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In this issue of, “Close But No Cigar, Bulls Fail To Capture Market Highs”

• Close But No Cigar
• The Coming Income Cliff
• Hedging Risk
• MacroView: Why Soros Just Called The Market A Bubble
• Sector & Market Analysis
• 401k Plan Manager

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

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Webinar: Retirement Right Lane (REPLAY)

If you missed our Right Lane Retirement workshop last weekend, don’t fret. We have the full replay for you here for a limited time. (Link will expire in one week.)

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Catch Up On What You Missed Last Week

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Close But No Cigar

As discussed last week in “Bulls Chant,” the markets pushed toward all-time highs: 

“While weaker economic data has not yet dented the “bullish sentiment” at this juncture, it doesn’t mean it won’t. However, as we have discussed over the last several weeks, a breakout of the consolidation range, which was capped by the June highs, would put all-time highs into focus.”

This week, despite repeated attempts, the bulls were unable to close above all-time highs solidly. As they say, “it was close, but no cigar.”

With options expiring next week, the bulls are going to attempt to push markets up. A breakout to all-time highs is entirely possible. However, the question is whether they will be able to maintain it?

A Normal Correction Is Likely

With the markets overbought on several measures, there is a downside risk heading into the end of the month. These risks come from several fronts we will discuss momentarily. However, from a technical perspective, the downside risk is about 5.6% to the 50-dma and 9.4% to the 200-dma. (Shown above)

A 5-10% decline in any given year is not outside of the norm. However, since investors have entirely forgotten what a drop feels like, a 5-10% slide will “feel” worse than it is.

As I stated, the market is overbought on multiple measures, which have typically coincided with short-term market peaks and corrections. With the S&P now trading more than 9% above the 200-dma, and all indicators back to overbought conditions, it is worth wary of potential short-term correction risks. 

Another way to look at deviations is where the S&P 500 ETF (SPY) trades relative to its 250-day volume-weighted average price (VWAP.) While deviations have been more extreme in the past, this is currently the highest level since February.

All this indicator suggests it there is “fuel” for a correction in the markets short-term. What is needed, of course, is a “catalyst” to ignite sellers.

That is where our discussion of the “Income Cliff” comes in.

The Income Cliff

One of the significant risks facing the market over the next couple of months is the “income cliff” as extended unemployment benefits run dry. 

“Last month, we argued that rapid and robust fiscal stimulus was a critical driver of the initial V-shaped recovery in consumer spending. Therefore, several benefits cliffs could endanger this momentum as the removal of government support was premature. 

The evaporation of these benefits highlights near-term downside risks to consumer spending, particularly for lower-income households, which have been a critical engine of the recovery despite being disproportionately more likely to lose a job during the pandemic — a testament to the effectiveness of the income supplement.” – Matt Luzzetti, chief U.S. economist at Deutsche Bank.

While the White House announced last week it would take executive action to reallocate unused dollars from the CARES Act to supplement existing unemployment programs, there remain challenges. At this point, there are no additional $1200 checks going to households, and as shown below, other benefits are plunging.

The initial rebound in retail sales, and much of the economic data, came from $1200 checks and $600/week in additional benefits. With Congress now heading off to summer recess, and the pre-election rhetoric about to begin, there is a risk of delay in any additional relief. Importantly, even if the passage of additional relief occurs, it will be less than previous amounts, which will slow any economic recovery.

Since sales are what drives corporate earnings, you can see the stock market’s issue over the next few quarters.

While watching the “income cliff” carefully, my colleague Doug Kass lays out 10-other risks, which could also provide the catalyst for a correction.

10-Other Factors That Could Spark A Correction

“My view is that the period leading up to the November election holds a list of unique and potentially worrisome risks:

1. Fundamentals Remain Too Optimistic. 
2. Technical Deterioration. Market breadth and new highs (only 59 yesterday), investor sentiment is growing ebullient (put/call ratios at a multi-month lows), the National Association of Active Investment Managers (NAAIM) has its highest long exposure in years at 102.4.
3. Covid-19 Remains A Wildcard. Currently, the virus continues to spread, and fatalities are expanding. Travel restrictions are tightening, schools and universities closing or have a reduced schedule, and small business openings remain uncertain. The recent fragile rise in consumer and business confidence could be fleeting.
4. Speculation Is Beginning to Moderate. Losses in the “shiny objects” may now be accumulating. 
5. The China/U.S. Rift Is Widening. China will likely play hardball in the face of a potential change of the Presidency. 
6. For a Host of Reasons, Our Society is Fractured. An intensification of violence could shake confidence as social issues become more heated, leading into the November election. 
7. The Social Safety Net Is Beginning to Fade. Federal unemployment benefits are getting extended but only a fraction of the $600. PPP is expiring in early August and is not being replaced or at a fraction of the previous level.
8. Market Structure Remains a Significant Risk. The intoxicating advance since March could easily move into reverse. “buyers live higher, but sellers live lower.”
9. A Democratic Sweep Will Result in More Distributional Policies. 
10. Higher individual and corporate tax rates, a possible wealth tax, and potential threats to the tech market leaders’ monopolistic positions could undermine growth.
11. There Are Numerous Knock On Problems That Could Reverberate in Our Economic and Markets Systems. Let’s call this the “unknowable”. 

Sitting Closer To The Exit

Point 10 in Doug’s list is the most critical. 

What eventually sparks a reversion is always the one thing no one is anticipating. Throughout history, the unexpected, exogenous event is what sends investors fleeing for the exits. After the damage occurs, the media’s excuse is always: “Well, no one could have seen that coming.” 

As noted above, overbought, extended, overly bullish markets are by themselves “bullish.” These conditions represent the current “momentum,” which keeps pushing assets higher and dragging investors into the market.

It’s very much like a crowded theater. Everything is fine, until that point where someone yells “fire.” At that point, everyone tries to rush towards a very narrow exit. The same holds for the market. 

Such was a point we discussed in 2017 in the “Rise Of The Robots:”

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. 

When the ‘robot trading algorithms’ begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation n or fundamental measures. The exit will become very narrow.

Importantly, as prices decline, it will trigger margin calls, which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. Such forces investors to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines. Such leaves investors helpless on the sidelines watching capital appreciation vanish in moments.”

No one believed me then. But it is what happened in March of 2020.

Hedging Risk

For all of these reasons, this is why we are sitting closer to exit. 

Retail investors have packed themselves into the same theater under the belief that asset prices can only go higher. As noted, numerous things could spark a “fire.” 

Furthermore, over the last couple of weeks, our portfolios remain weighted towards equity risk. Such makes us very uncomfortable, as “risk” controls are the backbone of our process. 

Such remains the case this week. 

Given we are now getting more extreme short-term overbought conditions, the risk of a short-term reversion has risen. Therefore, we continued making changes to portfolios last week. 

As noted previously in our “Commitment of Traders” report, the rather large short position in the US Dollar is a sign to hedge our dollar-based exposures (stocks, gold, and energy.) Therefore, we have been building a long-dollar position over the last two weeks and added to it again on Friday.

Furthermore, we added to our bond holdings, given the more extreme oversold condition. Just in case there is a correction, bonds should act as a hedge.

We are also beginning to add additional “value” positions to the portfolio. These positions carry high yields, have “fundamental value,” and have less downside currently. When the market begins to rotate towards safety, “value” may be a benefactor.

See our latest RIAPRO.NET (30-Day Risk-Free Trial) report on Exxon Mobil (XOM)

Consequently, the time has come to be more conservative in portfolios, even at the expense of short-term performance. When there is a more evident opportunity to take on risk, we will undoubtedly do so aggressively.

Sometimes, when you don’t know what to do, the best thing to do is not play. 

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The MacroView

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

See You Next Week

By Lance Roberts, CIO

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Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders

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S&P 500 Tear Sheet

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Performance Analysis

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Technical Composite

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Sector Model Analysis & Risk Ranges

How To Read.

• The table compares each sector and market to the S&P 500 index on relative performance.
• The “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.
• The table shows the price deviation above and below the weekly moving averages.

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Sector & Market Analysis:

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

Sector-by-Sector

Improving – Financials (XLF), Industrials (XLI), and Energy (XLE)

While Financials remain the improving quadrant, they are still vastly underperforming the market. Conversely, Industrials have broken above their 200-dma and are performing better. The sector is very overbought short-term, so a pullback to the 200-dma that holds will allow us to add more to our exposure. Energy continues to underperform the market vastly. While there is value in the sector, there is no reason for overweight holdings currently.

Current Positions: XLI

Outperforming – Materials (XLB), and Discretionary (XLY)

Discretionary stocks have broken out to new highs and continue to perform well due primarily to AMZN. However, the sector is extremely overbought, and a correction is likely. Take profits and rebalance risk accordingly. Materials are also struggling at all-time highs and are also extremely extended.

Current Positions: None

Weakening – Technology (XLK), and Communications (XLC)

After adding more exposure to our Technology holdings, the sectors have gone vertical with the rush to chase the 5-mega cap names. Technology began to struggle this week and is starting to consolidate gains. A correction is likely, so profits taking is advised. The same goes for the Communications sector as well.

Current Position: XLK, XLC

Lagging – Healthcare (XLV), Utilities (XLU), Real Estate (XLRE), and Staples (XLP)

Previously, we added to our core defensive positions Healthcare. We continue to hold Healthcare on a longer-term basis as it tends to outperform in tougher markets and hedges risk. Healthcare is overbought after the expected rally, Look for a correction back to support at the 200-dma.

Our defensive positioning in Staples has finally played catchup to the rest of the market. Staples are very overbought, so rebalance risk accordingly. Utilities continue to lag and remains directionless currently. Utilities will likely play better in a market correction.

Current Position: XLU, XLV, XLP

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – Both of these markets continue to underperform, but after perking up last week, began to lag again this week. Taking profits was advised last week. Same goes this week. 

Current Position: None

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

Emerging and International Markets have performed better recently. We added a long-dollar hedge to our portfolios, which will weigh on international exposure. However, we did add a small position of EFV (International Value) as we look to increase our “value” weightings in portfolios.

Current Position: None

S&P 500 Index (Exposure/Trading Rentals) – We currently have no “core” holdings.

Current Position: None

Gold (GLD) – Previously, we trimmed our exposure to IAU. Gold is a very overbought short-term, so we are looking for a pullback to rebuild exposures. The Dollar is extremely oversold; we added to our UUP position to hedge downside risk in Gold. 

Current Position: IAU, UUP

Bonds (TLT) –

We continue to hold our bond holdings as a hedge against market risk. This week, after a good correction, we added to our Treasury bonds holdings. 

Current Positions: TLT, MBB, & AGG

Portfolio / Client Update

With market volatility picking up over the last couple of weeks, there has been a wild rotation in markets. One day Technology is running, the next its Industrials, and back again. Historically, this type of action occurs closer to market peaks than not. 

Such is why we are currently sitting a bit closer to exit. We are presently getting more uncomfortable with the market. Given we are now getting more extreme short-term overbought conditions, the risk of a short term reversion has risen. Therefore, we began making changes to portfolios this past week. 

Portfolio Changes

In both models, we have begun adding to our “value” holdings, which should provide a “buffer” during a risk-off rotation. Last week, we added a value position in AT&T. Our analyst, Nick Lane, wrote a report this week on one of our other value holdings Exxon Mobil (XOM)

Nick Lane: The Value Seeker Report- Exxon Mobil (XOM)

We also added a small position in International Value (EFV), which has a 3.5% yield. 

As always, as we add to our equity exposures, we hedge that increase in “risk” with offsetting positions. Therefore, we increased our exposure to Treasuries, given the recent sell-off gave us an excellent entry opportunity. We also added to our long-dollar exposure to offset the risk in equities and gold. 

In conclusion, we will sacrifice some short-term performance if markets rally, but the risk of a correction has risen too much to ignore it wholly. Therefore, our allocations are going to become more conservative over the next couple of weeks. 

Please don’t hesitate to contact us if you have any questions or concerns.

Lance Roberts

CIO

In a previous post “Market Bubbles,” I touched on George Soros’ “theory of reflexivity.” Interestingly, MarketWatch discussed with George why he no longer participates in the “bubble.” The foundation of his argument comes from his previous work in “Alchemy of Finance.” To wit:

“Pivoting to his legendary approach to financial markets, Soros acknowledges that investors are in a bubble fueled by Fed liquidity, which creates a situation that he now avoids. He explained that ‘two simple propositions’ make up the framework that has historically given him an advantage. However, since he shared it in his book, ‘Alchemy of Finance,’ the advantage is gone.” – MarketWatch

Specifically, he eludes to his “theory of reflexivity.” 

“One is that in situations that have thinking participants, the participants’ view of the world is always incomplete and distorted. That is fallibility. The other is that these distorted views can influence the situation to which they relate, and distorted views lead to inappropriate actions. That is reflexivity.”

Before we get into the issue of “reflexivity,” let me recap what a “bubble” is.

Bubbles Are About Psychology, Not Metrics

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

Over the last few weeks, I have touched on the impact of valuations and forward returns. However, it is not just valuations, but also the surge in corporate debt and declining profitability resulting from weak economic growth. Historically, such a combination of factors is associated with previous “bear markets.” 

None of these fundamental concerns are currently a problem. Despite the March selloff, 50-million unemployed, and a deep recession, the markets currently hover near all-time highs.

Such was a point George also confirmed:

“We are in a crisis, the worst crisis in my lifetime since the Second World War. I would describe it as a revolutionary moment when the range of possibilities is much greater than in normal times. What is inconceivable in normal times becomes not only possible but actually happens. People are disoriented and scared. They do things that are bad for them and for the world.”- George Soros

As shown in the chart below, the S&P 500 is trading in the upper 90% of its historical valuation levels.

However, since stock market “bubbles” reflect speculation, greed, emotional biases, valuations only reflect those emotions. As such, price becomes more reflective of psychology.

From a “price perspective,” the level of “greed” is on full display as the S&P 500 trades at the greatest deviation on record from its long-term exponential trend. (Such is hard to reconcile given a 35% correction just a few months ago.)

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Notice that except for only 1929, 2000, and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently. 

A Basic Disregard

The chart, courtesy of Finviz.com, compares the year-to-date performance of the constituents of the S&P 500. The bigger the “bubble size,” the larger the market cap. Not surprisingly, the largest bubbles belong to the “mega-cap” stocks responsible for a majority of the market return. Importantly, notice the vast majority of stocks still sport negative returns.

In other words, investors push valuations simply on “momentum.” As shown, since 2018, the increase in stock prices is primarily attributable to “valuation expansion.”

The basic disregard by investors over fundamental valuations is a reflection of the “psychological” bias now engulfing market participants. However, being excessively “bullish” is not what causes the eventual reversion. It is just the “fuel” that drives it.

No Bubble Is Ever The Same

Historically, all market crashes have been the result of things unrelated to valuation levels. Issues such as liquidity, government actions, monetary policy mistakes, recessions, or inflationary spikes are the culprits that trigger the “reversion in sentiment.”

Importantly, the “bubbles” and “busts” are never the same.  

I previously quoted Bob Bronson on this point:

“It can be most reasonably assumed that markets are efficient enough that every bubble is significantly different than the previous one. A new bubble will always be different from the previous one(s). Such is since investors will only bid prices to extreme overvaluation levels if they are sure it is not repeating what led to the previous bubbles. Comparing the current extreme overvaluation to the dotcom is intellectually silly.

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

Comparing the current market to any previous period in the market is rather pointless. The current market is not like 1995, 1999, or 2007? Valuations, economics, drivers, etc. are all different from cycle to the next.

Most importantly, however, the financial markets adapt to the cause of the previous “fatal crashes.” However, that adaptation won’t prevent the next one.

“Thus, this vast increase in asset claims’ market value is partly the indirect result of investors accepting lower compensation for risk. Market participants too often view such an increase in market value as structural and permanent.

To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. Such is why history has not dealt kindly with the aftermath of protracted periods of low-risk premiums.” 

– Alan Greenspan, August 25^th, 2005.

Credit Risk Is The Tell

Just as it was in 2005, we see much of the same behavior in the markets today. One of the “key arguments” for continuing to chase stocks has been that “low rates justifies taking on increased risk.” Such was a point Mr. Greenspan obviously disagreed.

“A decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability and thus a willingness to reach over an ever-more extended period. But, because people are inherently risk-averse, risk premiums cannot decline indefinitely. 

Whatever the reason ‎ for narrowing credit spreads, and they differ from episode to episode, history cautions that extended periods of low concern have invariably been followed by a reversal, with an attendant fall in the prices of risky assets. Such developments reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender.”

