the weights but OER is at least a reasonable place to start. 

Weights in the CPI 

Home Owners Equivalent Rent

Notice that OER is the largest component at 24.6% of the CPI and rent of primary residence is another 7.86%.

In the last year, home prices are up 14.59%, the CPI is up 5.39%, but OER only 2.34% and Rent only 1.92%. 

OER and rent have held down the CPI considerably.

These inflation stats are understated because the latest CPI data is from June but the latest housing data is from April. 

I created the above charts using an assumption that home prices were flat in May and again in June although we know prices went up. 

CPI, CS-CPI Percent Change 

The above chart shows the impact of substituting home prices for OER in the CPI. 

Real Interest Rates 

Real rates are formed by subtracting various interest rates from the Fed Funds Rate, a minuscule 0.08%.

As such, real interest rates, factor in housing, and are about -7.5%. But that does not include home price increases in May or June. 

Real interest rates are more deeply negative than right before the housing crash. 

The Fed is purposely allowing inflation to run hot, and that does not count home prices at all, just rent.

Monetary Inflation vs Price Inflation

Some say that the increase in money supply is inflation and prices follow. But money measures themselves are very distorted and people bicker over how to measure them too. 

I will discuss monetary inflation next week, so stay tuned.

Historical Perspective On CPI Deflations

In its March report, the BIS took a look at the Costs of Deflations: A Historical Perspective. Here are the key findings.

Concerns about deflation – falling prices of goods and services – are rooted in the view that it is very costly. We test the historical link between output growth and deflation in a sample covering 140 years for up to 38 economies. The evidence suggests that this link is weak and derives largely from the Great Depression. But we find a stronger link between output growth and asset price deflations, particularly during postwar property price deflations. We fail to uncover evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations. The most damaging interaction appears to be between property price deflations and private debt.

Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive.

Once we control for persistent asset price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services (CPI ) deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period. They are uniformly statistically insignificant except for the first post-peak year during the postwar era – where, however, deflation appears to usher in stronger output growth. By contrast, the link of both property and equity price deflations with output growth is always the expected one, and is consistently statistically significant.

CPI Spotlight Is Wrong!

The BIS clearly draws the line on asset bubbles and property bubbles and so do I. 

The data shows the Fed has made the same mistake again, insisting on 2% CPI inflation while ignoring asset bubbles on grounds they are not inflation.

The Fed has a spotlight on the ant, missing the elephant in the room that it created. 

I will update the charts again when the next Case-Shiller reports come out.

In this 07-16-21 issue of “Earnings Seasons Kicks Off With Markets Priced For Perfection.”

• Market Pulls Back As Signals Turn
• Earnings Season Has A High Bar
• Markets Priced For Perfection
• Portfolio Positioning
• Sector & Market Analysis
• 401k Plan Manager

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

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Are you worried about the potential for a market correction, a surge in inflation, or are you unsure how to invest for your retirement? We can help. If you are not yet a client and would like to discuss your portfolio construction, please schedule a time to meet with one of our advisors below.

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Market Pulls Back As Signals Turn

Last week, we discussed the market hit new highs with the index getting back to more extended and overbought conditions. To wit:

“While market volatility did pick up this past week, the index held its breakout support levels and closed at a new high. Such keeps the bullish bias intact. However, as shown, the money flow signals are now back to more elevated levels, which will provide resistance to higher prices short term.

“The bulls are indeed in charge of the markets currently, but the clock is ticking.”

Not surprisingly, the market stumbled this past week as technology began to fade its recent outperformance. But, of course, investors have been piling into the trade as of late, pushing it to more overbought extremes. As noted by Sentiment Trader on Friday:

Of course, not surprisingly, investors are historically prone to “buying the most at the top.” With the seasonally weak trend of the Nasdaq approaching, with MACD’s triggering sell signals, there is likely to be some disappointment.

However, there are two reasons why investors are piling back into the 10-largest technology names:

1. Portfolio managers need to be invested to generate performance, and the mega-cap Technology names are easy to “hide” in given the large daily trading volumes.
2. These companies can generate earnings growth in a slowing economic environment.

The problem with the second point is that those top-10 mega-cap names generate the bulk of the earnings of the entire S&P 500 index. Such has only occurred at previous bull market peaks.

All of this suggests the risk of a correction remains elevated, particularly with the market priced for perfection.

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Earnings Season Has A High Bar

Over the last few months, the rush of analysts to upgrade earnings estimates for the S&P 500 is one for the record books. According to Factset:

“If the S&P 500 reports year-over-year growth in earnings of 69.3% in Q2, it would mark the highest (year-over-year) earnings growth rate reported by the index since Q4 2009 (109.1%).”

Of course, given the expectation of robust earnings growth for Q2, analysts still predict a double-digit price increase for the S&P 500. To wit:

“Industry analysts in aggregate predict the S&P 500 will see a price increase of 11.2% over the next 12 months. The bottom-up target price is calculated by aggregating the median target price estimates (based on company-level estimates submitted by industry analysts) for all  companies in the index. On July 8, the bottom-up target price for the S&P 500 was 4803.62, which was 11.2% above the closing price of 4320.82.” – FactSet

(Of course, it is worth noting the S&P NEVER matches its bottom-up price target. In other words, estimates are always too high compared to reality.)

Analysts have set a very high bar for the markets to hurdle, given already lofty valuations. With indices already well-stretched above their historical means, there is much room for disappointment.

With the currently very overbought short-term market, a 3% to 10% correction this summer remains likely.

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In Case You Missed It

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Markets Priced For Perfection

While earnings estimates are soaring on exuberant hopes of an indefinite economic boom, revenue may be telling a much different story. I noted this point earlier this week:

Thought this was interesting.#Earnings are expected to hit $151 #reported this quarter

Q4-2020 = 94.13
Q1-2021 = 128.20
Q2-2021 = 151.17 est.

But here is revenue

Q4-2020 = 367.48
Q1-2021 = 364.05
Q2-2021 = 360.81

Anyone notice an issue relating to #Price/Sales

— Lance Roberts (@LanceRoberts) July 13, 2021

Investors should not dismiss the above quickly. First, revenue is what happens at the top line. Secondly, revenue CAN NOT grow faster than the economy. Such is because revenue comes from consumers, and consumption makes up 70% of the GDP calculation. Earnings, however, are what happens at the bottom line and are subject to accounting gimmicks, wage suppression, buybacks, and other manipulations.

Since 2009, corporate operating earnings grew cumulatively by 339%. Yet, during that same period, the cumulative growth of revenue is only up 63%. It is through “accounting magic” that revenue gets multiplied to the bottom line. Out of each dollar of earnings, 82% is from accounting “management,” and just 18% is from revenue.

The majority of the rise in “profitability” came from various cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. While tax cuts certainly provided the capital for a surge in buybacks, revenue growth, the result of a consumption-based economy, remains muted.

The Valuation Problem

The problem is the market surged higher due to the ongoing liquidity injections from the Federal Reserve. While liquidity drives asset prices higher, it does not foster economic activity, which creates corporate revenue. Currently, the price-to-sales (revenue) ratio is at the highest level ever. As shown, the historical correlation suggests outcomes for investors will not be kind.