– Alan Greenspan, September 27th, 2005.

It’s not too hard to remember what happened next. In the short-term, investors always believe they can escape the eventual reversions of excess. In reality, they never do.

Soros’ Theory Of Reflexivity

With this background, we can better understand Soros’ “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, there is a lack of equilibrium conditions.

I have developed a rudimentary theory of bubbles along these lines. 

Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, it sets a boom-bust process in motion. The process is liable to be tested by negative feedback along the way. If it is strong enough to survive these tests, it reinforces both the trend and the misconception. 

Eventually, market expectations become so far removed from reality if forces people to recognize that a misconception is involved. A twilight period ensues during which doubts grow. More and more people lose faith, but the inertia sustains the prevailing trend.

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

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

Asymmetry

The chart below is an example of asymmetric bubbles.

Soros’ view on the pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view. Prices reflect the psychology of the market, creating a feedback loop between the markets and fundamentals.  As Soros stated:

“Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable, so neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”

The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis.  I then took a look at the markets before each major market correction and overlaid Soros’ asymmetrical bubble shape.

Conclusion

There is currently much debate about the health of financial markets. Can prices remain detached from the fundamentals long enough for the economic/earnings recession to catch up with prices?

Maybe. It has just never happened.

The speculative appetite for “yield,” which has been fostered by the Fed’s ongoing interventions and suppressed interest rates, remains a powerful force in the short term. Furthermore, investors have now been successfully “trained” by the markets to “stay invested” for “fear of missing out.”

The increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable correction. The only missing ingredient for such a correction currently is simply the catalyst that starts the “panic for the exit.” 

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

Of course, that is most likely why Soros is choosing not to participate. At 90-years of age, these boom cycles are nothing new. However, he also knows how they end.

Have you?

What You Missed On RIA This Week Ending 08-14-20

It’s been a long week. You probably didn’t have time to read everything that scrolled past you on RIA. Don’t worry, we’ve got you covered. Just in case you haven’t already, opt-in to get our newsletter and technical updates.

Here is this week’s rundown of what you missed. A collection of our best thoughts on investing, retirement, markets, and your money.

Webinar: Retirement Right Lane (REPLAY)

If you missed our Right Lane Retirement workshop last weekend, don’t fret. We have the full replay for you here for a limited time. (Link will expire in one week.)

What You Missed This Week In Blogs

Each week, the entire team at RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risk. Risk is what could negatively impact our client’s capital. If you missed our blogs last week, these are the risks we are watching now.

#MacroView: Fed Wants Inflation But Their Actions Are Deflationary

Justifiable Bullishness Or Is It Willful Blindness?

Technically Speaking: S&P 3750. Is It The Light, Or A Train?

The Decade Long Path Ahead To Recovery – Part 2 Depression

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What You Missed In Our Newsletter

Each week, our newsletter covers important topics and events. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how to trade it.

Bulls Chant Into A Megaphone – “All-Time Highs” 08-08-20

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What You Missed: RIA Pro On Investing

RIA Pro is our premium investment service. At RIAPro we publish our analysis, research, and data. (Click here to try it now and get 30-days free) Just in case you are a DIY investor, this is the site for you. RIAPRO has all the tools, data, and analysis you need to build, monitor, and manage your own money.

TPA Analytics: Top 10 Buys & Sells: 08-11-20

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The Best Of “The Real Investment Show”

Just in case, you didn’t tune in last week. That’s okay. Here are the best moments from the “Real Investment Show.” Every week, we cover the topics that mean the most to you from investing, to markets, and your money.

Best Clips Of The Week Ending 08-14-20

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What You Missed: Video Of The Week

Russia Covid Vaccine & Markets Not Participating

With markets pushing up on all-time highs, its only a small fraction of the market driving it there. What does that mean for investors who are trying to “beat the index.”

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What You Missed: Our Best Tweets

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. However, just in case you missed it, here are a few from this past week you may enjoy. You may also enjoy the occasional snarky humor.

Follow us on twitter @lanceroberts and @michaellebowitz.

I have always been a fan of #Zombie movies because I believed they weren't real.
Guess I was wrong. pic.twitter.com/GjQobeS1zu

— Lance Roberts (@LanceRoberts) August 12, 2020

Markets are broken when market cap is all that matters…. https://t.co/vC8lnvTAHz pic.twitter.com/Ho3FIGMkaA

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

Banks are better capitalized now than at the start of 2020.
>
>
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No shit. It only took $4 Trillion in Fed balance sheet expansion to get them there. pic.twitter.com/V6fXOphVem

— Lance Roberts (@LanceRoberts) August 13, 2020

Investors are rah rah about capitalism and then sit by and cheer the Fed socializing market prices.

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

World Market Cap now exceeds World GDP.
(I can't even think of anything #sarcastic to say) pic.twitter.com/T7dOjgpSXv

— Lance Roberts (@LanceRoberts) August 11, 2020

Investors are no longer concerned about a #correction in the markets. Even the #shorts have given up. pic.twitter.com/miwXthVUTJ

— Lance Roberts (@LanceRoberts) August 11, 2020

See you next week!

The Relative Value Report provides guidance on which sectors, factors, indexes, and bond classes are likely to outperform or underperform its appropriate benchmark and its relative strength on an absolute basis.

Click on the Users Guide for details on the model’s relative value calculations as well as guidance on how to read the graphs. 

This report is just one of many tools that we use to assess our holdings and decide on potential trades. Just because this report may send a strong buy or sell signal, we may not take any action if it is not affirmed in the other research and models we use.

Commentary

• We start with the Absolute graphs (third graph displayed below), showing that all S&P 500 sectors and all Factors/Indexes are overbought. On an absolute basis, Staples appear to be the most overbought sector. The S&P, as shown in the line chart, is now more overbought than any other time this year.
• On a relative value basis, versus the S&P 500, Industrial’s are now grossly overbought, with Financials, Transportation, and Discretionary not far behind. Despite being grossly overbought on an absolute basis, Staples are not too overbought versus the S&P 500.
• Technology, Communications, and Healthcare, the market leaders of the prior few months, are now oversold on a relative basis.
• Along the same lines, Momentum and the NASDAQ (QQQ) are oversold, while small cap, mid cap, and the equally weighted S&P (RSP) are overbought. We should be on the lookout for signs that the rotation to recent laggards may be nearing an end.
• The Factor/Index rotation can be easily seen in the Factor/Index Relative Value chart comparing current readings to those of 35 days ago.
• Long Treasury bonds (TLT) have cheapened on a relative basis versus IEI and on an absolute basis. We are considering adding to our TLT position in the coming days.

Graphs (Click on the graphs to expand)

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

In this edition of the Value Seeker Report we analyze an investment opportunity in Exxon Mobil (NYSE: XOM) using fundamental and technical analysis.

Overview

• We utilize RIA Advisors’ Discounted Cash Flow (DCF) valuation model to evaluate the investment merits of Exxon Mobil (NYSE: XOM). Our model is based on our forecasts of free cash flow over the next ten years.
• Using what we view as conservative forecasts, we arrive at an intrinsic value of $55.42 per share for XOM’s stock. The stock is currently trading at $44.51.

Pros

• Since the beginning of the COVID-19 pandemic, XOM has consistently under-performed the market. The stock still has almost 59% upside before it hits its 52-week high. Although we don’t expect XOM’s stock to climb back to its 52-week high, it helps demonstrate the conservatism in our forecasts.
• XOM has increased its dividend in each of the last 37 consecutive years. As a result, XOM has entrenched itself as a staple “widows and orphans” stock and remains committed to its dividend. The stock currently offers a dividend yield of 7.95%.
• XOM will undoubtedly see a shortage of cash flow in 2020. Fortunately, the proceeds from its recent debt issuance should allow the firm to maintain the current dividend for the forecast 10-year period.
• XOM has a very healthy Times Interest Earned (TIE) ratio of 10.25, which means it has the capacity to take on more debt should leadership deem it necessary.

Cons

• XOM currently trades at a Price to Earnings (P/E – TTM) ratio of 48.9, which is much higher than it’s been over the last 20 years. We expect the ratio to retreat to historical levels as earnings normalize. However, a resurgence in COVID-19 cases, vaccine delay, or other drag on economic recovery could result in an elevated P/E ratio for longer than expected.
• The recent crude price war between Saudi Arabia and Russia poses a risk to the path of the recovery in energy prices. At any point, the recovery in crude prices could be halted or even reversed by a supply glut.
• Future global policies geared toward protecting the environment may impose significant costs on XOM, leading to lower profit margins.

Key Assumptions

• Our forecasts are based, in part, on XOM’s 2019 Global Business Outlook, a relatively stable price of oil, and reflect our view of XOM’s path to recovery.
• XOM will see revenue decline substantially in 2020 and face a multi-year recovery in commodity prices. We expect XOM’s revenue to reach 2019 levels by the end of 2023.
• Although XOM has demonstrated industry leading cost discipline, its profit margin will be pressured in 2020. As global demand for energy recovers, XOM will see its profit margin recover. The profit margin will peak in 2023, then decrease slightly to its long-term forecast by 2026.
• Over the forecast 10-year period, the firm will continue to make the capital expenditures necessary to acquire and develop assets in both its upstream and downstream portfolios.

Technical Snapshot

• XOM is testing resistance at the 50-day moving average ($44.50). The stock has some support around $42.35 and more substantial support around $40.25, which could potentially serve as a stop-loss for investors. Above the 50-day moving average XOM should find resistance at $47.50 and the 200-day moving average.
• XOM worked off some of its overbought condition over the last few days, but has largely been range-bound since May.

Value Seeker Report Conclusion On XOM

• According to our forecasts, XOM is currently 23.3% undervalued by the market.
• XOM has failed to recover due to a sharp decrease in commodity prices and the possibility the firm will be forced to cut its dividend. If the firm is able to hold its dividend at $3.48 per share despite sizable cuts by other oil & gas majors, we could see out-performance from the stock.
• We expect XOM will be able to sustain its current dividend unless the economy deteriorates significantly and/or the price of oil collapses.

Fortunately, the economy appears to be stabilizing and showing signs of recovery. We caveat the statement as recovery rests solely on the crutches of unprecedented Federal and Monetary stimulus. Fed and government actions are not only buying economic growth but time.

The graphs below show that some of the economic damage seen thus far is mind-boggling.

Uncle Sam to the Rescue

The graphs above could be a lot worse.

The government, with the Fed’s backing, softened the economic blow with a myriad of stimulus programs. For starters, consider $1,200 checks, allowances for the forbearance of mortgages, and generous unemployment benefits. These and other programs allow people to remain solvent and, importantly, to continue spending. They also buy time, hoping that many people and businesses can get back on steady ground.

The best way to show how the government indirectly bought economic activity is via personal income and transfer payments. Transfer payments are government checks to citizens. As shown below, personal income plummeted, but personal income, including transfer payments, rose sharply.

Not only did the government make up for lost income, but in aggregate, citizens got a big bonus check. Without over $2 trillion in extra income from the government, annualized real GDP would be 10% lower.

The following graphs offer more context to an unprecedented amount of federal assistance. How will we pay for it given that tax receipts are falling? Ah, that is altogether another question.

The Hutchins Center provides valuable analysis on the impact of government stimulus on GDP. Per their report, Federal and state stimulus will contribute 9.25% to second-quarter GDP. They expect that amount to fall considerably to 4.55% in the third quarter and .86% in the fourth quarter. By the second quarter in 2021, they forecast an economic drag of 5.35%.

The $1,200 checks have primarily been spent. $600 of additional Unemployment insurance just ended but will likely be extended. Funds borrowed via PPP to pay employees are waning. Time is ticking unless stimulus continues at a breakneck pace.

Consumers

As many as 75% of American workers live paycheck to paycheck. In many of these cases, government programs were a lifeline for the last few months. It bought them time and breathing room. In many cases, they may have lost their job but were financially better off.

For many low to moderate income classes, the stimulus will bridge the gap to recovery. For others, it is a bridge to nowhere with more financial difficulties yet to come.

Now consider more fortunate households with some savings. For those with jobs and savings, the stimulus was mainly a bonus check. In some instances, it was spent, and others saved it or used it to pay down debt. Despite having savings, some in this camp have had their hours reduced or lost their jobs. While savings help, will the stimulus provide a long enough bridge?

Except for the very well-to-do, a majority of the population will emerge from the last few months with a new outlook on spending and savings. It is hard to see how citizens will not refocus on padding their nest eggs. Given the large baby boomer population just entering retirement, this is a big deal.

Consumers drive almost 70% of economic growth, and if savings become a higher priority, the outlook for spending must decline. Prolonged economic weakness, high unemployment, less consumption, and higher savings rates will weigh on the economy for years to come.

Corporations

It’s not just consumers facing headwinds. The following brand name companies have already filed for bankruptcy: Gold’s Gym, J.C. Penny, J. Crew, Modells Sporting Goods, Neiman Marcus, GNC, Chuck E Cheese’s, Lord & Taylors, and many lesser-known entities. There are many others on the brink of bankruptcy that are sacrificing future growth to stay alive.

Most big companies will avoid bankruptcy but will need to retrench to preserve liquidity and profits when possible. Many companies will reduce payrolls, which in turn results in a circular loop as the newly unemployed spend less. Companies are also making less capital and human resource investments to support future probability. The combination will no doubt reduce economic activity.

Companies are raising money at a record pace for liquidity purposes, not for productive investment. The new funds will help bridge the economic chasm, but as discussed in Part 1, at the cost of future growth. Before this year, corporate debt was at record levels to GDP. While only halfway done with the year, corporations have matched debt issuance totals of the prior few years.

In Part 1, we showed how increased government debt will inhibit economic growth. For the same reasons, corporations will contribute less to economic growth.

Municipalities

The following article from Bloomberg, Tax-Averse Nashville Goes Where Few other Cash-Poor Cities Dare,  discusses the impact that COVID is having on Nashville’s finances and the tough decisions it is making.

While the article is about the city of Nashville, it rings true for many states, counties, and cities throughout the United States. From the article:

“Congress has earmarked $150 billion for states and local governments — Nashville is slated to receive $122 million but the money must be spent on public health and can’t be used to fill budget holes.

State and local governments are in “uncharted territory” and will have to start making serious cuts if they don’t get more help, said Richard Auxier, a senior policy associate in the Urban-Brookings Tax Policy Center.”

Unless the government draws up a second and third round of muni bailouts, many state and local governments will have no choice but to raise taxes, lay off employees, and reduce services.

Like the Federal government, corporations, and citizens, municipalities will contribute less to economic activity.  They, too, will be a drag on economic growth for some time to come.

Summary

Like a pack of cigarettes, the economy of the 2020s should come with a boldly labeled warning: The economy may be hazardous to your wealth.

Despite many indicators that economic growth, and therefore corporate profits, will grow meagerly, markets are priced for a renewal of prior growth rates. We caution, in the long run, reality always trumps hope.

While the government may keep spending like a drunken sailor, the other sectors of the economy will have no choice but to hunker down. Government spending comes at a cost in the future, as we discussed in Part 1. The effects of the rest of the economy are likely to hit much sooner.

The bottom line- the recession or depression will have a lasting and negative effect on growth for years to come.

Mentally, it has been a challenge to marry a market challenging all-time highs against a backdrop of weaker earnings, falling profits, surging unemployment, and a recessionary economy. Yet, here we are. While the bulls have set S&P targets to 3750 over the next 12-months while bearish signals persist. For investors it will be the difference in determining the “light” from the “train.” 

As discussed in “Bulls Chant Into A Megaphone,” 

“A breakout of the consolidation range, which was capped by the June highs, would put all-time highs into focus.” 

Of course, we also discussed the importance of the issue of the “capitalization effect” on the market’s advance, mainly since Apple and Microsoft make up such a significant weight. As noted by Sentiment Trader last week:

“The most significant stock in the U.S. and nearly the world, Apple, keeps powering higher. At the end of June, the value of Apple alone was almost 80% of the Russell 2000 index’s market capitalization. As of today, it’s nearly 90%. Such is astounding – in the past 40 years, no single stock has come close to dwarfing the value of so many other companies. “

Recapping The Math

“Currently, the top-5 S&P stocks by market capitalization (AAPL, AMZN, GOOG, FB, and MSFT) make up the same amount of the S&P 500 as the bottom 394 stocks. Those same five also comprise 26% of the index alone. “

“What investors are missing is that the top-5 stocks are distorting the movements in the overall index.

Putting $1 into each of the top-5 stocks has the same impact as putting $1 into each of the bottom 394 stocks. Such is not a true representation of either the market or the economy. 

As we have noted recently, if you own anything OTHER than those top-5 stocks, your portfolio is likely underperforming the market this year.”

The distortion in the markets caused by the flows into the Mega cap stocks will most certainly be a problem. While investors have chased markets higher, these Megacaps will eventually also lead the markets lower. 

The question, as always, is the timing and catalyst, which eventually reverses the money flows. 

In the meantime, the question is, what is the most logical next target for the S&P 500 if bulls can achieve new “all-time” highs? 

Bulls Target 3750

Technical analysis works well when there are defined “knowns” such as a previous top (resistance) or bottom (support) from which to build analysis. However, when markets break out to new highs, it is becomes much more of a “wild @$$ guess” or “WAG.”

Lately, the bulls are running amok trying to predict how much higher the bull market can go. As noted on CNBC:

“We may stall here for a while into the fall, … but I think you’re going to get a rocket ship coming in the fall. I think the S&P is going to trade out above 4,000.” – Jeffrey Saut

As noted above, such would suggest a 12.2% advance from Friday’s close. While Saut’s 4000 number sounds excellent, such would violate trends that have existed for 11-years. 

Furthermore, 3750, much less 4000, is going to stretch the deviation from the long-term bullish trendline (lower line) to more extreme levels. The last time the market reached this extreme was in February of this year. It is also notable that 3750 also intersects with the accelerated trendline from the 2016 lows. 

As noted previously, trend lines and moving averages tend to act as “gravity.” The further away from the trendline, the market becomes, the greater the pull becomes.

Warning Signs

It the short-term, the market seems to be headed higher. However, it is worth remembering that every previous peak of the market since 2016 has been from “all-time” highs.  

With the market at all-time highs, there are numerous warning signs of excess built up, which could trigger a reversion. 

• Low participation
• An extremely low put/call ratio (speculative excess)
• Markets trading 2- and 3- standard deviations above their means.
• Large deviations from respective 200-dma’s
• High levels of investor optimism (chart below)
• A historical deviation between value and growth.
• A high level of equity allocations 
• Technical extremes (RIAPro technical gauge below)

Currently, the evidence is mounting that markets are reaching the limits of the current move. By itself, these signs reflect the prevailing extremely bullish attitude of market participants. However, much like an explosive, at some point, an unexpected, exogenous event occurs. That event is the catalyst which ignites the chain reaction. The ensuing “reversion” to the trend catches overly confident “bulls” off guard. 

Light At The End Of The Tunnel

The problem for investors currently is there is precious little that hasn’t already been fully priced into the market.

• A full economic recovery
• A return to full unemployment
• More stimulus
• Low bond yields
• No recession
• A return to pre-pandemic earnings levels

The problem comes when one, or more, of those things, fails to occur. Paul Singer of Elliot Management had a significant point in this regard:

“We cannot think of another time when the basic terms and conditions of making – and more to the point keeping – money were more challenged. The planet’s central bankers seem desperate to hold up all stock markets and keep them from tumbling to the floor. They think that’s the way to run monetary policy and, actually, fiscal policy as well. The fact that public policy is on a slippery slope to monetary ruin – and the slide is steepening – escapes their limited reasoning capability. 

They appear to think that so long as there is a model or theory to support their policies and no immediate catastrophe, they can keep doing it. The political winds are hot and fierce, blowing in the face of economic freedom and profits. There has never been a time when it was more important to protect the downside, so that at least nominal capital values are preserved. 

However, the reason capital doesn’t just build and build (given all the geniuses in the investment world) is simple: With normal approaches to money management, the march up in compounded value gets interrupted by big losses or wipeouts at infrequent, unpredictable intervals. Sometimes one can “see the train a’comin'”

However, most of the time, investors don’t see the “train,” but mistakenly believe it’s the “light at the end of the tunnel.” 

Conclusion

Price action still confirms relative weakness as shown by the percentage of stocks above the 200-dma. Furthermore, the recent rally was primarily focused in the largest capitalization-based companies. These indications suggest market action remains reminiscent of a market topping process rather than the beginning of a new leg of the bull market. With the market trading 3-standard deviations above its 50-dma, and very overbought, such was the same setup we saw at the beginning of the year. 

I am not suggesting that the market is on the precipice of another 35% plunge. I am suggesting that the current market and economic dynamics are not as stable as they were following previous market corrections. 

The challenge for investors will be the navigation of the markets to ensure they see the “train,” and not the “light.”

Importantly, while the “always bullish” media tends to dismiss warning signs as “just being bearish,” such unheeded warnings have been detrimental.

Complacency is not a great option for managing your capital.

HOW TO READ THE SECTOR BUY/SELL REVIEW: 08-11-20

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

You can also view sector momentum and relative strength daily here.

There are three primary components to each chart below:

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

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

We added 2- and 3-standard deviation extensions from the 50-dma this week. We are back to “stupid” overbought on many levels. Caution is advised.

SECTOR BUY/SELL REVIEW: 08-11-20

Basic Materials

• With the market trying desperately to make all-time highs, basic materials rallied on Monday back towards previous highs.
• The buy signal is now at the highest level on record. It WILL revert at some point soon, most likely after the bulls achieve an all-time high print for the index.
• Short-Term Positioning: Bullish
  • Last Week: No Positions
  • This Week: No Positions
• Stop-Loss moved up to $57
• Long-Term Positioning: Bearish

Communications

• XLC has pushed up on extremes with a large deviation from the 200-dma, and is pushing the most extreme overbought condition in its history. 
• A correction is coming. It is just a function of time.
• Take profits and reduce risk. Move up stop levels.
• We moved our stop to $53.
  • Short-Term Positioning: Bullish
  • Last Week: Hold positions
  • This Week: Hold positions
• Long-Term Positioning: Neutral

Energy

• Energy continues to push up on its 50-dma from an oversold condition and has done so again.
• It needs to break above the 50-dma if we are going to see an advance.
• The sector is not overbought, and there is room for energy to improve on the upside if we see a rotation to value occur. 
• Short-Term Positioning: Bullish
  • Last week: Hold positions
  • This week: Hold positions
• Stop loss adjusted to $34.00
• Long-Term Positioning: Bearish

Financials

• Financials continue to underperform and remain a sector to avoid currently.
  
• As noted previously, the initial support was at $24, which was violated. That level is being tested as “resistance” last week, and broke through on Monday. This puts the 200-dma as the next target.
• There may be a bit of pickup on a rotation plan, but banks remain out of favor for now.
• Short-Term Positioning: Neutral
  • Last week: No position
  • This week: No position
• Long-Term Positioning: Bearish

Industrials

• Industrials bounced of support at the 50% retracement level and triggered a buy signal. 
• That buy signal is very extended and industrials have surged into 3-standard deviation territory.
• We are watching the dollar as a counter-trend rally could impact the sector due to international exposure. 
• Take profits and rebalance risk. 
  • Short-Term Positioning: Neutral
  • Last week: Reduced XLI to 2% 
  • This week: Hold positions. Reduce risk. 
• Long-Term Positioning: Bearish

Technology

• Technology stocks, and the Nasdaq, are extremely overbought with the buy signal at a higher level now than in February before the crash. (It’s the highest level EVER.)
• We are holding our positions currently, after taking some profits. But the deviation above the moving averages will be resolved likely sooner than later. In other words, a correction is coming. 
• Short-Term Positioning: Bullish
  • Last week: Reduced positions slightly. 
  • This week: Hold positions. Reduce risk if you haven’t.
  • Long-Term Positioning: Bullish

Staples

• XLP triggered a buy signal after adding slightly to our positions previously. The buy signal is now extremely extended. 
• XLP is overbought and is trading at 3-standard deviations above the mean. A correction is coming, timing is the only question.
• Rebalance holdings and tighten up stop-losses.
• We are moving our stop-loss alert to $59 as our stop-level.
• Short-Term Positioning: Bullish
  • Last week: Hold positions
  • This week: Hold positions
  • Long-Term Positioning: Bullish

Real Estate

• Like XLP, XLRE has triggered a buy signal.
• XLRE broke above its consolidation wedge and the 200-dma. I would like to see XLRE hold the 200-dma before adding exposure to the sector. 
• Move stops up to $34.
• Short-Term Positioning: Neutral
  • Last week: No holdings.
  • This week: No holdings
  • Long-Term Positioning: Bullish

Utilities

• XLU has been lagging but has triggered a very early BUY signal. With XLRE also on a buy, it suggests we may see a rotation from risk starting. It’s early, so we will see.
• So far, support seems to be holding.
• Short-Term Positioning: Neutral
  • Last week: Hold positions
  • This week: Hold positions
• Long-Term Positioning: Bullish

Health Care

• As noted previously, XLV is trading 3-standard deviations above the moving average, a correction is likely short-term. 
• With the buy signal now getting more extremely overbought, corrections should be contained back to support where holdings can be added. 
• The 200-dma is now important support and needs to hold, along with the previous tops going back to 2018. 
• We are moving our stop to $96
• Short-Term Positioning: Bullish
  • Last week: Hold positions
  • This week: Hold positions.
• Long-Term Positioning: Bullish

Discretionary

• AMZN is still driving this sector and XLY is trading at extremes.
• With the buy signal at the highest level on record a correction is coming. It is just a function of time and a catalyst. (Common theme in this missive.)
• Hold current positions but maintain your stop levels. We recommend taking profits.
• Stop loss is set at $122.50
• Short-Term Positioning: Bullish
  • Last week: No position
  • This week: No position
• Long-Term Positioning: Neutral

Transportation

• The rally in XTN is now 3-standard deviations above the moving average after finally clearly the 200-dma resistance.
• The sector is still performing weakly, but had a chase on Monday. 
• Risk is elevated in the sector. Take profits and reduce risk.
• Stop loss set at $50
• Short-Term Positioning: Neutral
  • Last week: Reduced position in IYT.
  • This week: Rebalance and reduce risk. 
• Long-Term Positioning: Bearish

Note from the RIAPro Team:

We are proud to offer TPA Analytics to you at a deeply discounted price. TPA has been serving institutional clients with their trading ideas and strategies. Now you can add the same long-short strategies and ideas to your portfolio as well.

Click on RIAPro+ today to add TPA Research to your subscription for just $20/month. 

As a subscriber you will receive real-time alerts of trading activity by TPA and a minimum of 2-reports each week.

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Top 10 Buys & Sells As Of 08-03-20

These are high conviction stocks that TPA has recommended recently. They are technically positive for “buys,” or negative for “sells.” They are also trading at, or near, the recommended action price levels.

Currently, there is much bullish commentary suggesting stocks can only go higher from here. Is the bullishness in the markets justifiable, or is it willful blindness?

John Stoltzfus, CIO of Oppenheimer, is clearly in the bullish camp:

“We remain very bullish on this market. You’re going to see money beginning to further move out of the bond market, and it makes all the sense in the world to be positioned in equities.”

This seems a little optimistic given the amount of money that has already flooded into the 5-largest “mega-cap” stocks which have accounted for a bulk of this years market returns.

Nonetheless, it is an interesting question.

From the bulls viewpoint the focus has been the ability for these companies to grow earnings.

The bearish view is the problem with valuations.

As noted in “COT Positioning – Back To Extremes,” the Nasdaq set repeated new highs in 2020, which is astonishing given the depth of the economic recession. To wit:

“While the S&P 500 is primarily driven higher by the largest 5-market capitalization companies, it is the Nasdaq that has now reached a more extreme deviation from its longer-term moving average.”

“Moving averages, especially longer-term ones, are like gravity. The further prices become deviated from long-term averages, the greater the “gravitational pull” becomes. An “average” requires prices to trade above and below the “average” level. The risk of a reversion grows with the size of the deviation.

The Nasdaq currently trades more than 23% above its 200-dma. The last time such a deviation existed was in February of this year. The Nasdaq also trades 3-standard deviations above the 200-dma, which is another extreme indication.” 

It’s The Fed Stupid

The immediate conclusion is the drive higher in the markets is a function of massive amounts of liquidity being injected into the financial markets by the Federal Reserve. As shown below that was certainly the case during March and April.

However, since then the tapering of the liquidity injections by the Fed has been marked as the slowing uptake of the various programs reduced demand.

While there is indeed truth to the Fed’s impact on the market, it is not solely responsible for the dislocation of prices from the underlying fundamentals.

As shown, the decline in fundamentals didn’t start during the pandemic. The decline in earnings started in early 2019 as economic growth slowed, and accelerated during the pandemic. However, during that same period stock prices rose, which is almost entirely attributable to “valuation expansion.”

Dumb Money All In

E*Trade recently released survey data which showed that despite the market plunge in March, bullish sentiment has returned:

• Bullish sentiment returns. Half of surveyed investors (51%) are bullish, rising 13 percentage points since last quarter.
• Investors are more likely to believe the market will rise. Over half of investors (51%) believe the market will rise, skyrocketing 20 percentage points this quarter.
• But volatility will persist. More than half of investors (56%) believe volatility will continue, gaining nine percentage points since last quarter.
• And investors expect a long road to recovery. More than half (54%) believe it will take more than one year to recover from the pandemic, and just one out of five investors (23%) would give the economy an “A” or “B” grade.

You get the idea. Just one quarter after panic selling lows, investors are once again “back in the pool.” Despite the economy just printing a nearly 40% decline in Q2, and earnings having dropped by nearly 40% from their peak, the “dumb money” is back to chasing stocks.

In particular, not only are “retail investors” chasing stocks, they are doing it with increased leverage by using options. As noted by CNBC recently:

“Investors have reentered the market at a record rate following the coronavirus-induced sell-off in March, and as traders look to profit, options volume has soared to an all-time high.

The average daily value of options traded has exceeded shares for the first time, with July single stock options volumes currently tracking 114% of shares volumes.

In other words, the options market is now larger than the shares market.”

Willful Blindness

Willful blindness, also known as willful ignorance or contrived ignorance, is a term used in law. Being “willfully blind” describes a situation in which a person seeks to avoid civil or criminal liability for a wrongful act by keeping themselves unaware of the facts that would render them liable or implicated.

Although the term was originally used in legal contexts, the phrase “willful blindness” has come to mean any situation in which people avoid facts to absolve themselves of their liability. 

“‘Willful blindness’ is most prevalent in the financial markets. Investors regularly dismiss the ‘facts’ which run contrary to their current opinion. In behavioral investing terms this is also known as ‘confirmation bias.'” 

As markets rise, investors take on exceedingly more risk with the full knowledge that such actions will have a negative consequence. However, that “negative consequence” is dismissed by the “fear of missing out,” or rather F.O.M.O.

As “greed” overtakes “fear,” investors become more emboldened as rising markets reinforce the conviction that “this time is different.” Ultimately, when the negative consequence eventually occurs, instead of taking responsibility for their actions, they blame the media, Wall Street, or their advisor.

This currently where we are in the markets today.

Value Proves It

Investors know there is a rising risk of loss, but, they are willfully ignoring the facts and and piling into risk because the narrative has simply become “fundamentals don’t matter.”  In 2020, investors are again chasing “growth at any price” and rationalizing overpaying for growth. 

“Such makes the mantra of using 24-month estimates to justify paying exceedingly high valuations today, even riskier.”

This is also where there is the greatest disparity between growth and value on record.

There are two critical takeaways from the graph above:

• Over the last 90 years, value stocks have outperformed growth stocks by an average of 4.44% per year (orange line).
• There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2019.

In other words, there is high probability that investors chasing “growth” are going to pay a heavy price in the future..

It’s The Economy

The problem, as discussed in “Insanely Stupid,” the ability for stocks to continue to grow earnings at a rate to support high valuations will be problematic. Such is due to rising debts and deficits which will retard economic growth in the future. To wit:

“Before the ‘Financial Crisis,’ the economy had a linear growth trend of real GDP of 3.2%. Following the 2008 recession, the growth rate dropped to the exponential growth trend of roughly 2.2%. Instead of reducing the debt problems, unproductive debt, and leverage increased.

The ‘COVID-19’ crisis led to a debt surge to new highs. Such will result in a retardation of economic growth to 1.5% or less.” 

Slower economic growth, combined with a potential for higher taxes, increases the probability that  “risk” may well outweigh “reward” at this juncture.

Such doesn’t mean that stocks can’t go higher in the near term, and despite some wiggles along the way, it is quite likely they will simply because of momentum and lot’s of “bullish bias.” 