Of course, given that revenue can only grow roughly as fast as the economy, the market-capitalization to GDP ratio is very important. While the “price” of the market can outpace economic growth in the short term, it can’t do so indefinitely. Thus, at 2.4x economic growth, the market is highly overvalued relative to what the economy can generate in revenue growth.

Lastly, with markets currently perched near all-time highs, both operating and reported earnings will fall in Q2 versus Q1 as economic growth peaks. (We have repeatedly warned of this issue.)

Note that as of Q2-2021, operating earnings (earnings without all the bad stuff) will only be 10% higher than they were in 2018. Yet, the market is currently trading 48% higher.

Even with the “sharpest recovery in earning in history,” the market continues to expand its valuation multiple. (Chart below uses current estimates for Q2-2021) So much for earnings catching up with the price.

As I said, investors have priced the market for perfection. Therefore, any disappointment could lead to poor outcomes for investors taking on excess risk.

Portfolio Update

I wanted to wrap up today’s note with some comments from my colleague Doug Kass on “Lessons Learned & Relearned.” As investors, the market has a habit of teaching us we aren’t as smart as we think.

* We learn from history, which usually rhymes.

* Liquidity is an overriding market force and influence as markets are a function of demand versus supply. The size of the Fed’s balance sheet will have an overriding impact on the markets. But the reduced supply of equities also is an important part of the investment equation. (There are about half the listed companies compared to what existed two decades ago. Of the companies still listed, more than 25% of outstanding shares are retired).

* A market in motion tends to stay in motion. Higher valuations usually beget higher valuations (and vice versa). A bona fide (and correct) contrarian view is a low probability practice. But, when the contrarian is correct, it can deliver large payoffs.

* Markets and emotions often go to extremes. Importantly, mean regression is a powerful force and consistent feature in the market.

* Seek precision when playing chess but not when investing.

* The notion, held by some, that the direction of the broad markets is a function of the health of speculative stocks is grossly incorrect. Crap doesn’t lead except for brief periods of time.

* It is fine to take chances and make mistakes. However, while it might work briefly, it is foolish to trade stocks with admittedly little value simply because they are moving higher.

* Avoid “group stink” as it can be harmful to your investment well being“

The risk of a correction is high but not necessarily immediate.

Manage your risk accordingly.

Have a great weekend.

By Lance Roberts, CIO

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Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members

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S&P 500 Tear Sheet

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Performance Analysis

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Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” are oversold. The current reading is 80.76 out of a possible 100.

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Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 85.37 out of a possible 100.

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Sector Model Analysis & Risk Ranges

How To Read This Table

• The table compares each sector and market to the S&P 500 index on relative performance.
• “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
• The risk range is a function of the month-end closing price and the “beta” of the sector or market.
• Table shows the price deviation above and below the weekly moving averages.

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Weekly Stock Screens

Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

Low P/B, High-Value Score, High Dividend Screen

Fundamental Growth Screen

Aggressive Growth Strategy

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Portfolio / Client Update

Not much to update from this past week. As noted:

“With our money flow signals returning to peaks, which typically precede a pickup in volatility, we took the opportunity to reduce our index trading positions. That action raised our cash levels by 5% to provide a bit more of a cash cushion for now.”

Over the next 3-weeks, we will enter the heart of earnings season for the S&P 500. As discussed in the main body of this week’s newsletter, earnings appear to have peaked with economic activity in Q2, so the valuation question will become much more important going forward.

However, in the short term, the psychology of “Fed liquidity” continues to override the fundamental underpinnings of the market. So, for now, we will continue to let our positions participate with the underlying momentum until it requires a change.

Regardless, we continue to monitor the markets closely. If our signals become aligned, we will take further action to reduce risk exposures accordingly. As stated last week, there are no “red flags,” but if things change, we will change as well.

Portfolio Changes

During the past week, we made minor changes to portfolios. In addition, we post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

“This morning, we took some profits in LIT in the sector model as it is overbought and replaced it with XLB, which got oversold. Both trades were for .5%. The trade will slightly reduce net exposure as LIT was overallocated and XLB slightly under-allocated versus the model.” – 07/12/2021

ETF Model

• Reduce LIT to 2.5% of the portfolio.
• Increase XLB to 2% of the portfolio.

As always, our short-term concern remains the protection of your portfolio. Accordingly, we have shifted our focus from the election back to the economic recovery and where we go from here.

Lance Roberts

CIO

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THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors

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

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401k Model Performance Analysis

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

Have a great week!

The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You will find more detail on the model and the specific tickers below the charts.

Commentary 7-16-21

• Bad market breadth was in play again this past week. There were only four sectors that beat the S&P 500. Of note, the two most oversold sectors over prior months finally woke up. XLU and XLP beat the S&P 500 by 1.74% and 1.29% respectively. Their improvement can also be seen on the first relative set of graphs as they are not among the most oversold sectors anymore. If you think the reflation trade is dead, these sectors should continue to gain on the S&P and other sectors in the coming weeks and months.
• The reflation sectors continue to lag the market. Energy and transportation are the most oversold sectors. Financials are struggling due to the flattening yield curve accompanying lower yields and reduced inflation expectations.
• The bond market continues to push lower in yield, warning economic growth and inflation may be peaking. If bond traders have this right, the technology and healthcare sectors should continue to lead. Further, staples and utilities have ground to catch up and such an environment should be relatively friendly for them.
• The relative factor/index graph also shows the stunning divergences between the S&P and other indexes. The NASDAQ (QQQ) is the only equity factor/index above fair value versus the S&P. Small-cap, mid-cap, and emerging markets are in deeply oversold territory and might bounce on any signs the reflation the trade is back on. Over the last four weeks, small caps have given up 6% to the S&P and emerging markets a little over 5%.
• The absolute graphs tell a similar story of which sectors are leading and lagging. The market has been generally drifting higher leaving energy, transportation, and materials as the only oversold sectors. They are not deeply oversold, so the trends can easily continue. Real estate and technology are moving into deeply overbought territory so caution is advised especially going into earnings reports in the last week of July for many tech companies.
• The S&P 500 is overbought, but in its recent value range as shown in the bottom right of the second set of graphs.
• All bond sectors are overbought on an absolute basis. However, on a relative basis versus the 5-7 year UST ETF (IEI), TLT and investment-grade corporates (LQD) are the only overbought sectors. Junk bonds, mortgages, and TIPs have been lagging IEI. Also, note on the chart our proprietary inflation/deflation index is decently oversold. Since June 16th, one month ago, the inflationary sectors have given up almost 10% to the deflationary sectors. A listing of the constituents in each index can be found at the bottom of this report.

Graphs (Click on the graphs to expand)

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Users Guide

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change trend. When the scatter plot in the sector graphs has an R-squared greater than .60 the signals are more reliable.