“We’ve often noted that during times of unhealthy market environments, when fewer than 60% of stocks can hold above their 200-day averages, that periods of high optimism tend to lead to below-average forward returns.

We’re seeing that now, to a historic degree. Since we’ve been tracking this data, just over 20 years, there has never been a day when Dumb Money Confidence was at or above 80% while fewer than 60% of stocks in the S&P 500 were trading above their 200-day averages. Until now.” – Sentiment Trader

The Problem Of Eternal Bullishness

The problem of “eternal bullishness” is it leads to the “willful blindness” of risks, rather than having a healthy respect for, and recognition of, those risks. This leads to the unfortunate problem of being “all-in” on every hand which has a devastating consequence when a mean reverting event occurs.

Our job as investors is to navigate the waters within which we currently sail, not the waters we think we will sail in later. Higher returns come from the management of “risks” rather than the attempt to create returns by chasing markets.

I recently quoted Robert Rubin, former Secretary of the Treasury, in “This Is Nuts,” as it defined our philosophy on risk.

‘As I think back over the years, I have been guided by four principles for decision making. The only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty, we must decide and we must act. And lastly, we need to judge decisions not only on the results but also on how we made them.

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecasted. Such keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.’” – Robert Rubin

Focus On Risk

It should be evident that an honest assessment of uncertainty leads to better decisions.

The problem with “Eternal Bullishness” and “Willful Blindness” is that the failure to embrace uncertainty increases risk, and ultimately loss.

We must be able to recognize and be responsive to changes in underlying market dynamics. If they change for the worse, we must be aware of the inherent risks in portfolio allocation models. The reality is that we can’t control outcomes. The most we can do is influence the probability of specific outcomes.

Focusing on risk not only removes “willful blindness” from the process, it is essential to capital preservation and investment success over time.

HOW TO READ THE MAJOR MARKET BUY SELL REVIEW 08-10-20

There are three primary components to each Major Market Buy/Sell chart in this RIAPro review:

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

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

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

Major Market Buy/Sell Review 08-10-20

S&P 500 Index

• SPY is now both extremely overbought and pushing into 3-standard deviations above the 50-dma.
• This is the point where a correction usually begins to some degree. 
• The push now is for the market to claim “all-time highs,” but I suspect we will see a correction shorly thereafter. Exuberance is a bit on the extreme side.
• Caution is advised. 
• Short-Term Positioning: Bullish
  • Last Week: No holdings.
  • This Week: No holdings
  • Stop-loss set at $305 for trading positions.
  • Long-Term Positioning: Bullish

Dow Jones Industrial Average

• The Dow continues to underperform other major indices due to its lack of the 5-major FANG stocks.
• With the buy-signal extremely extended, pushing into 3-standard deviation territory, and underperforming other assets, we are going to focus our attention elsewhere for now.
• Short-Term Positioning: Bearish
  • Last Week: No position..
  • This Week: No position.
  • Stop-loss moved up to $260
• Long-Term Positioning: Bullish

Nasdaq Composite

• QQQ’s outperformance of SPY turned up a bit last week as expected. We added to our tech exposure two weeks ago.
• The QQQ’s remain massively overbought, the buy signal is extremely extended, and QQQ is still pushing 3-standard deviations above the 200-dma. 
• However, for now, tech really is about the “only game in town.”
• Take profits and rebalance as needed.
• Short-Term Positioning: Bearish – Extension above 200-dma.
  • Last Week: Added to tech holdings (MSFT, AAPL, NFLX, AMZN, ADBE, CRM, XLK)
  • This Week: No changes this week. 
  • Stop-loss moved up to $240
• Long-Term Positioning: Bullish

S&P 600 Index (Small-Cap)

• Small-caps finally broke above the 200-dma and are now historically overbought and 3-standard deviations above the mean. 
• With the buy-signal extremely extended, and the market under-performing, the risk is still too high.
• With small-caps very susceptible to weak economic growth, we are still avoiding this area of the market. 
• Support is critical at the $58 level.
• Short-Term Positioning: Bearish – Market Risk Is High
  • Last Week: No positions
  • This Week: No positions.
  • Stop-loss reset at $58
• Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

• The relative performance remains poor as with SLY. However, MDY also broke above the 200-dma resistance. It is now testing previous highs and is 3-standard deviations above the mean. 
• We are also avoiding mid-caps for the time being until relative performance improves.
• The $320 stop-loss remains. Use this rally to reduce if needed. 
• Short-Term Positioning: Bearish
  • Last Week: No holding
  • This Week: No holding
  • Stop Loss reset at $320
• Long-Term Positioning: Bearish

Emerging Markets

• Emerging markets have performed better on a relative basis but are now extremely extended. As with all other markets, the buy signal is at the highest level on record.  
• Look for a correction that does not violate the 200-dma to add a trading position. Target is $41. 
• There dollar decline, responsible for EEM performance, is well overdone. Look for a counter-trend rally which will push EEM lower. 
• Short-Term Positioning: Bullish
  • Last Week: No position
  • This Week: No position.
  • Stop-loss remains at $40 for trading positions.
• Long-Term Positioning: Bearish

International Markets

• EFA was holding up better but is being tested by the rally in the dollar.
• It will be important for EFA to hold support at the 200-dma, but the overbought condition puts this at risk. 
• As with EEM, EFA is dollar sensitive, so we also added a dollar hedge. 
• Short-Term Positioning: Bearish
  • Last Week: Sold position in EFA.
  • This Week: No position.
  • Stop-loss set at $62
• Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

• Oil prices are struggling to move higher and are running into the 200-dma resistance. 
• We suggested last: “Look for a correction to reverse some of the extreme overbought.” That correction hasn’t occured yet, but may have started on Friday. 
• Oil is also subject to a reversal in the dollar, another reason we are adding a dollar hedge.
• Energy stocks are underperforming oil prices currently, which suggests more trouble in the sector. However, there remains relative value in some energy companies which may perform better than oil prices in the near-term. 
• Oil should hold support between $30 and $35 and we will look to increase our holdings on pullbacks.
• Short-Term Positioning: Bearish
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop for trading positions at $32.50
• Long-Term Positioning: Bearish

Gold

• We remain long our current position in IAU, but did take some profits last week due to the risk of a counter-trend rally in the dollar. 
• Gold is extremely overbought and starting to push 4-standard deviations above the 200-dma. 
• We suggest taking some profits for now and look for a pullback to increase our sizing. 
• We believe downside risk is fairly limited, but as always maintain stops.
• Short-Term Positioning: Bullish
  • Last week: Hold positions.
  • This week: Hold positions
  • Stop-loss moved up to $165
  • Long-Term Positioning: Bullish

Bonds (Inverse Of Interest Rates)

• While bonds are overbought short-term, with every other market extremely extended into overbought territory, if a correction occurs, TLT should hedge risk to some degree as rates push towards zero. 
• There is potentially some short-term risk of a short-term correction, but given the extreme extension of the equity markets, dips should be bought. 
• There is still upside potential in bonds if there is a dollar rally or a correction in equities as we move into August. 
• Short-Term Positioning: Neutral
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop-loss moved up to $155
  • Long-Term Positioning: Bullish

U.S. Dollar

• The dollar bounced off support on Friday, so we will see if we get some follow through this week.
• Given the large number of analysts with “bearish” forecasts on the dollar the probability of a dollar rally has risen. We have started building a trading position for such a counter rally and to hedge our international, energy and gold holdings.
• Trading positions can be added to hedge portfolios but there is not likely a huge move available currently given the current market dynamics. 
• Stop-loss adjusted to $93

New RIA PRO Features

We always get lots of great suggestions from our users, and we are working closely with our development team to incorporate as many suggestions as we can.

Turing Point Analytics

Many of our users have requested a more active portfolio trading style which both goes long and short individual securities. We have recently fulfilled that request by striking a deal with Jeffrey Marcus of Turning Point Analytics. 

“Turning Point Analytics utilizes a time-tested, real-world strategy that optimizes the clients entry and exit points and adds alpha. TPA defines each stock as Trend or Range to identify actionable inflection points. TPA has been serving institutional clients with their trading ideas and strategies.”

Get up to 3-emails each week discussing markets, trades, outlook, and tactics.

Plus receive real-time alerts of portfolio changes. 

Add TPA to your currently subscription by clicking here.

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This weekend we also released 2-NEW Site-Wide Features 

NEWS

On your dashboard you will see a new tab your alert table below the latest Articles and Commentary boxes.

We have added all incoming news headlines in the first tab for the day, so that you can see what is potentially moving the markets. 

Of course, our main news page remains under the RESEARCH tab so that you can review news from previous days from any of our sources as needed. 

Importantly, next to the new HEADLINES tab remains the News, Alerts, Dividend, and Earnings data for any of the positions you have added to your personal watch lists or portfolios.

New Data Feed = New Resources

We have recently acquired a data stream for the site as well which is giving access to a variety of new information sources to enhance your portfolio management opportunities. 

The first integration of the new data can be found under the RESEARCH tab by clicking on OPTIONS.

Under this tab you will find all of the option chains for an individual security you are interested in. You will find all of the available strike months, call and put options for each month and strike, as well as the current bid and ask for each option.

With this data you can start to construct a variety of hedging strategies from writing puts, to covered calls, cashless collars, ratio spreads, etc. 

Much More Coming

Over the next few months we have a lot of new features in the works for you. Such as:

• A premium technical charting service which will allow you to save your settings, create multiple charting templates, access to dozens of indicators, etc. 
• Insider trading information 
• Corporate announcements.
• Click-to-trade
• Automated portfolio management
• Financial planning 

We are dedicated to making RIAPro a useful tool for your personal money management needs. With your help and suggestions, we will continue to improve. 

Thank you for using RIAPro and let us know how we can serve you. 

One of the interesting aspects of investing is that many of the momentous changes that can make a big difference to portfolio performance only come around once in a great while. The emanation of inflation may be one of those changes. As a result, some of the trickiest aspects of investing are recognizing those big turning points and then having the courage to act decisively when the time comes.

It takes a unique set of skills and a unique mindset to pull this off; it is all-too-easy to find oneself disabled by indecision right when it matters most. Fortunately, there is a straightforward way to hack this natural weakness: The answer is to bone up on financial history. With the winds of inflation blowing again, there may be no better time to do it.

Russell Napier

One of the people uniquely suited to help with this endeavor is Russell Napier. He has worked in the investment business for 30 years and wrote a book on the historical lessons of bear markets entitled Anatomy of The Bear: Lessons From Wall Street’s Four Great Bottoms. Napier also founded a course in “The Practical History of Financial Markets.” He is always quick to explain why he founded the course, too:

“Because the business schools don’t teach it.”

In the aftermath of the GFC, Napier recognized the condition of exploding levels of government debt differed from the experience in World War II. During a 2010 presentation to the CFA Society of Baltimore, he noted:

“Through WWII the US only borrowed money to ‘kill people.’”

In other words, using debt in extreme circumstances of existential necessity is acceptable.

After the GFC, however, the rationale changed:

“Now the US is borrowing money to keep people alive – which is more expensive.”

The ongoing and nonproductive (at least in economic terms) nature of the borrowing did not provide the necessary ingredients for inflation.

At the time, Napier’s prognosis of disinflation competed with calls for increasing inflation and a “beautiful deleveraging.” He predicated his forecast on the faulty transmission mechanism of monetary policy.

As he noted in an interview with The Market/NZZ,

“QE was a fiasco. All these central banks have achieved over the past ten years is creating a lot of non-bank debt.”

Looking back over the last ten years, Napier got the big points right.

Anatomy Of The Bear

His book, Anatomy of the Bear, also provides helpful lessons for investors. Napier describes the book as a “field guide for the financial bear.” Napier analyzed 70,000 articles from the Wall Street Journal to capture the contemporaneous sentiment of bear market bottoms. He also distinguished factors which  “proved to be good markers to the future, and those which are  misleading.”

The critical strategic conclusion from the book is that “swings in equity valuation are driven primarily by changes in inflation.“ As a result, the catalyst to “reduce equities to cheap levels” typically involves “a material disturbance to the general price level.” He also notes “All four of our bear-market bottoms occurred during economic recessions.”

So, where does that leave investors today? Napier started telegraphing a change in sentiment from his deflationist views after the March selloff. I highlighted his comments from Grant’s Interest Rate Observer in an early April blog post: “Government interventions to bail out an entire commercial system or portion of the commercial system, in my opinion, are entirely novel.”

Since then, Napier’s perspective has evolved, and he explains why:

“It’s a shift in the way the creation of money has changed the game fundamentally … Such is money creation in a way that is completely circumventing central banks … And more importantly, the control of money supply has moved from central bankers to politicians.“

Napier explains the significance of this change in the Financial Times: “As a result, investors need to prepare for a new era of inflation.”

Emanation Of Inflation

As talented as Napier is at analyzing the investment environment and understanding it from a historical perspective, he is at least as gifted at communicating what the implications are. Importantly, inflation will come along with a policy to cap rates below the inflation rate. As to what that means, Napier expounds:

“Savers, through government-mandated bond holdings, will have to bear the burden of capped yields and will watch a portion of their savings eaten away through inflation.“

In economic terms, it is the very definition of financial repression. Such can be hard to understand for two reasons. One is that it is an abstract concept. Another is that it involves politicians intentionally causing harm to people and organizations that save money. In a separate interview with MacroVoices, Napier describes how this works in plain terms:

“I was once asked by a retired lady how I would put that phrase [financial repression] into English. Such is an excellent question, I think. And I replied that it was stealing money from older adults slowly. And the ‘slowly’ bit is significant. Because you ‘don’t want to frighten the horses. You want to try and keep them corralled in fixed-interest securities. So, on the whole, doing it slowly is probably the democratic way to do it.”

Financial Repression

While an environment of financial repression is not a good place for savers, it isn’t a good place for people who invest on behalf of others either. In the same interview, Napier described that most of the skills developed by investors over the last forty years are “probably redundant”.

He goes as far as to recommend his institutional clients promote emerging markets people to lead their developed markets groups. The reason is that those people are much more familiar with the “higher levels of inflation, government interference, and capital controls” that will now also be pervasive in developed markets.

The investment strategy for dealing with the new inflationary environment falls into the category of “simple, but not easy.” It is simple because it focuses on preserving wealth in a system designed to slowly “steal” it. It is not easy because it requires a mindset and a commitment to do something very different from what has worked in the past.

“In this new age of repression, the secret to preserving the purchasing power of savings lies not in the mix of assets, but the quantities. Investors should hold as much gold and as little government debt as they feel comfortable with.“

The Rationale Of Gold

In his MacroVoices interview, he elaborates on the rationale for gold:

“But that is where the gold price gets a second kick. It is not an asset which is easy to manipulate for governments.”

In other words, gold protects not just against inflation, but government intervention in the form of financial repression. Such also has implications for the types of exposure to gold: The less potential for government intervention, the better.

Such a radically different environment for investing will also create a radically different environment in which companies operate. Historically, the beneficiaries of higher inflation are companies with large fixed assets that don’t have high reinvestment requirements. Conversely, the relative losers are the asset-light companies that have been the stars of the last forty years.

Although Napier expresses the conviction that inflation will emerge and be an essential factor for long-term investors, he also acknowledges this forecast depends on the velocity of money increasing. While he does expect spending patterns to resume and the savings rate to decline, any delays in those dynamics would also delay the emergence of inflation.

Another factor that could delay (but not prevent) his forecast would be deflationary pressures originating outside of the US. Before the COVID lockdowns, Napier was concerned that outside of America, “most of the credit risk still rests on bank balance sheets.” Although other news has overshadowed the woes of European banks recently, the potential for bad debts to create problems remains high.

Conclusion

China could also be a factor. As the home of incredibly high credit growth and uncertainty surrounding its exchange rate, China has a great deal of potential to transmit deflationary forces. Besides, escalating tensions between the US and China threaten to further weigh on global trade, which would exacerbate those forces.

All in all, though, it looks like we are finally going to experience inflation in the not-too-distant future, and this is the key takeaway for long-term investors. It is also important to remember as this unfolds, however, that official communications will not be helpful but crafted instead to keep the “horses from being frightened.”

There will be PR campaigns describing why a “little” inflation is a good thing. Other communications will describe measures as “temporary”. There will be other platitudes too.

It helps to appreciate that this is probably one of the relatively few big turning points that can materially affect wealth distribution. For the intellectually curious, it is a rare and exciting chance to observe and learn. For savers, it is crucial to understand precisely how different and how damaging this will be. Either way, it’s a great time to embrace the lessons of financial history.

The employment report showed an increase of 1.8 million in July, nearly in line with the economic consensus. However, looking below the headlines the report was not nearly as strong as it seems.

The BLS Employment Report for July shows employment rose by 1.8 million in July following a gain of 4.8 million in June and 2.7 million in May. The unemployment rate fell slightly to 10.2%.

Initial Reaction

The Bloomberg Econoday consensus jobs estimate was +1.677 million, and the unemployment rate consensus was 10.5%.

The BLS said that errors that plagued the household survey since March was not as bad this month.

BLS Error Rate

For March through June, BLS published an estimate of what the unemployment rate would have been had misclassified workers been included. Repeating this same approach, the overall July unemployment rate would have been about 1-percentage point higher than reported. However, this represents the upper bound of our estimate of misclassification and probably overstates the size of the misclassification error. 

According to usual practice, we accept the data from the household survey as recorded. To maintain data integrity, we take no ad hoc actions to reclassify survey responses.      

Add 1-percentage to the unemployment rate for a better estimate.

Job Revisions

The change in total nonfarm payroll employment for May was revised up by 26,000, from +2,699,000 to +2,725,000, and the change for June was revised down by 9,000, from +4,800,000 to +4,791,000. With these revisions, employment in May and June combined was 17,000 higher than previously reported.

(Monthly revisions result from additional employment reports received from businesses and government agencies since the last published estimates and from the recalculation of seasonal factors.) 

BLS Jobs Statistics at a Glance

• Nonfarm Payroll: +1,800,000 – Establishment Survey
• Employment Report: +1,350,000 – Household Survey
• Unemployment: -1,412,000 – Household Survey
• Baseline Unemployment Rate: -0.9 to 10.2% – Household Survey
• U-6 unemployment: -1.5 to 16.5% – Household Survey
• Civilian Non-institutional Population: +169,000
• Civilian Labor Force: -620,000 – Household Survey
• Not in Labor Force: +230,000 – Household Survey
• Participation Rate: -0.1 to 61.4% – Household Survey

Part-Time Jobs

• Total Part-Time Work Change: -1,571.000
• Involuntary Part-Time Work: -1,605,000 – Household Survey
• Voluntary Part-Time Work: +2,743,000 – Household Survey

Don’t try to make sense of those numbers as they never add up. I list them as reported.

BLS Employment Report Statement

Total nonfarm payroll employment rose by 4.8 million in June. The unemployment rate declined to 11.1 percent, the U.S. Bureau of Labor Statistics reported today. These improvements in the labor market reflected the continued resumption of economic activity curtailed in March and April due to the coronavirus (COVID-19) pandemic and efforts to contain it. In June, employment in leisure and hospitality rose sharply. Notable job gains also occurred in retail trade, education and health services, other services, manufacturing, and professional and business services.

Unemployment Rate – Seasonally Adjusted

The above Unemployment Rate Chart is from the BLS. Click on the link for an interactive chart.

Month-Over-Month Changes By Job Type

Hours and Wages

Average weekly hours of all private employees declined 0.1 hours to 34.5 hours while average weekly hours of all private service-providing employees decline 0.1 hours to 33.5 hours. For manufactures, average weekly hours rose 0.7 hours to at 39.7 hours.

Average Hourly Earnings of All Nonfarm Workers rose $0.07 to $29.39.

Year-over-year, wages rose from $28.05 to $29.39. That’s a gain of 4.7%.

The month-to-month and especially year-over-year gains are very distorted because more higher-paid workers kept their jobs than lower-paid employees.

Average hourly earnings of Production and Supervisory Workers fell $0.11 to $24.63.

The decline is a good thing in that it reflects more people returning to work.

Year-over-year, wages rose from $23.54 to $24.63. That’s a gain of 4.6%.

For a discussion of income distribution, please see What’s “Really” Behind Gross Inequalities In Income Distribution?

Birth Death Model

Starting January 2014, I dropped the Birth/Death Model charts from this report.

For those who follow the numbers, I retain this caution: Do not subtract the reported Birth-Death number from the reported headline number. That approach is statistically invalid.

BLS Covid-19 Statement on the Birth-Death Model

The widespread disruption to labor markets due to the COVID-19 pandemic and the potential impact on the birth-death model have prompted BLS to revisit research conducted in the aftermath of the Great Recession (2008-2009) and incorporate new ideas to account for changes in the number of business openings and closings. The BLS is implementing two areas of research to improve our birth-death model’s accuracy in the CES estimates. These adjustments will better reflect the net effect of the contribution of business births and deaths to the estimates. These two methodological changes are the following:

1: A portion of both reported zeros, and returns from zero, in the current month from the sample, were used in estimation to better account for the fact that business births and deaths will not offset.

2: Current sample growth rates were included in the net birth-death forecasting model to better account for the changing relationships between business openings and closings.

BLS will determine monthly if the adjusted birth-death model described here continues to be necessary. We will disclose these changes each month in the Employment Situation news release. All months in the tables of net birth-death forecasts on this page include footnotes for any month in which we use a regressor to supplement the forecasts.

The Birth-Death model is essentially garbage but we likely will not find how distorted this is until the annual revisions next year.

Table 15 BLS Alternative Measures of Unemployment

​Table A-15 is where one can find a better approximation of what the unemployment rate is.

The official unemployment rate is 10.2%. However, suppose you start counting all the people who want a job but gave up. Then count all the people with part-time jobs that want a full-time job. Finally, add all the people who dropped off the unemployment rolls because their unemployment benefits ran out, etc. Now, you get a closer picture of the unemployment rate. That number is in the last row labeled U-6.

U-6 is much higher at 16.5%. Both numbers would be way higher still, were it not for millions dropping out of the labor force over the past few years.

Some of those dropping out of the labor force retired because they wanted to retire. The rest is disability fraud, forced retirement, discouraged workers, and kids moving back home because they cannot find a job.

Strength is Relative

It’s essential to put the jobs numbers into proper perspective.

If you work as little as 1-hour a week in the household survey, even selling trinkets on eBay, the BLS considers you employed.

Furthermore, in the household survey, if you work three part-time jobs, 12 hours each, the BLS considers you a full-time employee.

In the payroll survey, three part-time jobs count as three jobs. The BLS attempts to factor this in, but they do not weed out duplicate Social Security numbers.

The potential for double-counting jobs in the payroll survey is large.

Household Survey vs. Payroll Survey

The payroll survey (sometimes called the establishment survey) is the headline jobs number, which the BLS releases on the first Friday of every month. The BLS bases its estimates on employer reporting.

The household survey is a phone survey conducted by the BLS. It measures unemployment and many other factors.

If you work for one hour, you are employed. If you don’t have a job and fail to look for one, you are not considered unemployed; rather, you drop out of the labor force.

Looking for jobs on Monster does not count as “looking for a job.” You need an actual interview or send out a resume.

These distortions artificially lower the unemployment rate, artificially boost full-time employment, and artificially increase the payroll jobs report every month.

Seasonal Adjustments

The report this month is weaker than it looks. Huge seasonal adjustments were in play as were temporary Census jobs.

I discussed this yesterday evening in Seasonal Adjustments Likely to Boost Friday’s Job Numbers

Recovery Will Take Years

Last month I noted The Fed Promotes a Quickening that Takes Many Years

This report provides evidence. The recovery has slowed. Furthermore, huge headwinds remain, and the reopenings reversed in July. 

The economy has added about 9.5 million jobs since the April lows. 

However, jobs remain nearly 13 million jobs below the February 2020 peak. Millions of those jobs will not return.

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In this issue of, “Bulls Chant Into A Megaphone – ‘All-Time Highs:”

• Bulls Charge To All-Time Highs
• Exuberance Abounds
• The Megaphone
• Risk/Reward Ranges
• MacroView: Everything The Fed Does Is Deflationary
• Sector & Market Analysis
• 401k Plan Manager

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

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We Need You To Manage Our Growth.

Are you a strong advisor who wants to grow your practice? We are needing partners we can work with to manage our lead flow. If you are ready to move your practice forward, we would love to talk.

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Catch Up On What You Missed Last Week

 

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Bulls Charge To All-Time Highs

As discussed previously in “Insanely Stupid,” we noted the market remained confined to its consolidation channel, but the bullish bias was to the upside.

“While the market has not been able to push above the recent July highs, support is holding at the rising bullish trend line. With the short-term ‘buy signals’ back in play, the bias at the moment is to the upside.

However, as we have discussed over the last couple of weeks, July held to its historical trends of strength. With a bulk of the S&P 500 earnings season behind us, we suspect the weakening economic data will begin to weigh sentiment on August and September.“

While weaker economic data has not yet dented the “bullish sentiment” at this juncture, it doesn’t mean it won’t. However, as we have discussed over the last several weeks, a breakout of the consolidation range, which was capped by the June highs, would put all-time highs into focus. 

A Weighted Distortion

The concern is that what you see with the market, is not necessarily what you get. The chart below shows the number of stocks trading above the 200-dma versus the S&P 500 trading above its 200-dma.

In theory, if the “market” is above its 200-dma, then a large number of stocks, usually about 80%, should also be. However, such is not the case, as only 55% currently do so. 

The market is currently being driven to new highs by the “chase” into the largest mega-capitalization stocks. Sentiment Trader noted this on Friday:

“The biggest stock in the U.S. and nearly the world, Apple, keeps powering higher. At the end of June, the value of Apple alone was nearly 80% of the Russell 2000 index’s market capitalization. As of today, it’s nearly 90%. This is astounding – in the past 40 years, no single stock has come close to dwarfing the value of so many other companies.“

By itself, this data point does not have a lot of historical relevance. However, it does tend to be more of an indication of underlying “exuberance” in the market. 

The point here, however, is the top-5 stocks are distorting the overall market participation.

Let Me Explain The Math

Currently, the top-5 S&P stocks by market capitalization (AAPL, AMZN, GOOG, FB, and MSFT) make up the same amount of the S&P 500 as the bottom 394 stocks. Those same five also comprise 26% of the index alone. 

What investors are missing is that the top-5 stocks are distorting the movements in the overall index.

For each $1 put into each of those top-5 stocks, the impact on the index is the same as putting $1 into each of the bottom 394 stocks. Such is clearly not a true representation of either the market or the economy. 

As we have noted recently, if you own anything OTHER than those top-5 stocks, your portfolio is likely underperforming the market this year.

Exuberance Abounds

This past week, we discussed with our RIAPro Subscribers (Try Risk-Free for 30-days) the dangers of chasing markets, which have deviated extremely from their long-term means. The risk, of course, is that markets always, without exception, revert to the mean. The only question is the “timing” of the event. 

Specifically, we noted the deviation of the Nasdaq from its 200-dma, which remains near a record high. 

“Moving averages, especially longer-term ones, are like gravity. The further prices become deviated from long-term averages, the greater the ‘gravitational pull’ becomes. An ‘average’ requires prices to trade above and below the “average” level. The risk of a reversion grows with the size of the deviation.

The Nasdaq currently trades more than 23% above its 200-dma. The last time such a deviation existed was in February of this year. The Nasdaq also trades 3-standard deviations above the 200-dma, which is another extreme indication. 

Such does not mean the market is about to crash. However, it does suggest the ‘rubber band’ is stretched so tightly any minor disappointment could lead to a contraction in prices.”

Again, this deviation is driven by the largest cap-weighted names. Still, there are also more extreme signs of speculative appetite currently flowing into the markets. 

The Greed Factor

The RIAPro sentiment gauge, which is based on actual investor positioning, is at more extreme levels.

The put/call ratio is also at a historic low, which suggests that investors have given up hedging risk in portfolios entirely. I have marked the previous points where the put/call ratio was this imbalanced.

Importantly, this is all very “bullish” for now.

The point about these indicators, is that in the short-term (a few days to a few weeks) it suggests the markets will likely continue to rise. Such is because “momentum” is a tough thing to kill.  

However, longer-term, they have a long history of suggesting increasing levels of risk, which eventually leads to less pleasant outcomes.

The Megaphone

In the short-term, there seems to be little worry about. I thought this sentiment was summed up best by Jeffrey Marcus, who manages the TPA Analystics long-short portfolio for RIAPro:

I think I have figured it out-all outcomes are good for assets. Either the economy recovers=good or Covid gets worse, more stimulus, no evictions, foreclosures, more FED=good. Always good when there is an infinite printing press. @TpaResearch @LanceRoberts @michaellebowitz pic.twitter.com/73Ijn2Q4D1

— Jeffrey Marcus (@TpaResearch) August 6, 2020

However, in the longer-term, the bulls may be walking into a trap. 

While the bulls are chanting “all-time highs,” it falls within the context of an ongoing topping process referred to as a “megaphone” pattern. Here is the definition:

“A broadening formation is a price chart pattern characterized by increasing price volatility and diagrammed as two diverging trend lines, one rising and one falling. 

These formations are relatively rare during normal market conditions over the long-term since most markets tend to trend in one direction or another over time. The formations are more common when market participants have begun to process a series of unsettling news topics. Topics such as geopolitical conflict, a change in Fed policy, or a combination of the two, are likely to coincide with such formations.

 

Broadening formations are generally bearish for most long-term investors since they are characterized by rising volatility without a clear move in a single direction.” 

It’s Just A Chart

This broadening, or megaphone, pattern is seen below on the monthly chart. Importantly, despite the “correction,” in March, the “bull market” that began in 2009 remains intact as the low monthly close did not break the 4-year moving average. 

Furthermore, this is a “monthly” chart, so it is very slow to form. As such, it is critical to consider this analysis in context. The chart does not mean the markets are about to crash, nor is it a useful tool to try and “time” the market.

The market will hit new highs as it reaches the top of the upper trendline, where it will meet more formidable resistance. With the market back to a more extreme overbought condition, the “low hanging fruit” has been picked.

Risk/Reward Ranges

Nonetheless, as discussed below, the current levels of “bullish sentiment” and “momentum” keeps our portfolios allocated toward “risk.” However, we are moving closer toward the “exit,” so we are not the last one trying to get out of the theater when someone yells “fire.” 

With the markets closing just at all-time highs, we can only guess where the next market peak will be. Therefore, to gauge risk and reward ranges, we have set targets at 3500, 3750, and 4000 or 4.4%, 12.2%, and 19.5%, respectively. 

Here are the current risk/reward ranges:

• +4.4% to 3500 vs. -4.3% to June high breakout support. 
• +4.4% to 3500 vs. -5.7% to the 50-dma.
• +12.2% to 3750 vs. -9.6% to the 200-dma 
• +12.2% to 3750 vs. -11.5% to the June consolidation lows.
• +19.5% to 4000 vs. -22.17% to the March closing low. (Not shown)

Given there is no good measure to justify upside potential from a breakout to new highs, you can personally go through a lot of mental exercises. While there is certainly a potential the market could rally 19.9% to 4000, it is also just as reasonable the market could decline 22.2% test the March closing lows. Completion of the “megaphone pattern” discussed above would be a 37.43% decline. 

Just in case you think that can’t happen, just remember no one was expecting a 35% decline in March either. 

As we said last week, “risk happens fast.”

Portfolio Positioning

Let me restate our position for the last several weeks.

“With our portfolios almost entirely allocated towards equity risk in the short-term, we remain incredibly uncomfortable.”

Such remains the case this week. While we certainly enjoy the markets lifting our client’s portfolio values higher, we are keenly aware of the risk. 

As Chuck Prince, CEO of Citigroup, once stated:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” – July 2007

Note the date. 

Just as it was then, stocks kept running well into 2008. But eventually, the music stopped, and poor Chuck was left without a chair. 

Given we are now getting more extreme short-term overbought conditions, the risk of a short-term reversion has risen. 

As noted last week, we have continued to maintain our equity exposure to the markets. Still , we have continued to “hedge around the edges,” by adjusting our bond duration, adding a long-dollar position to hedge our gold exposures, and adding more “defensive” names to our equity allocation. 

Our job remains the same, protect our client’s capital, reduce risk, and try to come out on the other side in one piece. 

While we are certainly more bullish on markets currently, as momentum is still in play, it doesn’t mean we aren’t keenly aware of the risk.

Pay attention to what you own, and how much risk you are taking to generate returns. Going forward, this market will likely have a nasty habit of biting you when you least expect it.

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The MacroView

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

See You Next Week

By Lance Roberts, CIO

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Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders

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S&P 500 Tear Sheet

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Performance Analysis

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Technical Composite

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Sector Model Analysis & Risk Ranges

How To Read.