The first set of four graphs below are relative value-based, meaning the technical analysis is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

• Staples XLP
• Utilities XLU
• Health Care XLV
• Real Estate XLRE
• Materials XLB
• Industrials XLI
• Communications XLC
• Banking XLF
• Transportation XTN
• Energy XLE
• Discretionary XLY
• S&P 500 SPY
• Value IVE
• Growth IVW
• Small Cap SLY
• Mid Cap MDY
• Momentum MTUM
• Equal Weighted S&P 500 RSP
• NASDAQ QQQ
• Dow Jones DIA
• Emerg. Markets EEM
• Foreign Markets EFA
• IG Corp Bonds LQD
• High Yield Bonds HYG
• Long Tsy Bonds TLT
• Med Term Tsy IEI
• Mortgages MBB
• Inflation TIP
• Inflation Index- XLB, XLE, XLF, and Value (IVE)
• Deflation Index- XLP, XLU, XLK, and Growth (IWE)

Monetary policy is not expansionary despite widespread belief otherwise.

The general assumption by the Federal Reserve is that by providing excess reserves to the banking system, the banks would then lend to businesses and individuals to expand economic activity. Furthermore, as discussed previously, the Federal Reserve’s entire premise of inflating asset prices was the subsequent boost to economic activity from an increased “wealth effect.”

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

However, after more than a decade of “monetary policy,” there is little evidence that supports those claims. Instead, there is sufficient evidence that “monetary policy” leads to greater wealth inequality and slower economic growth.

Prima Facie Evidence

The only reason Central Bank liquidity “seems” to be a success is when viewed through the lens of the stock market. Through the end of Q2-2021, using quarterly data, the stock market has returned almost 198% from the 2007 peak. Such is more than 8x the GDP growth and 3.9x the increase in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not AS subject to manipulation.)

Unfortunately, the “wealth effect” impact has only benefited a relatively small percentage of the overall economy. Currently, the top 10% of income earners own nearly 90% of the stock market. The rest are just struggling to make ends meet. Thus, the impact of the Fed’s monetary interventions on the equity value of the top 1% is evident.

While short-term ongoing monetary interventions may appear to be expansionary, it creates negative incentives to economic activity and monetary velocity.

QE Has A Negative Incentive

As noted above, the Fed suggests that by providing excess reserves to the banking system, the banks will then “lend” those reserves. In turn, as businesses borrow money to expand production or consumption, the economy gets a lift.

However, in reality, it is precisely the opposite. Each time the Fed has engaged in QE programs, the banks “hoard” those reserves as the “risk/reward” of loaning money into the economy is not justified. For example, in early 2020, as the economy was “shut down” due to the COVID pandemic, companies tapped credit lines at their banks to ensure sufficient capitalization. After that initial surge in lending activity, banks reversed back into a more “protectionary” mode.

Another way to view the same is by looking at monetary velocity. Monetary velocity, or M2V, measures the rate at which money (M2) moves through the economy (GDP). As shown, velocity continues to plummet as the banks contract their lending.

Such is not surprising given that 80% of the population are living primarily paycheck to paycheck. The risk of repayment and defaults remains a disincentive to lend. For the banks, the risk preference is to hoard reserves for more profitable, less risky, investment banking activities.

Fed Actions Are Disinflationary

Another thesis that requires correcting was summed up well in a recent email question.

“Given the Fed is buying 100% of the Treasury bills plus other bonds at auction…I believe the Fed is manipulating bond yields lower.” – T. Stephenson

The problem for the Federal Reserve is that the fiscal and monetary stimulus imputed into the economy is, in reality, “dis-inflationary.” 

“Contrary to the conventional wisdom, disinflation is more likely than accelerating inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. Once these base effects are exhausted, cyclical, structural, and monetary considerations suggest that the inflation rate will moderate lower by year end and will undershoot the Fed Reserve’s target of 2%. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation.” – Dr. Lacy Hunt

While the economic growth rate may be booming momentarily, inflation, which is destructive when not paired with rising wages, will be transient. Given the massive surge in prices for homes, autos, and food, the reversal will cause a substantial disinflationary drag on economic growth.

The most considerable risk is a divergence among Fed policymakers which possibly leads to a policy mistake of tapering too quickly or even hiking rates. 

Fed Buying Drives Rates Higher

The majority of the inflation and economic growth pressures are artificial, stemming from the stimulus injections over the last year. However, with those inputs fading as year-over-year comparisons become more challenging, the “deflationary” impact could be more significant than expected.

There is also one other point about the Fed tapering the purchases. As shown in the chart below, rates rise during phases of QE as money rotates from bonds to stocks for the “risk-on” trade. The opposite occurs when they start to taper, suggesting a decline in rates if “taper talk” increases.

Such is because, after more than a decade of monetary interventions, the Fed has created a “psychological” link between “QE” and the equity markets. As a result, the liquidity provision creates an asset preference of “risk-on” assets, equities, versus “risk-off” assets, bonds.

(It is also worth noting the massive current deviation of the equity market from the liner growth trend.)

The result is that during QE programs, interest rates rise due to the psychological impact of asset preference.

Fed Requires Debt Issuance

Of course, the Federal Reserve requires debt issuance by the Government to facilitate Quantitative Easing. Since the “Financial Crisis,” total Government interventions surpassed $43 Trillion into the economy to keep it “afloat.”

I say “afloat” rather than “growing” because, since 2008, the total cumulative growth of the economy is just $3.5 trillion. In other words, for each dollar of economic growth since 2008, it required $12 of monetary stimulus. Such sounds okay until you realize it came solely from debt issuance.

Government Spending Has A Negative Multipler

Here is the problem. Excess “debt” has a zero to a negative multiplier effect. Such was shown in a study by the Mercatus Center at George Mason University by economists Jones and De Rugy.

“The multiplier looks at the return in economic output when the government spends a dollar. If the multiplier is above one, it means that government spending draws in the private sector and generates more private consumer spending, private investment, and exports to foreign countries. If the multiplier is below one, the government spending crowds out the private sector, hence reducing it all.

The evidence suggests that government purchases probably reduce the size of the private sector as they increase the size of the government sector. On net, incomes grow, but privately produced incomes shrink.”

Notably, politicians spend money based on political ideologies rather than sound economic policy. Therefore, the findings should not surprise you. However, the conclusion of the study is most telling.

“If you think that the Federal Reserve’s current monetary policy is reasonably competent, then you actually shouldn’t expect the fiscal boost from all that spending to be large. In fact, it could be close to zero.

This is, of course, all before taking future taxes into account. When economists like Robert Barro and Charles Redlick studied the multiplier, they found once you account for future taxes required to pay for the spending, the multiplier could be negative.”

Monetary policy, in its current form, is not helping the economy. As a result, the Federal Reserve has lost the ability to influence economic growth.

Conclusion

The Federal Reserve has no real options unless they are willing to allow the system to reset painfully.

Unfortunately, we now have a decade of experience of watching monetary experiments only succeed in creating a massive “wealth gap.” 

Most telling is the current economists’ inability to realize the problem is trying to “cure a debt problem with more debt.”

In conclusion, the Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the result, has been wrong. It hasn’t happened in 40 years.

The reality is that monetary policy is not expansionary but rather contractionary. Unfortunately, deflation remains the most significant threat as permanent growth doesn’t come from an artificial stimulus or debt.

But such is a lesson that has yet to get learned.

Bubbles are evident and only get acknowledged after they pop. Such is because, during the inflation phase of the market bubble, investors rationalize why “this time is different.” 

We have seen many examples of this rationalization over the last couple of years. Such as stocks are cheap based on economic growth, low-interest rates justify high valuations or the “moral hazard” of the “Fed put.” Other examples come from the analysis of stock prices, such as this tweet recently.

The average stock in North America went nowhere for 5 years and is up just 14% from the 2018 high.

Not exactly what I would call a bubble. pic.twitter.com/H8JuOVm4Qt

— Danny Merkel (@ChartingTrends) July 4, 2021

While the analysis is correct, average stock prices do not solely define a bubble.

Such is where we need to start.

What Is A Bubble?

According to Investopedia:

“A bubble is a market cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. Typically, what creates a bubble is a surge in asset prices driven by exuberant market behavior. During a bubble, assets typically trade at a price that greatly exceeds the asset’s intrinsic value. Rather, the price does not align with the fundamentals of the asset.“

This definition is suitable for our discussion; there are three components of a “bubble.” The first two, price and valuation, as noted above, are get dismissed or rationalized during the inflation phase. That rationalization is due to investor psychology and the “Fear Of Missing Out (F.O.M.O.)

Jeremy Grantham posted the following chart of 40-years of price bubbles in the markets. During the inflation phase, each got rationalized that “this time is different.” 

However, we are most interested in the “third” component of “bubbles,” which is investor psychology.

Charles Kindleberger noted that speculative manias typically commence with a “displacement” that excites speculative interest. Then, the speculation becomes reinforced by a “positive feedback” loop from rising prices.

Such ultimately induces “inexperienced investors” to enter the market. As the positive feedback loop continues and the “euphoria” increases, retail investors then begin to “leverage” their risk in the market as “rationality” weakens.

During the mania, speculation becomes more diffused and spreads to different asset classes. New companies come to market to take advantage of the euphoria, and investors leverage their gains using derivatives, stock loans, and leveraged instruments.

This activity also aligns with the historical cycle of market bubbles.

Evidence Of A Bubble

There are several psychological phases investors go through during a “full market cycle.” 

Near peaks of market cycles, investors become swept up by the underlying exuberance. That exuberance breeds the “rationalization” that “this time is different.” So how do you know the market is exuberant currently? In “Warning Signs,” we discussed the following graphic from Sentiment Trader.

“This type of market activity is an indication that markets have returned their ‘enthusiasm’ stage. Such is characterized by:

• High optimism
• Easy credit (too easy, with loose terms)
• A rush of initial and secondary offerings
• Risky stocks outperforming
• Stretched valuations”

Let’s run through that list.

Exuburance? Check.

Easy Credit & Leverage? Check.

According to a recent survey from Magnify Money:

• Many consumers have taken on debt to invest, with Gen Zers leading the charge. 40% of investors said they have taken on debt to invest, including 80% of Gen Zers, 60% of millennials, 28% of Gen Xers, and 9% of baby boomer investors.
• Personal loans were the most popular choice among those who took on debt to invest, followed by borrowing from friends or family. 38% of those who went into debt to invest took out a personal loan, while 23% borrowed from friends or family.
• When it comes to taking on debt to invest, many went big. Of those who took on debt to invest, nearly half (46%) borrowed $5,000 or more.

Rush Of Initial Or Secondary Offerings? Check.

Investing In Risky Stocks? Check.

Stretched Valuations? Check.

There is little doubt the psychology of a bubble is present. But does that mean the markets will “crash” immediately?

Bubbles Last Until They Don’t

John Maynard Keynes once quipped the “markets can remain irrational longer than you can remain solvent.“

Such is the problem with trying to “time” a bubble, as they can last much longer than logic would predict. George Soros explained this well in his theory of reflexivity.

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

Every bubble has two components:

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

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

In simplistic terms, Soros says that once the bubble inflates, it will remain inflated until some unexpected, exogenous event causes a reversal in the underlying psychology. That reversal then creates a reversion in psychology from “exuberance” to “fear.”

What will cause that reversion in psychology? No one knows.

However, the important lesson is that bubbles are entirely a function of “psychology.” The manifestation of that “bubble psychology” manifests itself in asset prices and valuations.

Conclusion

‘I have no idea whether the stock market is actually forming a bubble that’s about to break. But I do know many bulls are fooling themselves thinking a bubble can’t happen when there is widespread concern. In fact, one of the distinguishing characteristics of a bubble is just that.” – Mark Hulbert

Whether you agree a bubble exists is largely irrelevant. Every investor approaches investing differently.

However, if you’re nearing or are a retiree, your investment horizon is shorter than those much younger. Therefore, given you are less able to recover from the deflation of a market bubble, it may be wise to consider the possibility.

So, what can you do to navigate the bubble?

• Avoid the “herd mentality” of paying increasingly higher prices without sound reasoning.
• Do your own research and avoid “confirmation bias.” 
• Develop a sound long-term investment strategy that includes “risk management” protocals.
• Diversify your portfolio allocation model to include “safer assets.”
• Control your “greed” and resist the temptation to “get rich quick” in speculative investments.
• Resist getting caught up in “what could have been” or “anchoring” to a past value. Such leads to emotional mistakes. 
• Realize that price inflation does not last forever. The larger the deviation from the mean, the greater the eventual reversion will be. Invest accordingly. 

The increase in speculative risks, combined with excess leverage, leaves the market vulnerable to a sizable correction. But, unfortunately, the only missing ingredient is the catalyst that brings “fear” into an overly complacent marketplace.  

Currently, investors believe “this time IS different.” 

“This time” is different only because the variables are different. The variables always are, but outcomes are always the same.

When the bubble pops, the media will tell you “no one could have seen it coming.”

Of course, hindsight isn’t very useful in protecting your capital.

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Infrastructure spending can be economically beneficial. But, unfortunately, the type of “spending” the Democrats are proposing will not be.

We must begin our discussion with the textbook definition of “infrastructure.”

“Infrastructure is the general term for the basic physical systems of a business, region, or nation. Examples of infrastructure include transportation systems, communication networks, sewage, water, and electric systems. These systems tend to be capital intensive and high-cost investments, and are vital to a country’s economic development and prosperity.” – Investopedia

Now, we must break that definition down into its most essential points:

• Basic Physical Systems
• Transportation, Communication, Sewage, Water, and Electric
• Capital Intensive
• High-Cost Investments

The fourth point is the most important – “investments.”

So, what is the definition of “investment.”

“An investment is an asset or item acquired with the goal of generating income or appreciation.” – Investopedia

Therefore, a good definition of infrastructure is:

“An investment into the basic physical systems of the nation with the goal of generating income to pay for the capital intensive expenditure”.

Biden’s “Big Money” Infrastructure Plan

There is considerable debate in Washington over the full “infrastructure” spending plan. As shown in the chart below, the original proposal contains just 25% that could get classified as “infrastructure.” The other 75% increases the social welfare net.

As Fortune recently lamented:

“Like all humongous-scale legislative efforts, the Biden administration’s new $2.2 trillion infrastructure plan contains surprises—unrelated provisions that are hitching a ride on a juggernaut. In this case, they’re not like barnacles on a giant ship. Some of these surprises are surprisingly large.”