• The table compares each sector and market to the S&P 500 index on relative performance.
• The “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.
• The table shows the price deviation above and below the weekly moving averages.

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Sector & Market Analysis:

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

Sector-by-Sector

Improving – Financials (XLF), Industrials (XLI), and Energy (XLE)

While Financials remain the improving quadrant, they are still vastly underperforming the market. Conversely, Industrials have broken above their 200-dma and are performing better. The sector is very overbought short-term, so a pullback to the 200-dma that holds will allow us to add more to our exposure. Energy continues to underperform the market vastly. While there is value in the sector, there is no reason for overweight holdings currently.

Current Positions: XLI

Outperforming – Materials (XLB), and Discretionary (XLY)

Discretionary stocks have broken out to new highs and continue to perform well due primarily to AMZN. However, the sector is extremely overbought, and a correction is likely. Take profits and rebalance risk accordingly. Materials are also struggling at all-time highs and are also extremely extended.

Current Positions: None

Weakening – Technology (XLK), and Communications (XLC)

After adding more exposure to our Technology holdings, the sectors have gone vertical with the rush to chase the 5-mega cap names. Once again, we need to take profits due to the extreme extension potentially. A correction is likely. The same goes for the Communications sector as well.

Current Position: XLK, XLC

Lagging – Healthcare (XLV), Utilities (XLU), Real Estate (XLRE), and Staples (XLP)

Previously, we added to our core defensive positions Healthcare. We continue to hold Healthcare on a longer-term basis as it tends to outperform in tougher markets and hedges risk. Healthcare is overbought after the expected rally, Look for a correction back to support at the 200-dma.

Our defensive positioning in Staples has finally played catchup to the rest of the market. Staples are very overbought, so rebalance risk accordingly. Utilities continue to lag, but performance is improving.

Current Position: XLU, XLV, XLP

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – Both of these markets continue to underperform, but did perk up this past week. We suspect this will be a temporary rotation, so take profits and rebalance longs if you have them. 

Current Position: None

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

Emerging and International Markets have performed better recently. We added a long-dollar hedge to our portfolios, which will weigh on international exposure. However, we will look to add international back to portfolios once the dollar reversal occurs.

Current Position: None

S&P 500 Index (Exposure/Trading Rentals) – We currently have no “core” holdings.

Current Position: None

Gold (GLD) – Previously, we trimmed our exposure to IAU. Gold is a bit overbought short-term, so we are looking for a pullback to rebuild exposures. The Dollar is extremely oversold; we have added a small UUP position to hedge downside risk in Gold. 

Current Position: IAU, UUP

Bonds (TLT) –

We continue to hold our bond holdings as a hedge against market risk. However, those positions are starting to get very extended, so we will likely rebalance soon. No change this week.

Current Positions: TLT, MBB, & AGG

Portfolio / Client Update

As noted last week, we are heading into two of the seasonally weak months of the year. Over the last couple of weeks, we made changes to portfolios to rebalance risk, add a hedge, and shift exposures into protected areas against risk.

I was having a discussion with a client last week about “relative performance” in portfolios. Here are the important points of that discussion. 

1. 1. We run an “equally” weighted portfolio versus a “market cap” weighted portfolio. The chart of an equal-weight and market-cap weight S&P is below for clarity.
   2. We also run a stock/bond allocation model versus an all-equity benchmark. 
   3. Given roughly 80% of the returns have come from about 10-stocks in total, ANY portfolio allocation containing more than those “mega-cap” stocks has underperformed this year. 
   4.  

Here is the point. 

If you are looking at the S&P 500 index and wondering “how you can get some of that,” I can certainly do that for you. We need to put everything you own into FB, AAPL, MSFT, NFLX, GOOG, and AMZN. 

I highly suspect you understand the absurdity of making such a move with your retirement money. 

Unfortunately, this is the absurdity of the market we currently live with. 

As John Maynard Keynes once quipped:

“The markets can remain irrational longer than you can remain solvent.”

Solvency is what we are focused on with YOUR money.

Portfolio Changes

In both models, we added a value position in AT&T. 

For the full reasoning behind this trade, please read our report from our analyst Nick Lane:

Nick Lane: The Value Seeker Report- AT&T (T)

We continue to look for opportunities to abate risk, add return either in appreciation or income, and protect capital. 

Please don’t hesitate to contact us if you have any questions or concerns.

Lance Roberts

CIO

Market observations

One of the hardest things about managing this market is determining which price moves are informative and actionable and which ones are not. A huge part of the problem for long-term investors is that there is so much short-term trading and so much momentum that big moves can appear more meaningful than they are.

It isn’t exactly rocket science, but when something has happened “never times before” like the performance of gold over the last few weeks, there is a good chance the activity is extreme.

John Authers discussed the gold phenomenon at some length in his “Points of Return” email from Aug. 6. He revealed a model indicating “that fair value [of gold] has risen sharply to reach its previous record in recent weeks, and that the actual price is significantly higher.”

There are lots of different models that say different things, but this strikes me as about right. It also illustrates a couple of important investment challenges right now.

One of those challenges is reconciling how both gold and the Nasdaq can be realizing the same kind of parabolic appreciation at the same time. One possibility is that Nasdaq stocks are actually defensive, but that is a huge stretch. More likely in my mind is that reasons don’t really matter right now – flows do. What sets the price is simply a significant enough contingent of investors willing to chase a trend. Such inconsistencies are just one more indicator of how untethered from economic reality prices have become.

That raises another challenge. If long-term investors like the defensive characteristics of gold but are concerned about overpaying in the near-term, what should they do? It is an excellent question and there are no great answers. Primarily it depends on one’s current exposure and opportunity cost.

That said, when any asset becomes popular and people buy it simply because others are buying, those are typically not “strong hands”. In other words, when the going gets a little tougher, or when the price just stops going up so much, many of those people will sell just as quickly as they bought. In addition, such times are also often associated with forced selling which exacerbates any decline. These situations create much better buying opportunities.

Economy

In order to establish the most robust perspective on a subject, it helps to observe it from different angles. This is especially true in the economic environment right now when so many traditional metrics do not provide a clear view.

FEDUPBIZOWNER posted a terrifically insightful thread beginning with the tweet at the right on small business lending. In short, the banks aren’t doing it.

Some of the highlights of the thread include evidence of a collapse in the pace of funding for small businesses, reluctance to lend even with the 80% guarantees of the CARES Act, and efforts to increase loan guarantees from 80% to 90%.

It doesn’t take long to appreciate just how “stuck” opportunities for small business growth are. It also doesn’t take long to feel sick about the role of banks in impeding progress. The irony is that by taking such hard positions on government loan guarantees, banks may also be sealing their own loss of autonomy in the future. Why should banks be allowed to earn any profit if the government takes the vast majority of the credit risk anyway?

Coronavirus

It is interesting in hindsight that so many people and policy makers responded to the pandemic by simply suspending expectations for about three months and then expecting things to magically pick up where they left off.

While it was always possible for such an outcome to be realized, what was almost universally overlooked was that it would take good planning, communication, and widespread conscientiousness to happen. In short, expectations were established on hope and without giving any consideration to what needed to be done to execute on those expectations.

Now that it is obvious we came up short on all of these counts, a good baseline assumption at this juncture is that a second wave will emerge and will be even worse than the first …

Avoiding a Second Wave

 “there’s a growing likelihood that the remainder of the year – if we’re not careful – could bring far larger disruptions than most people seem to envision.”

“The problem is that the pool of infected cases has expanded again, and it remains large enough to keep us teetering right at the edge of a second exponential outbreak. It’s important to understand how bad this could get, and how quickly the situation could deteriorate in response to even a slight easing of containment – unless we shrink the infective pool first.”

One point is “the 1918-1920 influenza pandemic … occurred in multiple ‘waves,’ where the second episode was markedly worse than the first.” There are good reasons for this. An important variable is the size of the infective pool and it is larger the second time around. It’s really just math.

Another point is that policies and communications regarding pandemic response are still woefully inadequate and inconsistent. John Hussman has been one of a handful of people who have consistently provided useful insights. The commentary listed not only provides a helpful framework for managing transmission of the coronavirus, but also highlights some important considerations for reopening schools.

It is also interesting to observe that the phenomenon of establishing expectations based on hope rather than well considered plans is par for the course in the corporate world as well. The blurb at the right came out of the second quarter earnings presentation for Borg Warner, but is representative of many companies. The company provides high and low scenarios for production for the remainder of the year, but the low scenario assume there is no second wave. Doesn’t sound very low to me.

The triumph of hope over experience is also clearly evident in emerging markets. The FT published a good overview of the situation in Turkey on Tuesday noting “The government is betting that the economy will not be hit by a second wave of infections.”

The report goes on to quote Brad Setser from the Council on Foreign Relations who says Turkey is coming “about as close as it gets” to what he calls a “classic first generation emerging market financial crisis”. So, this is one more data point suggesting a slow-motion accident in Turkey. It is also part of a broader pattern of what at least appears to be a routine of either desperation or incompetence rather than effective leadership in response to the pandemic.

Commercial real estate

Almost Daily Grant’s, July 30, 2020

“According to the Manhattan Chamber of Commerce, overall foot traffic across the Big Apple is down 46% from its pre-pandemic levels.  As of last week, only 8% of employees at downtown office buildings managed by CBRE Group had physically returned to work.” 

“The buyer and seller expectations are not aligned,’ Simon Mallinson, an executive managing director at RCA, told Bloomberg last week. ‘Sellers aren’t being forced to the market because there’s no realized distress and buyers are sitting on the sidelines thinking there’s going to be distress’.”

“It’s becoming clearer, especially with the resurgence in [virus] cases across the country, that a three-month forbearance is not really going to satisfy the situation.”

There are several great insights in this one note from Grant’s. One is yet another indication of how much activity has declined in New York City, which seems to be bearing disproportionate harm from the pandemic.

Another is the state of limbo in commercial real estate nationwide. The data show “commercial real estate transactions fell 68% in the second quarter compared to a year ago”. Grant’s explains why: Three-month forbearance policies have delayed the realization of distress. Not only does this obfuscate metrics for monitoring current conditions, but also as I pointed out last week, “is a latent deflationary force.

The third point is a broader one. When the pandemic first started taking hold, it was reasonable to believe that it could be managed in a way that involved severe but short-lived constraints on activity. For a number of different reasons, this did not work and therefore transformed what could have been an acute challenge into a chronic one. This means different policies will now be required and expectations for a return to normalcy will also need to adjust. John Dizard explains this very clearly …

Hope will not save US commercial properties

“So CMBS sponsors and holders are killing time by creating two fictions for everyone to believe. The first is that the US only needs a month or two to get back to a V-shaped boom.”

“Commercial real estate will have to be entirely restructured in the US. More equity and less . . . hope. Starting next year.” 

Systemic risk

Ex-BoE deputy governor fears ‘utter mayhem’ from clearing house reform

“Their vital role, standing between parties trading trillions of dollars a day and dealing with defaults, has raised concern that they are ‘too important to fail’.”

One of the big problems in the GFC was transmission of risk through the financial system. One institution would become weak or collapse and suddenly several other organizations were also infected. As a result, a core effort by regulators since then has been to reign in systemic risk.

Many of the areas – bank capital, interconnected organizations – have been addressed if not completely resolved. However, in the efforts to shift risk from banks to capital markets, the sources of systemic risk have also shifted in the direction of clearing houses.

It is true that they “are absolutely at the centre of the modern financial system” and it is also true that “there would be utter mayhem” if one collapsed. Although this story has not made headlines, it has not escaped the notice of astute market observers either. Four years ago, for example, John Dizard raised the issue in the FT where he recognized: “The problem is that in volatile or discontinuous markets, clearing houses do not eliminate risks, but rather concentrate them on the clearing house’s own balance sheets.”

Inflation

The graph at the right from the DailyShot.com does a nice job of capturing where inflation is in the mindset of the general public. Clearly, the amalgam of public policy initiatives and increasing commentary on the subject have done more than just restore concerns about inflation to earlier levels, but have raised them to even higher levels.

While this is certainly consistent with what Russell Napier has been saying (see Public policy), another eminent economist, Gary Shilling, is emphasizing the short-term impact from the pandemic. He thinks a “second wave” of deflationary forces are in store. While the two views are not necessarily very far apart, it will be interesting to watch the tug-of-war between inflationary and deflationary forces in upcoming months.

Gary Shilling: Stocks May Start Sliding About 7 Weeks From Now

“The recent Treasury bond rally fits with our forecast that the recession has a second, more serious leg that will extend well into 2021, despite massive monetary and fiscal stimulus.”

Public policy

Central Banks have Become Irrelevant

“But let me be precise: It will be governments who will act to stop bond yields from going up. They will force their domestic savings institutions to buy government bonds to keep yields down. The bit of your statement I disagree with is that central banks will put a cap on bond yields. They won’t be able to.”

One of the things about Russell Napier is that he is such a good thinker and careful communicator that his presentations are often so rich as to demand a couple of passes to fully appreciate. In my latest blog post I focused on Napier’s belief that control of the money supply is shifting to governments – and that shift will eventually cause inflation.

What I didn’t have room to expand on in the blog are the subtle implications of how financial repression will be implemented. As Napier states, “governments … will act to stop bond yields from going up”. Governments, not central banks. This is a key distinction. Politicians, not central bankers.

The way governments will act to suppress bond yields will be to “force savings institutions to buy government bonds”. In other words, these institutions will be forced to provide so much demand for Treasuries to overcome flat demand from outside the US and still sufficient to suppress yields.

Mind you, these are the very same savings institutions that have been struggling to even come close to meeting their return targets that will allow them to satisfy their liabilities. Their futile effort to earn higher returns by investing in riskier assets like private equity, hedge funds, and real estate will be further obstructed by obligations to own even more low yielding Treasuries.

It is interesting to observe all of this. While most investors seem laser-focused on what the Fed is doing, which ultimately is not going to matter much, they also seem to completely overlook what the government is doing, which will matter a lot. It is almost like a magic act that employs intentional misdirection. Regardless of intent, it will be important to maintain attention on what counts.

Implications for investment strategy

Russell Napier: The coming credit crisis will be outside the U.S., MacroVoices, January 23^rd, 2020

“So I think we can all go back and look at that period in history [1945-1980] as a sort of guide to what to do and how to invest and where to make money. Maybe I can just leave you with one idea of what some of the real winners of that period of history in equities, were companies with very large fixed assets.”

One of the broadly successful investment themes of the last forty years has been high duration because it benefits from declining interest rates. Stocks that have high growth and big potential payoffs far into the future fit the profile well. Platform companies that can scale quickly also fit the bill. Indeed, good times have been rolling for “asset-light” companies.

As the landscape transitions to a more inflationary one, however, “the winners and the losers are likely to be very different in this new world”. The new beneficiaries will be “asset-heavy” companies, especially ones that do not have substantial ongoing reinvestment needs.

Napier says this change in investment environment “couldn’t be more profound”. That sounds about right. Look across the largest stocks in the S&P 500 and how many have substantial fixed assets? Conversely, look at the asset-heavy companies and most of them are small and midcap names now.

Another interesting implication will be on the ESG field. Some strands of ESG rate asset-light companies highly because they inherently have less impact on the environment by having fewer tangible assets. If these types of companies begin to significantly underperform asset-heavy companies, it could cause a major re-evaluation of ESG principles.

One of the implications I am most confident of is that there will be a massive reordering process that will wreak havoc on passive portfolios that have no way to respond.

Feedback

This publication is an experiment intended to share some of the ideas I come across regularly that I think might be useful. As a result, I would really appreciate any comments about what works for you, what doesn’t work, and what you might like to see in the future. Please email comments to me at drobertson@areteam.com. Thanks!        – Dave

Principles for Areté’s Observations

1. All of the research I reference is curated in the sense that it comes from what I consider to be reliable sources and to provide meaningful contributions to understanding what is going on. The goal here is to figure things out, not to advocate.
2. One objective is to simply share some of the interesting tidbits of information that I come across every day from reading and doing research. Many of these do not make big headlines individually, but often shed light on something important.
3. One of the big problems with investing is that most investment theses are one-sided. This creates a number of problems for investors trying to make good decisions. Whenever there are multiple sides to an issue, I try to present each side with its pros and cons.
4. Because most investment theses tend to be one-sided, it can be very difficult to determine which is the better argument. Each may be plausible, and even entirely correct, but still have a fatal flaw or miss a higher point. For important debates that have more than one side, Areté’s Takes are designed to show both sides of an argument and to express my opinion as to which side has the stronger case, and why.
5. With the high volume of investment-related information available, the bigger issue today is not acquiring information, but being able to make sense of all of it and keep it in perspective. As a result, I describe news stories in the context of bodies of financial knowledge, my studies of financial history, and over thirty years of investment experience.