At the moment, there is a smaller bipartisan infrastructure bill in the works. However, Democrats are looking to use the “reconciliation” process to pass the full “social spending plan” noted above.

“The Senate may work into its August recess to pass both a bipartisan infrastructure plan and a budget resolution that would allow Democrats to enact a range of priorities without Republican support, Senate Majority Leader Chuck Schumer said Friday.

In a letter to his caucus, the New York Democrat said senators are working with the White House to turn the $1.2 trillion infrastructure framework into legislation. The Senate Budget Committee is also crafting a measure that would allow Democrats to pass a sprawling child-care, health-care and climate policy plan without a GOP vote.” – CNBC

Regardless of which bill passes, our focus is on “infrastructure” spending in general.

Debt & More Debt

As the Cato Institute noted concerning the original bill.

“It moves entirely in the wrong direction by increasing subsidies and centralizing power. A better approach would be to end federal subsidies and decentralize infrastructure ownership and decisionmaking.”

However, one of the essential points overlooked by both the Heritage Foundation and the Cato Institute is the entire plan must get funded by a further expansion of debt.

Let’s revisit our definition of “infrastructure.”

Since the onset of the pandemic-driven economic shutdown, the Government has intervened with a massive expansion of debt. The hope was the increase in debt would keep the economy from slipping into a deeper economic recession.

However, debt was already rising sharply since President Obama took office in 2009. The irony is that the continued expansion of government interventions did not lead to organic economic growth. On the contrary, the more the debt increased, the more debt it took to sustain weak economic growth rates.

Debt Versus Growth

As stated above, since we must use debt to fund “infrastructure” spending, the debt must pay for itself. In other words, every project must generate a stream of cash flows through fees, taxes or duties, to repay the debt-funded capital investment over time.

Dr. Brock is an economist who holds 5-degrees in Math and Economics, and the author of “American Gridlock” explained this well using the following example of two countries.

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

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

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

Social Welfare Is Not Infrastructure

For debt-funded government spending to be effective, the “payback” from investments made with debt must yield a higher rate of return than the debt used to fund it. While Biden’s plan has a hint of investment, it is primarily social welfare.

As noted by Dr. Brock, government spending has shifted away from productive investments, like the Hoover Dam, that creates jobs (infrastructure and development) to primarily social welfare and debt service, which has a negative rate of return.

As shown in “Biden’s Stimulus Won’t Solve Poverty:”

“According to the Center On Budget & Policy Priorities, in 2020, roughly 75% of every tax dollar went to non-productive spending.

‘In the fiscal year 2019, the Federal Government spent $4.4 trillion, amounting to 21 percent of the nation’s gross domestic product (GDP). Of that $4.4 trillion, federal revenues financed only $3.5 trillion. The remaining $984 billion came from debt issuance. As the chart below shows, three major areas of spending make up most of the budget.'”

“Think about that for a minute. In 2019, 75% of all expenditures went to social welfare and interest on the debt. Those payments required $3.3 Trillion of the $3.5 Trillion (or 95%) of the total revenue collected.

Given the decline in economic activity during 2020, those numbers become markedly worse. As a result, for the first time in U.S. history, the Government will issue debt to cover mandatory spending.”

As Dr. Brock noted above, the U.S. is now “Country A.” 

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

Infrastructure Won’t Grow The Economy

While the Biden Administration promises the “infrastructure” plan will create jobs and grow the economy, it most likely won’t.

As noted by the Mises Institute:

“There is a fallacy that government spending, on infrastructure or anything else, creates jobs or economic growth in the aggregate. Murray Rothbard addressed the issue in great detail in his article ‘The Fallacy of the ‘Public Sector.’’ In summary, there is no such thing as the Infrastructure Fairy that takes government spending and magically turns it into economic growth.”

As the Mises Institute points out, Government spending is ultimately a “zero-sum” game given the money gets borrowed and, eventually, gets repaid through the collection of taxes.

“The money spent on infrastructure must get borrowed, taxed, or printed (a tax not called a tax) out of the non-government economy. One minus one equals zero. That’s not conservative economics or liberal economics. It’s not Democrat economics or Republican economics. It’s just economics.”

As shown, there is no evidence that more money borrowed and spent by the Government will lead to more robust economic growth rates or prosperity.

A Major Diversion

The biggest problem with the proposed “infrastructure” spending is that it diverts jobs and investment away from the private sector.

“The Tax Foundation found that Biden’s proposed tax increases would reduce private investment by more than $1 trillion. In addition, Biden’s proposed green and labor union regulations would further undermine infrastructure investment.

Corporations are already investing in activities favored by the Biden administration, such as electric vehicles, renewable energy, and broadband. Rather than subsidizing, Biden should reduce regulatory barriers to infrastructure investment and cut corporate taxes to increase investment incentives.

If we dig deeper into the realities behind government spending, however, we can see that an ‘infrastructure stimulus program’ would probably make matters worse than they are. After all, private investment is made with the goal of producing something that consumers want to buy, at a price that will generate a profit. These activities, if successful, would enable continued reinvestment in the same enterprise, and continued employment of the individuals therein.” – Cato Institute

The government, via taxation, produces something that the consumers have not already chosen to buy. If they were already producing and buying such things, no government intervention is “necessary.” 

Not A “New New Deal”

While the media is quick to fawn on Biden’s stimulus plan, claiming it to be the 2nd coming of FDR, it isn’t.

FDR’s “New Deal” did have many “social programs” embedded in it, including the beginning of the social welfare safety net. However, FDR backed those social programs with massive works projects from the Hoover Dam’s building to the Tennesse River Valley Authority. Not only did the spending on these projects create jobs, but they were also productive investments repaying the debt used to fund them.

Ultimately, spending on infrastructure no more “creates wealth” than any other kind of government spending. Like all government spending, it’s taking money from some people to give to others. The money taken from the taxpayers must get subtracted from the money spent, leaving no net gain. Of course, after the politicians and the government contractors take their cut, they’ll do pretty well. The rest of us won’t be so lucky.

The Real Solution

The honest answer is to allow the private sector to do what it does best: efficiently allocate capital for profitable outcomes.

“We would get a real revolution in infrastructure by adopting reforms from abroad to privatize passenger rail, airports, seaports, air traffic control, water systems, and other facilities. There is no need to subsidize infrastructure if it can be moved out of the government and supported by user fees. Rather than spending $2 trillion, we should privatize infrastructure where feasible and cut taxes and regulations on the rest.” – Cato Institute

There is one easy definition for “infrastructure” that politicians should adopt – if it requires a tax credit or incentive to encourage people to use it, it isn’t infrastructure. But this is the long and unprofitable history of the government selecting winners and losers in the economy. If there is a product, service, or need, the private sector will figure out how to produce it profitability. If it isn’t viable, it will die a natural death. That is the “Darwinian” nature of capitalism.

But this is a lesson dismissed by politicians who are more worried about winning the next election than creating economic prosperity for all.

In this 07-09-21 issue of “Yields Plunge Dollar Surges The Reflation Trade Unravels.“

• Market Pulls Back As Signals Turn
• Yield Plunge, Dollar Surge
• The Reflation Trade Unravels
• Portfolio Positioning
• Sector & Market Analysis
• 401k Plan Manager

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

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Are you worried about the potential for a market correction, a surge in inflation, or are you unsure how to invest for your retirement? We can help. If you are not yet a client and would like to discuss your portfolio construction, please schedule a time to meet with one of our advisors below.