Note on references

The links provided above refer to several sources that are free but also refer to sources that are behind paywalls. All of these are designed to help you corroborate and investigate on your own. For the paywall sites, it is fair to assume that I subscribe because I derive a great deal of value from the subscription.

Disclosures

This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization’s particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. 

Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.

This material may not be reproduced in whole or in part without the express written permission of Areté Asset Management.

A recent CNBC article states the Fed will make a major commitment to ramping up inflation. How is this different than the past decade of promises for higher inflation? More importantly, while the Fed may want inflation, their very actions continue to be deflationary.

The Fed Has A Plan

“In the next few months, the Federal Reserve will be solidifying a policy outline that would commit it to low rates for years as it pursues an agenda of higher inflation and a return to the full employment picture that vanished as the coronavirus pandemic hit. 

Recent statements from Fed officials and analysis from market veterans and economists point to a move to “average inflation” targeting in which inflation above the central bank’s usual 2% target would be tolerated and even desired. 

To achieve that goal, officials would pledge not to raise interest rates until both the inflation and employment targets are hit.” – CNBC

Such certainly sounds familiar.

“The Federal Reserve took the historic step on Wednesday of setting an inflation target that brings the Fed in line with many of the world’s other major central banks.

In its first-ever ‘longer-run goals and policy strategy’ statement, the U.S. central bank said an inflation rate of 2 percent best aligned with its congressionally mandated goals of price stability and full employment.”– Reuters Reporting On Ben Bernanke’s Fed Policy Statement January 26, 2012

The Unseen

Over the last decade, the Federal Reserve has engaged in never-ending “emergency measures” to support asset markets and the economy. The stated goal was, and remains, such actions would foster full employment and price stability. There has been little evidence of success.

The table and charts below show the Fed’s balance sheet’s expansion and its effective “return on investment” on various aspects of the economy. For example, since 2009, the Fed has expanded its balance sheet by 612%. During that time, the cumulative total growth in GDP (through Q2-2020) was just 34.83%. In effect, it required $17.58 for every $1 of economic growth. We have applied that same measure across various economic metrics.

No matter how you analyze it, the “effective ROI” has been lousy.

These are the unseen consequences of the Fed’s monetary policies.

The Seen

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 the Q2-2020, using quarterly data, the stock market has returned almost 135% from the 2007 peak. Such is more than 12x the growth in GDP and 3.6x 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 87% of the stock market. The rest are just struggling to make ends meet.

While in the short-term ongoing monetary interventions may appear to be “risk-free,” in the longer-term, the Fed has now reached the “end game” of monetary policy.

Fed’s Actions Are Deflationary

What the Federal Reserve has failed to grasp is that monetary policy is “deflationary” when “debt” is required to fund it.

How do we know this? Monetary velocity tells the story.

What is “monetary velocity?” 

“The velocity of money is important for measuring the rate at which money in circulation is used for purchasing goods and services. Velocity is useful in gauging the health and vitality of the economy. High money velocity is usually associated with a healthy, expanding economy. Low money velocity is usually associated with recessions and contractions.” – Investopedia

With each monetary policy intervention, the velocity of money has slowed along with the breadth and strength of economic activity.

However, it isn’t just the expansion of the Fed’s balance sheet which is undermining the strength of the economy. It is also the ongoing suppression of interest rates to try and stimulate economic activity.

In 2000, the Fed “crossed the Rubicon,” where lowering interest rates did not stimulate economic activity. Instead, the “debt burden” detracted from it.

To illustrate the last point, we can compare monetary velocity to the deficit.

To no surprise, monetary velocity increases when the deficit reverses to a surplus. Such allows revenues to move into productive investments rather than debt service.

The problem for the Fed is the misunderstanding of the derivation of organic economic inflation

It’s The Debt

It isn’t just the Federal debt burden that is detracting from economic growth. It is all debt. As stated, the belief that lower interest rates would spur more economic activity was correct, to a point. However, as shown, once the debt burden because to consume more than it produced, the lure of debt turned sour.

You will notice that in 1998, monetary velocity peaked and began to turn lower. Such coincides with the point that consumers were forced into debt to sustain their standard of living. For decades, WallStreet, advertisers, and corporate powerhouses flooded consumers with advertising to induce them into buying bigger houses, televisions, and cars. The age of “consumerism” took hold.

However, while corporations grew richer, households got poorer, as growth in the economy and wages remained nascent.

The problem for the Federal Reserve, is that due to the massive levels of debt underlying the meager economic activity it generates, interest rates MUST remain low. Any uptick in rates quickly slows economic activity, forcing the Fed to lower rates and support it.

Economic Inflation

For the last several years, the Fed’s belief has been inflating asset prices would lead to a rise in economic prosperity and inflation. As noted, the Fed did achieve “asset inflation,” which led to a burgeoning “wealth gap.”

What monetary policy did not do was lead to “general fluctuations in price levels.” 

Despite the Fed’s annual call of higher rates of inflation and economic growth, the realization of those goals remains elusive.

The problem for the Fed is that monetary policy creates “bad” inflation, without supporting the things that lead to “good” inflation.

Good Inflation

The Fed believes the rise in inflationary pressures is directly related to an increase in economic strength. However, as I will explain: Inflation can be both good and bad.

The Liquidity Trap

Here is the definition:

“When injections of cash into the private banking system by a central bank fail to lower interest rates or stimulate economic growth. A liquidity trap occurs when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.

Signature characteristics of a liquidity trap are short-term interest rates remain near zero. Furthermore, fluctuations in the monetary base fail to translate into fluctuations in general price levels.”

Pay particular attention to the last sentence.

As discussed through the entirety of this article, every aspect of a liquidity-trap has been checked:

• Lower interest rates fail to stimulate economic growth
• People hoard cash because they expect an adverse event (economic crisis).
• Short-term interest rates near zero.
• Fluctuations in monetary base fail to translate into general price levels.

Importantly, the issue of monetary velocity and saving rates is critical to defining a “liquidity trap.”

Confirmation

As noted by Treasury&Risk:

“It is hard to overstate the degree to which psychology drives 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 all 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.

As investors become more conservative, they commit less money to debt investments. Producers become more conservative and reduce expansion plans. Likewise, consumers become more conservative, and save more and spend less.

These behaviors reduce the velocity of money, which puts downward pressure on prices. Money velocity has already been slowing for years, a classic warning sign that deflation is impending. Now, thanks to the virus-related lockdowns, money velocity has begun to collapse. As widespread pessimism takes hold, expect it to fall even further.”

Deflationary Spiral

Such is the biggest problem for the Fed and one that monetary policy cannot fix.

Deflationary “psychology” is a very hard cycle to break.

“In addition to the psychological drivers, there are structural underpinnings of deflation as well. A financial system’s ability to sustain increasing levels of credit rests upon a vibrant economy. A high-debt situation becomes unsustainable when the rate of economic growth falls beneath the prevailing rate of interest owed.

As the slowing economy reduces borrowers’ ability to pay what they owe. In turn, creditors may refuse to underwrite interest payments on the existing debt by extending even more credit. When the burden becomes too great for the economy to support, defaults rise. Moreover, fear of defaults prompts creditors to reduce lending even further.”

For the last four decades, every time the Fed has taken action trying to achieve their goals of “full employment and stable prices,” it has led to an economic slowdown, or worse.

The relevance of debt growth versus economic growth is all too evident. Over the last decade, it has taken an ever-increasing amount of debt to generate $1 of economic growth.

In other words, without debt, there has been no organic economic growth.

While the Fed has been diligently working on its next program to achieve the long-elusive 2% inflation target, it will result in the same outcome as the last decade. 

The problem is the debt, and you can’t solve a debt problem with more debt. 

At some point, you have to stop digging.

The Relative Value Report provides guidance on which sectors, factors, indexes, and bond classes are likely to outperform or underperform its appropriate benchmark.

Click on the Users Guide for details on the model’s relative value calculations as well as guidance on how to read the graphs. 

This report is just one of many tools that we use to assess our holdings and decide on potential trades. Just because this report may send a strong buy or sell signal, we may not take any action if it is not affirmed in the other research and models we use.

Commentary

• Over the last few weeks, we have noticed that the standard deviation score we use has been muted as compared to scores from a month or two ago. This is logical given the reduced market volatility and the way we normalize data to calculate the score. The takeaway is that extreme scores may now be between +/-1 to 2 versus +/-3 to 4.
• The last graph shown below, titled “S&P Sector Relative Value- SCORE”, shows the raw relative value scores (before normalizing). Note the greater divergence in scores versus the normalized graph we lead with below.
• Materials and Discretionary appear the most overbought sectors this week, while Healthcare and Real estate the most oversold.
• Most of the factor/indexes are hovering near fair value versus the S&P or their appropriate benchmark. Small and Mid-cap are overbought, while value versus growth continues to languish.
• Bonds continue to remain stable as yields trade in a tight range.
• We have been working on a new version of this report using the same technical scoring methodology but on an absolute, not relative basis. We do not assess the ratio of one index to another, instead just the index outright. This is comparable to what we put out in the Weekend Newsletter.
• On an absolute basis, every sector is overbought but Energy. The graph shows the score, which is not normalized. Not surprisingly, Technology and Communications are the most overbought.
• The chart to the right graphs the absolute score (orange line) of the S&P with its price in gray. While its extremely overbought score fell slightly this past week, the S&P 500 is still more overbought today than at the prior record highs in February.

Graphs (Click on the graphs to expand)

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

What You Missed On RIA This Week Ending 08-07-20

It’s been a long week, and you probably didn’t have time to dive into all the headlines that scrolled past you on RIA. Don’t worry, we’ve got you covered. Just in case you haven’t already, be sure to opt-in and to get our newsletter and technical updates.

Here is this week’s rundown of what you missed. A collection of our best thoughts on investing, retirement, markets, and your money.

Webinar: Retirement Right Lane

Got questions regarding your retirement strategy, social security, medicare, the markets, and how to achieve your financial dreams.

You are in luck. This is the webinar for you. Everything you need to know to stay in the “Right Lane” for your retirement.

Join Us: Saturday, August 8th, from 9-11 am.

What You Missed This Week In Blogs

Each week, the entire team at RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus are the risks which may negatively impact our client’s capital. If you missed our blogs last week, these are the risks we are focusing on now.

Safety, Liquidity, Or Return. Why Cash Is An Important Hedge.

Technically Speaking: COT Positioning – Back To Extremes: Q2-2020

The Difference Between Good Economics And Bad

#MacroView: Universal Basic Income Is Not An Economic Savior

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What You Missed In Our Newsletter

Each week, our newsletter covers important topics, events, and how the market finished up the week. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how to trade it.

“Insanely Stupid” To Chase Stocks As Economy Plunges? 07-31-20

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What You Missed: RIA Pro On Investing

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free) Just in case you are a DIY investor, this is the site for you. Furthermore, RIAPRO has all the tools, data, and analysis you need to build, monitor and manage your own money.

Nick Lane: The Value Seeker Report- AT&T (T)

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The Best Of “The Real Investment Show”

Just in case, you didn’t tune in last week. That’s okay. Here are the best moments from the “Real Investment Show.” Every week, we cover the topics that mean the most to you from investing, to markets, and your money.

Best Clips Of The Week Ending 08-07-20

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What You Missed: Video Of The Week

Markets Are Headed To All Time Highs

I discuss the markets heading to all-time highs, and what’s driving it. Furthermore, I dig into the issue of the Fed’s “new plan” to create inflation with Michael Lebowitz, CFA. For instance, we discuss why is the new plan the same as the old plan?

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What You Missed: Our Best Tweets

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. However, just in case you missed it, here are a few from this past week you may enjoy. You may also enjoy the occasional snarky humor.

Follow us on twitter @lanceroberts and @michaellebowitz.

Pretty amazing.
The #MarketCap of $FB, $AMZN, $AAPL, #NFLX, #MSFT, and $GOOG are now worth MORE than the #Financial, #Energy, #Industrial, and #Material sectors combined. I am pretty sure this is not a good thing. pic.twitter.com/CXHBG0ZHoe

— Lance Roberts (@LanceRoberts) August 6, 2020

The market has sped well past the point of irrationality.

— Michael Lebowitz, CFA (@michaellebowitz) August 6, 2020

The #Fed is going to unveil a strategy soon on how they are going to create #inflation in the #economy.
The #TIPS market is telling them they are full of 💩
Mr. #Powell – Welcome to the #LiquidityTrap. pic.twitter.com/lBDoZvfYtc

— Lance Roberts (@LanceRoberts) August 5, 2020

Too low he says…. https://t.co/S0PEFiqXQx pic.twitter.com/DlxEscdE9D

— Michael Lebowitz, CFA (@michaellebowitz) August 5, 2020

Another reason we trimmed our $AAPL exposure recently besides the fact it is more than 3-standard deviations above its long-term mean. Getting a bit ridiculous. pic.twitter.com/BKiCMhTWmA

— Lance Roberts (@LanceRoberts) August 5, 2020

Markets were always working, the Fed just didn't like the prices the market decided upon.

— Michael Lebowitz, CFA (@michaellebowitz) July 29, 2020

See you next week!

In this edition of the Value Seeker Report we analyze an investment opportunity in AT&T (NYSE: T) using fundamental and technical analysis.

Overview

• We utilize RIA Advisors’ Discounted Cash Flow (DCF) valuation model to evaluate the investment merits of AT&T (NYSE: T). Our model is based on our forecasts of free cash flow over the next ten years.
• Using what we view as conservative forecasts, we arrive at an intrinsic value of $38.09 per share for T’s Stock. The stock is currently trading at $29.82.

Pros

• T declined in line with the market in March, but its performance has lagged the market since the bottom. As a result, the dividend yield on this stock is currently hovering around 7%.
• T has increased its dividend for 15 consecutive years. In each of the last 11 years, they have increased the dividend by $0.04 per share.
• According to our forecasts, T will produce enough cash flow to continue this trend for the next ten years.
• T trades at a Price to Earnings (P/E) of 8.45, which is near the lowest it has been in at least 20 years.

Cons

• As shown below, the market feels a lack of enthusiasm towards T’s recent acquisitions of DirecTV in 2015 and Time Warner in 2018. Due to these acquisitions, the market is concerned that T will continue to make less-than-optimal investments and fall further behind in the race to deploy nationwide 5G coverage. This could lead to price stagnation for the stock until Investors see a reason to believe the firm can successfully roll out its 5G network.

Key Assumptions

• Despite revenue growth of 5+% on an annualized basis over periods of the last 5-years and last 20-years, we conservatively assume negative growth in FY20 and muted growth in the following 9 years. The chart below compares our forecasts to a linear projection (green dotted line) based on historical revenue.
• T will have depressed profit margins in 2020, which should recover gradually. As the market for 5G coverage begins to mature, margins should trend down to our long-term forecast.
• Over the forecasted 10-year period, the firm will make the capital investments necessary to support the nationwide expansion of its 5G network.

Technical Snapshot

• T is about $4 a share above a critical support line going back over a decade. This is an important support and provides investors with a reasonable stop-loss if it is materially violated.
• On a short-term basis, T is set up to test resistance at the 50-day moving average. At the same time, we see money flow buy signals. We would need to see a sustained price move above the 50-day moving average before the uptrend is confirmed.

Value Seeker Report Conclusion On (T)

• According to our forecasts, T is currently 27.7% undervalued by the market.
• In an environment with high equity valuations and bonds yielding little, T represents a valuable investment opportunity due to its dividend yield and potential price appreciation. While there are certainly some pitfalls, we believe the discounted stock price and high dividend offer a margin of error that makes the investment worthwhile.

Monday Market Blues

Most people hate Mondays.  The reason is perhaps obvious: it is the end of a two-day rest for many, and the beginning of another work week.

Monday is the first step up a long, steep hill, and apparently most people don’t like to climb hills.

In 2005, Gallup conducted a poll which sought to discover people’s favorite seasons, months, and days of the week.  The most significant result in the survey – not surprisingly – was that people listed Monday as their least favorite day of the week.

Source: Gallup

Some people believe that the stock market is a barometer of investor emotion, and we believe that there is merit to this statement.

One thing is for sure.  The stock market hates Mondays just as much as you do.