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Market Stumbles But Rallies Back

Last week, we discussed the market hit new highs with the index getting back to more extended and overbought conditions. To wit:

“The technical backdrop is not great. With the market back to 2-standard deviations above the 50-dma, conviction weak, and investors extremely bullish, the market remains set up for additional weakness.

However, we are in the first two weeks of July, which tends to be bullishly biased. After increasing our equity exposure previously, we will give the market the benefit of seasonality for now.”

While market volatility did pick up this past week, the index held its breakout support levels and closed at a new high. Such keeps the bullish bias intact. However, as shown, the money flow signals are now back to more elevated levels, which will provide resistance to higher prices short term. 

We are still within the seasonally strong period of July, which tends to last through mid-month. However, August and September are typically more challenging for returns. As we stated last week:

“The bulls are indeed in charge of the markets currently, but the clock is ticking.”

The market is also weak from a breadth perspective. While large-cap stocks have done better as of late, the rest of the markets have not. I discuss this in more detail in Friday’s 3-minutes video.

The critical point, as noted in the video, is there has been a definite rotation out of the “reflation trade” (small, mid, emerging, and international markets) into the large-cap names (primarily technology), which is the “deflation trade.”

As we will discuss, the reflation trade ran well ahead of reality. Over the next couple of months, the test will be to see if earnings can support the surge in prices and valuations.

Yields Overbought

We will discuss the “yield warning” momentarily. However, in the short term, yields have gotten very overbought. We suspect we could see a retracement in yields short-term, but such will likely be an opportunity to increase bond exposure in portfolios as we head further into the year. 

As shown, previous overbought conditions (indicators get inverted concerning yields) lead to retracements to resistance. Currently, a retracement to 1.5% would be likely. Ultimately, a break below 1.25% will suggest much lower yields are coming. 

From a positioning standpoint, we increased our bond duration several weeks ago. However, while we want to increase our exposure eventually, we need to wait for the short-term overbought condition to reverse. 

Longer-term, as we will discuss next, we believe yields are potentially headed lower as economic growth and inflationary pressures wane.

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Yield Plunge, Dollar Surge

In our #MacroView this week, we discuss the warning sign that yields are sending in more detail. However, importantly, the plunge in yields is suggestive that something in the market is becoming strained. As discussed in that article, when interest rise, and peak, such has corresponded with more negative market outcomes.

Is the current rise in rates signifying the next market downturn? Historically, sharp spikes in rates have done so by slowing economic growth more than expected. However, as we noted previously in our Commitment Of Traders report:

“The number of contracts net-long the 10-year Treasury already suggests the recent uptick in rates, while barely noticeable, maybe near its peak.”

Some of the pressure in bonds has come from the market bracing itself for some large auctions of new bonds next week. A lot of the action on Friday was the shift in focus to next week’s auctions. On Monday, there will be $38 billion in 10-year notes and $24 billion in 30-year bonds on Tuesday.

However, as noted by Zerohedge on Friday:

“But those who are betting on a continued rise in yields may get disappointed for one key technical reason. As Morgan Stanley’s derivatives strategist Chris Metli notes, CTAs – those mindless trend-followers who just ride on momentum waves until they crash, are still short bonds and at current yields have to buy $95bn notional of TY-equivalent duration over the next week.

As Morgan Stanley notes such ‘could continue the bond rally and put pressure on stocks as equity investors fear the bond market knows something they don’t about future growth prospects.'”

The dollar is also confirming the same.

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In Case You Missed It

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The Dollar Is Confirming The Same

We specifically noted that the dollar was about to rise sharply. To wit:

“The one thing that always trips the market is what no one is paying attention to. For me, that risk lies with the US Dollar. As noted previously, everyone expects the dollar to continue to decline, and the falling dollar has been the tailwind for the emerging market, commodity, and equity risk-on trade. So, whatever causes the dollar to reverse will likely bring the equity market down with it.”

While the dollar rally is still young, there was a successful test of the “double bottom” with higher lows. The break above the 50- and 200-dma also suggests the rally is just getting started. A further rally in the dollar will get fueled by additional short-covering.

There is a significant difference between a “recovery” and an “expansion.” One is durable and sustainable; the other is not.

Dollar & Rates Are Warning Signs

Those expecting a significant surge in inflation will likely be disappointed for the one reason which seems to get mostly overlooked.

“If the economy were growing organically, which would create stronger rates of wage growth and inflation, then there would be no need for zero interest rates, continued monetary interventions by the Federal Reserve, or deficit spending from the Government.”

The obvious problem is that not all “spending” is equal. Pulling forward consumption through stimulus is indeed short-term inflationary but long-term deflationary. Moreover, since 1980, there has been a shift in the economy’s fiscal makeup from productive to non-productive investment. 

As we have pointed out previously, you can not overstate the impact of psychology on an economy’s shift to “deflation.” When the prevailing economic mood in a nation changes from optimism to pessimism, participants change. Creditors, debtors, investors, producers, and consumers change their primary orientation from expansion to conservation.

• Creditors become more conservative and slow their lending.
• Potential debtors become more conservative and borrow less or not at all.
• Investors get increasingly conservative, and they commit less money to debt investments.
• Producers become more conservative and reduce expansion plans.
• Consumers become more conservative, and save more, and spend less.

As we have been witnessing since the turn of the century, these behaviors reduce the velocity of money. Consequently, the decline in velocity puts downward pressure on prices. Moreover, given the massive increases in debt and deficits, the deflationary drag increases as the stimulus fades from the system.

Likely, the dollar and rates already figured this out.

The Reflation Trade Unravels

The importance of this analysis relates to a potential change in investor positioning in the market. To wit:

“The unraveling of the inflation/reflation trade has accelerated over the past week. US 10y bond yields continue to decline and have now broken a crucial technical level. Such could see the rally accelerate sharply, and with it, the continued unraveling of both cyclicals and commodities.” – Albert Edwards

Albert’s comment aligns with our views previously that such would likely be the case.

I believe that the pandemic recession allowed policymakers to cross the Rubicon of fiscal rectitude. They have reached a new land where existing monetary profligacy can now get coupled with fiscal debauchery.

In that respect, I am very much in the inflation/reflation camp. But I think it is a secular theme that will play out later in this cycle. The problem is the markets have been too early in betting on the reflation trade and have gotten set up for a huge disappointment.”

We have previously discussed the change in the deflationary credit impulse. But, importantly, the bond and dollar markets are now reflecting that deflation.

Does such mean the markets will crash tomorrow? No.

What is critical to recognize is that the market is well ahead of what reality will turn out to be. As such, when overly exuberant earnings and economic growth expectations fade, the justification supporting overpaying for assets will run into trouble.

Portfolio Update

There is something “not quite right” with the market currently. As discussed previously, the problem with technical indicators is that they do not distinguish between a consolidation, a correction, or more. Therefore, we have to pay attention to warnings, much the same as driving a car.

A yield sign is a warning. We have a choice to blow through yields signs and may get away with it 100 times. However, the 101st time leads to a devastating crash. In the markets, the warning signs suggest reducing our “speed” in the portfolio slightly, watching for risk, and then returning to speed once the danger has passed. 

After increasing our bond duration in portfolios to hedge risk, we removed our index trading positions this past week and lowered our equity exposure to hedge risk further. (We slowed down.)

With our money flow “sell signals” approaching high levels, taking some action could be beneficial. 

• Trim back winning positions to original portfolio weights: Investment Rule: Let Winners Run
• Sell positions that simply are not working (if the position was not working in a rising market, it likely won’t in a declining market.) Investment Rule: Cut Losers Short
• Hold the cash raised from these activities until the next buying opportunity occurs. Investment Rule: Buy Low

Minor adjustments can make significant differences to outcomes when you can avoid “the wreck.”

By Lance Roberts, CIO

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Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members

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S&P 500 Tear Sheet

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Performance Analysis

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Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” are oversold. The current reading is 91.91 out of a possible 100.

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Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 84.20 out of a possible 100.

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Sector Model Analysis & Risk Ranges

How To Read This Table

• The table compares each sector and market to the S&P 500 index on relative performance.
• “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
• The risk range is a function of the month-end closing price and the “beta” of the sector or market.
• Table shows the price deviation above and below the weekly moving averages.

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Weekly Stock Screens

Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

Low P/B, High-Value Score, High Dividend Screen

Fundamental Growth Screen

Aggressive Growth Strategy

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Portfolio / Client Update

With our money flow signals returning to peaks, which typically precede a pickup in volatility, we took the opportunity to reduce our index trading positions. That action raised our cash levels by 5% to provide a bit more of a cash cushion for now.

As discussed in the main body of this week’s newsletter, one of the more significant concerns is the sharp drop in yields over the last two weeks. Such suggests there is a problem brewing somewhere in the market. While that problem isn’t evident at the moment, such doesn’t mean it doesn’t exist.

We are monitoring the markets closely. If our signals do get triggered, we will take further action to reduce risk exposures accordingly. In addition, we are watching all of our positions for violations of support or a change in fundamental underpinnings. At the current time, there are no “red flags,” but if things change, we will change as well.

Portfolio Changes

During the past week, we made minor changes to portfolios. In addition, we post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

“Given the plunge in yields, there is something not “quite right” with the market. We are taking our DIA trading position off for now at a minimal loss to reduce our overall equity exposure. If the current sell-off begins to gain some traction, we will take further risk reduction actions” – 07/08/21

Equity & ETF Model

• Sell 100% of DIA

“In the equity model, we sold NXPI as it performed poorly versus the tech sector and its weakening from a technical perspective. As we discussed this morning the tech sector is overbought as well. In the sector model, we reduced XLY and XLV by 1% each to reduce exposure to overweight sectors that are overbought.” – 07/09/21

Equity Model

• Sell 100% of NXPI

ETF Model

• Reduce XLY by 1% of the portfolio.
• Reduce XLV by 1% of the portfolio

As always, our short-term concern remains the protection of your portfolio. Accordingly, we have shifted our focus from the election back to the economic recovery and where we go from here.

Lance Roberts

CIO

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THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors

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

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401k Model Performance Analysis

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

Have a great week!

The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You will find more detail on the model and the specific tickers below the charts.

Commentary 7-09-21

• The first set of relative value charts show technology, discretionary and healthcare are leading the market charge higher almost singlehandedly. Real estate, communications, and financials are at fair value and the remaining six sectors are decently oversold. This condition is in line with a few charts and words we posted in the dashboard and weekly newsletter describing our concern about the poor breadth of the market despite a string of all-time highs.
• Energy, finally broke down into oversold territory after having a positive relative score since April. The sector gave up 4.73% versus the S&P over the last week. It appears to be catching down to the other inflationary stocks that have recently performed poorly versus the market.
• The factor/index relative graphs also tell a story of bad market breadth. Technology is slightly overbought while every other factor/index is decently oversold. Of note, emerging and developing markets are strongly oversold versus the S&P 500. Over the last 20 days emerging markets underperformed the S&P 500 by 6.35 and developed foreign markets by 4.98%. On a relative basis, we might see these sectors outperform, especially if the recent deflationary bias eases. Higher bond yields would signal such a circumstance.
• On the relative fixed income graphs, TLT (long duration USTs) is the most overbought sector versus (IEI 5-7 yr UST) while the inflationary sectors (TIPs and our inflation index) along with mortgages are the most oversold. Mortgages are trading weaker due to market concerns the Fed will begin to taper MBS purchases shortly.
• The scatter plot shows a very high confidence score (.8041) meaning the scores are accurately portraying their relative performance.
• 7 of the 12 sectors are trading below their 50 dmas despite the market hitting a record high on Wednesday. All sectors remain above their 200 dmas.
• The divergence of the underlying sectors is also seen in the absolute series of graphs. Technology, Realestate, Healthcare, and Discretionary are decently overbought. Transports (XTN) are the most oversold sector but not to a degree that might signal a reversal.
• Despite Thursday’s decline, the S&P 500 (bottom right graph in the absolute charts) remains decently overbought. As we noted earlier, foreign markets are oversold on an absolute basis but like transports, not to a degree that might signal an imminent reversal.
• The third graph shows the excess returns by sector for four different time frames. The poor breadth is clearly evident.

Graphs (Click on the graphs to expand)

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Users Guide

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change trend. When the scatter plot in the sector graphs has an R-squared greater than .60 the signals are more reliable.

The first set of four graphs below are relative value-based, meaning the technical analysis is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

• Staples XLP
• Utilities XLU
• Health Care XLV
• Real Estate XLRE
• Materials XLB
• Industrials XLI
• Communications XLC
• Banking XLF
• Transportation XTN
• Energy XLE
• Discretionary XLY
• S&P 500 SPY
• Value IVE
• Growth IVW
• Small Cap SLY
• Mid Cap MDY
• Momentum MTUM
• Equal Weighted S&P 500 RSP
• NASDAQ QQQ
• Dow Jones DIA
• Emerg. Markets EEM
• Foreign Markets EFA
• IG Corp Bonds LQD
• High Yield Bonds HYG
• Long Tsy Bonds TLT
• Med Term Tsy IEI
• Mortgages MBB
• Inflation TIP
• Inflation Index- XLB, XLE, XLF, and Value (IVE)
• Deflation Index- XLP, XLU, XLK, and Growth (IWE)

Bond yields are sending an economic warning as this past week 10-year Treasury yields dropped back to 1.3%.  With the simultaneous surge in the dollar, there is rising evidence the economic “reflation” trade is geting unwound.

Such is despite overly exuberant expectations of strong economic growth by the mainstream media. As we suggested in 2019, bonds generally have the outlook correct more often than stocks.

Such is not surprising as the long-term correlation between economic growth and rates remains high.

We remain in the camp that, due to the rising debt and deficits, rates must remain low. However, given most people don’t understand bonds, we will recap our previous analysis. 

If you don’t understand what bonds are and what they can do for your portfolio, you may be missing out on something really big. And not just if you’re a retiree either.

Why Bonds Correlate To Economic Growth & Inflation

As stated in “bonds are not overvalued:”

“Unlike stocks, bonds have a finite value. At maturity, the principal gets returned to the “lender” along with the final interest payment. Therefore, bond buyers are very aware of the price they pay today for the return they will get tomorrow. As opposed to an equity buyer taking on ‘investment risk,’ a bond buyer is ‘loaning’ money to another entity for a specific period. Therefore, the ‘interest rate’ takes into account several substantial ‘risks:’

• Default risk
• Rate risk
• Inflation risk
• Opportunity risk
• Economic growth risk

Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer will not pay a price that yields a negative return in the future. (This assumes a holding period until maturity. One might purchase a negative yield on a trading basis if expectations are benchmark rates will decline further.)

As noted, since bonds are loans to borrowers, the interest rate of a bond is tied to the prevailing rate environment at the time of issuance. (For this discussion, we are using the 10-year Treasury rate often referred to as the ‘risk-free’ rate.)”

There are some caveats to this analysis related to the secondary market, which we cover in the linked article.

However, the critical point is that bond buyers compensate for both what the market will pay in terms of interest rates, but also ensure they get paid for the various risks they take.

Yields Vs. Economic Growth

Given that analysis, it should not be surprising that interest rates reflect three primary economic factors: economic growth, wage growth, and inflation. But, again, the relationship is not unexpected as the “rate” for lending money must account for varoius risks.

We created a composite of the three underlying measures to get a more direct relationship. For example, the chart below combines inflation, wages, and economic growth into a single composite and compares it to the 10-year Treasury rate.

Again, the correlation should not be surprising given rates must adjust for future impacts on capital.

• Equity investors expect that as economic growth and inflationary pressures increase, the value of their invested capital will increase to compensate for higher costs.
• Bond investors have a fixed rate of return. Therefore, the fixed return rate is tied to forward expectations. Otherwise, capital is damaged due to inflation and lost opportunity costs. 

As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.

The disappointment of economic growth is also a function of the surging debt and deficit levels discussed previously.

Bonds Are Sending A Warning

The differential between yields also confirm our concerns that expectations for economic growth and inflation are overly optimistic. The yield curve continues to flatten over the last few months as opposed to steepening with strong economic expectations.

(Importantly, a flattening yield curve only suggests growth and inflation will be weaker than expected. However, an inverted yield curve is what will predict the next bear market and recession.)

If yields are correct, then investors should be heeding its warning as lower yields will translate into slower earnings growth. In “Warning Signs,” we discussed the more extreme detachment of stocks from the underlying economy.

“The market is currently trading more than twice what the economy can generate in revenue growth for companies. (There is a long-term correlation between the rate of economic growth and earnings.)”

Investors currently “hope” that earnings will catch up with the price of the market. Such would reduce the valuation problem. However, while such is certainly possible, it has never previously happened in history.

Yields are suggesting this time will not be different.

Why We Own Bonds

As we often discuss in our weekly newsletter (subscribe for free,) we continue to opportunistic bond buyers to hedge against risk.

There is little doubt the market is currently in “risk-on” mode as investors throw “caution to wind” due to the Fed’s ongoing interventions. But, for now, that “psychology” works well.

However, when that psychology changes, for whatever reason, the rotation from “risk-on” to “risk-off” will find Treasury bonds as a “store of safety.” Historically, such is always the case during crisis events in markets.

For most investors, it was a mistake to discount the advantage of owning bonds over the last 20 years. By reducing volatility and drawdowns, investors could withstand the storms that wiped out large chunks of capital.

With stocks again grossly overvalued, a significant drawdown is probable in the coming years.

Over the next decade, the prospect of low stock market returns, possibly approaching zero, seems much less appealing than the positive return offered by a risk-free asset.

Given that we are in the most extended bull market cycle in history, combined with high valuations and weakening fundamentals, it might be time to pay more attention to what bonds can offer you.

Bonds are sending a warning once again.

Disregarding the warning has historically been costly.

As a business owner, there are 3-steps to increase 401k plan employee engagement.

I get it! The last thing that most employees want to do is talk about retirement. It seems so far into the future that it does not connect with their current priorities. It is also frustrating that you spend so much time managing something not taken advantage of by the people it means to serve.

Again…I get it!

Here are three simple steps to increase engagement amongst your staff:

Connect to Their Current Situation:

Retirement is such an exoteric concept, and most people underestimate what their needs will be in the future. $500,000 sounds like a lot of money. But what if I told you that a $500,000 account balance would safely support a $25,000 per year income replacement? Holy cow! It changes people’s perceptions.

An alternative approach to increase employee engagement is to show them what their current 401(k) balance means in terms of a bi-weekly or monthly paycheck. That is how most people think of their current income anyway. We all get the notification from our bank that a deposit of $XX has hit our bank account. What if we did the same on our monthly or quarterly 401(k) statements as well as action steps to get them back on the right track?

Such can get done with different service providers in the industry. Therefore, we will see more and more of this type of communication with participants in the future.

Dedicate a Day to Corporate Wellness:

Unlocking the productivity of your workforce is an art. That is why we spend money on human resources and develop strategies that evolve around performance, workplace culture, and overall wellness. By having healthy employees, both mentally & physically, you can increase their productivity by increasing their focus on their jobs.

One solution is devoting a day to speaking to the needs of your workforce outside of their day-to-day duties. Not only will it show you as being a dedicated employer that cares about the well-being of their employees, but it will also build camaraderie amongst your leadership and those they are supposed to lead to move your company’s mission forward. Making it a part of your culture will make it become a habit for your employees.

Such can include healthy activities like exercise, stress management, team building, and financial fitness. In addition, many different specialists can come in and address the needs of your workforce.

Revisit Your Company’s 401(k) Plan Design

Successful employee participation is a delicate balance between incentivizing and “nudging,” a term popular by University of Chicago behavioral economist Richard Thaler.

The best incentive employers have to increase participation is to offer a company match. Industry-standard is a matching between 4-6% of employee compensation. When you are in the middle of budget planning, you can incorporate the matching contribution as part of labor. The good news is that you can also attach a vesting schedule out to 6 years on all matching contributions, which can help you save money over time.

You can also look into “automatic features” like automatic enrollment and automatic escalation. Such is the “nudge” I was referring to earlier. By building enrollment into your employee onboarding process, your workforce can start saving immediately and set the expectation that financial wellness and retirement planning are a priority of your company.

The only caveat I will mention with “automatic features” is that it IS NOT as automatic as it gets pitched. Certain service providers do a better job at helping the plan administrator at the employer manage the automatic enrollment and escalation process, but most will not. That means that you must have great internal controls in place to make sure you are managing, tracking, and enrolling participants on time. In addition, there could be penalties associated with having certain participants fall through the cracks, so make sure you know how your service provider can assist and what processes you need to have in place.

Need Assistance?

If you seek assistance from an independent fiduciary plan advisor, you can always schedule a free consultation by calling 855-RIA-PLAN. We are more than happy to discuss options to help get you and your plan on the right track.

If you are interested in a no-obligation assessment of your company’s 401(k) plan and how RIA Advisors can help you level up, feel free to contact me directly.