History of Returns

We study the markets and look for repeatable patterns that we put into our investment models.  Recently, we came across a pattern that has persisted from 1927 to the present: historically, Monday is by far the worst performing day in the S&P 500.

Every other day in the S&P 500 has a positive return, and Monday is decidedly negative.  Turn-around Tuesday really is a thing.

Monday Performance During Sell-offs

Further, in addition to modeling day-of-the-week returns for the entire history, we also looked at data during the recent sell-offs of 2008, 2018 and 2020.  In all cases, Monday under-performed[1].  During 2008, the Monday trade was a slow grind lower, and Tuesday was a slow grind higher.

In late 2018, Monday returns began to drift lower, and were a significant source of the spike lower in March 2020.

Risk-Adjusted Return

Eliminate Monday returns from the S&P for the last 93 years and you will dramatically increase total risk adjusted return[2].  This model sells the S&P Friday at the close and buys the S&P 500 Monday at the close.

[1] A “Monday” return consists of buying at the Friday close and selling the Monday close.  A Tuesday return comes from buying at the Monday close and selling the Tuesday close.

[2] Sharpe ratio is the realized return divided by the standard deviation of the return.

Why has this pattern persisted for almost 100 years?  We don’t know for sure.  Is it about weekend news?  Is it about order flow?  Maybe it’s because most people hate Mondays.

Whatever the causes, this pattern may be something to keep in mind when buying and selling stocks.

Authors

Viking Analytics is a quantitative research firm that develops tools to help navigate complex markets.  If you would like to learn more, please visit our website, or download a complimentary report.

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. He holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. He has deep experience with market data, software and model building in financial markets.  Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.

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The Visible Hand

Beginning in February, the Federal Reserve (Fed) initiated several policy programs resulting in massive surge of their balance sheet. In just 13 weeks, the Fed provided over $3 trillion of liquidity to financial markets. The Fed’s efforts in 2008 pale in comparison.

While such a policy did not forestall a recession, the objective is clearly to mitigate damage in risky asset markets. Actions of this sort are becoming increasingly routine for frightened policymakers. In the name of expedience, they aim to “rescue” financial markets.

On the other hand, in Congressional testimony (those with whom oversight of the Fed resides) and in media appearances, Fed members apply vacuous counter-factual arguments. “Had we not taken forceful action, things would be much worse,” always goes uncontested by elected officials. Uncontested because wealthy individuals and corporations are their primary source of campaign funds. Re-election odds for incumbents correlate well with market direction.

Secondary Consequences

The other issue, the one we write about here, is how that policy response sets the table for other problems. Henry Hazlitt, in his profound book, Economics in One Lesson, describes it this way.

“…a main factor that spawns new economic fallacies everyday…is the persistent tendency of men to see only the immediate effects of a given policy, or its effects only on a special group, and to neglect to inquire what the long-run effects of that policy will be not only on that special group but on all groups. It is the fallacy of overlooking secondary consequences.”

Hazlitt immediately continues-

“In this lies the whole difference between good economics and bad.”

The Federal Reserve’s pragmatism is driven by the influence of wealthy men, corporate executives, and political donors. By insisting that every action be taken with no regard for long-term effects makes certain the influencers’ wealth is protected.

Using the opening quote as an analogy, the Fed has become a notoriously overprotective helicopter parent to the stock market since the financial crisis, shielding it from every hazard. Just as in the case of child-rearing, their actions are responsible for producing an extraordinarily petulant and fragile system.

Drawing again from Wendy Mogel –

“If a child is distressed and sees Mom react with panic, he knows he should wail; if she’s compassionate but calm, he tends to recover quickly.”

This long-term “parental” panic pattern results in a variety of adverse consequences. The worst of them may be the extreme surge in passive investing. As we wrote in a Passive Fingerprints are all over This Crazy Market, the influence of passive investing on the current market is extreme.

Other Factors

In 2014 Steve Bregman at Horizon Analytics, enlightened us to what he calls the ETF (exchange-traded fund) divide. His argument highlights the passive, indiscriminate nature of ETF investors. The monumental shift away from discretionary (active) value-oriented strategies was well underway but not yet diagnosed in a way that Bregman astutely observed.

Since then, the wave of passive investing has become a tsunami. Passive, or index strategies, attract massive capital at the expense of discretionary or active mutual fund managers.

That re-allocation means two things:

1. Money is leaving active managers who regularly hold 5% cash on average and is going into passive ETFs which hold less than 0.10% cash
2. Active managers have historically been the cops on the beat patrolling overvalued stocks and selling them when those conditions are clear. Those cops are being systematically “defunded,” and there is no consideration of “value” in the passive index world.

Seismic Shift

Why are these issues so important?

First, when $3 or 4 trillion dollars move from funds managed with 5% cash  to funds with near-zero cash, $150 to $200 billion of “new money” leads to an explosive upside effect on individual stocks targeted in passive funds.

Second, when money is removed from discretionary hands and reallocated to index funds, there is no consideration for price, ever. When a passive S&P 500 or NASDAQ 100 fund receives one dollar to invest, it immediately invests in all of the underlying stocks. It does so at whatever price is available. The top decile, ranked by market cap, perpetually benefits the most as the inflows occur. The bottom decile also benefits via overvaluation, but to a lesser extent.

Stocks that do not benefit are those not in passive ETF/indexes. Those are stocks that enjoy none of the indiscriminate flows of capital and frequently become undervalued.

Blame Game

The Fed is responsible for market inefficiencies in the same way a parent is responsible for the demeanor of an entitled child. If policymakers repeatedly rush to the care of markets anytime difficulties arise, then investors never see problems. Prudence and risk management are put aside and neglected.  The buy-the-dip mentality goes beyond a humorous meme, it becomes a doctrine.

Over time and with plenty of Fed parenting, passive investors outperform the prudence and diligence of discretionary value managers. When the pattern repeats for a decade, then the chart above of net flows is the result. The concentration of passive investing becomes acute, and its effects on valuations extreme.

As Bregman pointed out in 2014, a proliferation of the ETF divide had, even then, begun to reveal itself in unhealthy ways. Those circumstances persist. The strong correlation of large S&P 500 components to the S&P 500 is now stark. The table below adds recent data from 2020 to Bregman’s original table.

The dramatic rise in correlation means there is less benefit to diversification than historically has been the case. Owning a variety of stocks and being well-diversified makes sense unless the benefits of that strategy no longer exist. Based on current data, diversification using index funds is futile.

Summary

Central bankers are prone to applying a convenient narrative to justify their actions. Their dialogue is usually laced with contempt for those who cast doubt. That is not a sign of confidence; it is a sign of deep insecurity. A sign of confidence would be humility, a characteristic one never sees out of Fed leadership.

Markets are more fragile today because of a hovering Fed parent, shielding investors from every hazard. The second and third-order effects continue to evolve, but the volatility in the first quarter offered a glimpse of disturbing possibilities.

HOW TO READ THE SECTOR BUY/SELL REVIEW: 08-04-20

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

You can also view sector momentum and relative strength daily here.

There are three primary components to each chart below:

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

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

We added 2- and 3-standard deviation extensions from the 50-dma this week. We are back to “stupid” overbought on many levels. Caution is advised.

SECTOR BUY/SELL REVIEW: 08-04-20

Basic Materials

• As we noted previously, XLB was too overbought and a correction was likely. That correction started over the last couple of days.
• The buy signal is now at the highest level on record. It WILL revert at some point soon.
• Short-Term Positioning: Bullish
  • Last Week: No Positions
  • This Week: No Positions
• Stop-Loss moved up to $57
• Long-Term Positioning: Bearish

Communications

• XLC has pushed up on extremes with a large deviation from the 200-dma, and is pushing the most extreme overbought condition in its history. 
• A correction is coming. It is just a function of time.
• Take profits and reduce risk. Move up stop levels.
• We moved our stop to $53.
  • Short-Term Positioning: Bullish
  • Last Week: Hold positions
  • This Week: Hold positions
• Long-Term Positioning: Neutral

Energy

• Energy continues to push up on its 50-dma from an oversold condition.
• Energy is not overbought, and there is room for energy to improve on the upside if we see a rotation to value occur. 
• However, that has not occurred and energy failed at the 50-dma. It needs to hold support at the recent lows of $35.
• Short-Term Positioning: Bullish
  • Last week: Hold positions
  • This week: Hold positions
• Stop loss adjusted to $34.00
• Long-Term Positioning: Bearish

Financials

• Financials continue to underperform and remain a sector to avoid currently.
  
• As noted previously, the initial support was at $24, which was violated. Now that level is being tested as “resistance.” 
• There may be a bit of pickup on a rotation plan, but banks remain out of favor for now.
• Short-Term Positioning: Neutral
  • Last week: No position
  • This week: No position
• Long-Term Positioning: Bearish

Industrials

• Industrials bounced of support at the 50% retracement level and triggered a buy signal.
• That buy signal is very extended and the 200-dma is acting as tough resistance. 
• We are watching the dollar as a counter-trend rally could impact the sector due to international exposure.
• We took profits in our position last week. 
  • Short-Term Positioning: Neutral
  • Last week: No position.
  • This week: Reduced XLI to 2% 
• Long-Term Positioning: Bearish

Technology

• Technology continues to push higher as the “momentum chase” continues. On Monday there was a sharp advance in the sector following our increase of XLK last Thursday and strong earnings from tech giants later that night. 
• Technology stocks, and the Nasdaq, are extremely overbought with the buy signal at a higher level now than in February before the crash. (It’s the highest level EVER.)
• We are holding our positions currently, but took profits in AAPL on Monday after adding to it  last Thursday. 
• The deviation above the moving averages will be resolved likely sooner than later. In other words, a correction is coming. 
• Short-Term Positioning: Bullish
  • Last week: Reduced positions slightly. 
  • This week: Took profits in AAPL.
  • Long-Term Positioning: Bullish

Staples

• XLP triggered a buy signal after adding slightly to our positions previously. The buy signal is now extremely extended. 
• XLP is overbought and is trading at 3-standard deviations above the mean. A correction is coming, timing is the only question.
• Rebalance holdings and tighten up stop-losses.
• We are moving our stop-loss alert to $59 as our stop-level.
• Short-Term Positioning: Bullish
  • Last week: Hold positions
  • This week: Hold positions
  • Long-Term Positioning: Bullish

Real Estate

• Like XLP, XLRE has triggered a buy signal.
• XLRE broke above its consolidation wedge and the 200-dma. I would like to see XLRE hold the 200-dma before adding exposure to the sector. 
• Move stops up to $34.
• Short-Term Positioning: Neutral
  • Last week: No holdings.
  • This week: No holdings
  • Long-Term Positioning: Bullish

Utilities

• XLU has been lagging but has triggered a very early BUY signal. With XLRE also on a buy, it suggests we may see a rotation from risk starting. It’s early, so we will see.
• On Monday, Utilities badly underperformed so we need to see some improvement.
• Short-Term Positioning: Neutral
  • Last week: Hold positions
  • This week: Hold positions
• Long-Term Positioning: Bullish

Health Care

• As noted previously, XLV is trading 3-standard deviations above the moving average, a correction is likely short-term. 
• With the buy signal now getting more extremely overbought, corrections should be contained back to support where holdings can be added. 
• The 200-dma is now important support and needs to hold, along with the previous tops going back to 2018. 
• We are moving our stop to $96
• Short-Term Positioning: Bullish
  • Last week: Hold positions
  • This week: Hold positions.
• Long-Term Positioning: Bullish

Discretionary

• AMZN is still driving this sector and XLY is trading at extremes.
• With the buy signal at the highest level on record a correction is coming. It is just a function of time and a catalyst. (Common theme in this missive.)
• Hold current positions but maintain your stop levels. We recommend taking profits.
• Stop loss is set at $122.50
• Short-Term Positioning: Bullish
  • Last week: No position
  • This week: No position
• Long-Term Positioning: Neutral

Transportation

• The rally in XTN is losing traction and failed at resistance again at the 200-dma.
• The sector is performing weakly so caution is advised. 
• If the economy begins to show signs of deterioration, we will likely see the recent rally in transportation fail. Risk is elevated.
• Stop loss set at $50
• Short-Term Positioning: Neutral
  • Last week: Hold positions
  • This week: Reduced position in IYT.
• Long-Term Positioning: Bearish

As discussed in Is It Insanely Stupid To Chase Stocks, the market has gotten quite ahead of the fundamentals as money continues to chase performance. In the Q2-2020 review of Commitment Of Traders report (COT,) we can see how positioning has moved back to extremes.

The market remains in a bullish trend from the market lows but is very overbought short-term. Despite valuations reaching more extreme levels, economic growth very weak, and a risk of a reduction in stimulus; investors continue to chase markets.

While the S&P 500 is primarily driven higher by the largest 5-market capitalization companies, it is the Nasdaq that has now reached a more extreme deviation from its longer-term moving average.

Moving averages, especially longer-term ones, are like gravity. The further prices become deviated from long-term averages, the greater the “gravitational pull” becomes. An “average” requires prices to trade above and below the “average” level. The risk of a reversion grows with the size of the deviation.

The Nasdaq currently trades more than 23% above its 200-dma. The last time such a deviation existed was in February of this year. The Nasdaq also trades 3-standard deviations above the 200-dma, which is another extreme indication. 

Such does not mean the market is about to crash. However, it does suggest the “rubber band” is stretched so tightly any minor disappointment could lead to a contraction in prices.

But it isn’t just the more extreme advance of the market over the past 8-weeks which has us a bit concerned in the short-term, but a series of other indications which typically suggest short- to intermediate-terms corrections in the market.

The “Greed” Factor

Market sentiment is back to more “extreme greed” levels. Unlike a pure “sentiment” based indicator, this gauge is a view of what investors are doing, versus what they are “feeling.”

The rapid acceleration in price has sent our technical composite gauge back towards extreme overbought levels as well. (Get this chart every week at RIAPRO.NET)

What we know is that markets move based on sentiment and positioning. Such makes sense considering that prices are affected by buyers and sellers’ actions at any given time. Most importantly, when prices, or positioning, become too “one-sided,” a reversion always occurs. As Bob Farrell’s Rule #9 states:

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

So, how are traders positioning themselves currently?

Positioning Review

The COT (Commitment Of Traders) data, which is exceptionally important, is the sole source of the actual holdings of the three key commodity-trading groups, namely:

• Commercial Traders: this group consists of traders that use futures contracts for hedging purposes and whose positions exceed the reporting levels of the CFTC. These traders are usually involved with the production and/or processing of the underlying commodity.
• Non-Commercial Traders: this group consists of traders that don’t use futures contracts for hedging and whose positions exceed the CFTC reporting levels. They are typically large traders such as clearinghouses, futures commission merchants, foreign brokers, etc.
• Small Traders: the positions of these traders do not exceed the CFTC reporting levels, and as the name implies, these are usually small traders.

The data we are interested in is the second group of Non-Commercial Traders.

This is the group that speculates on where they believe the market is headed. While you would expect these individuals to be “smarter” than retail investors, we find they are just as subject to “human fallacy” and “herd mentality” as everyone else.

Therefore, as shown in the charts below, we can look at their current net positioning (long contracts minus short contracts) to gauge excessive bullishness or bearishness. 

Volatility 

The extreme net-short positioning against the volatility index was an excellent indicator of the February peak. The sharp sell-off in March, not surprisingly, sharply reduced the short-positions outstanding.

With the markets continuing to rally from the March lows, investors are again becoming encouraged to take on risk. Currently, net shorts on the VIX are rising sharply and are back to more extreme levels. While not as severe as seen in 2017 or 2020, the positioning is large enough to fuel a more significant correction. The only question is the catalyst.

Investors have gotten used to extremely low levels of volatility, which is unique to this market cycle. Due to low volatility, the complacency has encouraged investors to take on greater levels of risk than they currently realize. When volatility eventually makes it return, as we saw in March, the consequences will not be kind.

Crude Oil Extreme

The recent attempt by crude oil to get back above the 200-dma coincided with the Fed’s initiation of QE-4. Historically, these liquidity programs tend to benefit highly speculative positions like commodities, as liquidity seeks the highest rate of return.

While prices collapsed along with the economy in March, there has been a sharp reversion on expectations for a global economic recovery. Interestingly, with the economic recovery showing signs of slowing, crude oil has stalled below its 200-dma. As we discussed recently with our RIAPRO subscribers:

• The rally in oil has stalled at the 200-dma and the 50% Fibonacci retracement level.
• Importantly, the lower pane “buy/sell” signal is the most overbought in 25-years. (We see the same in many other areas of the market as well like Technology, Materials, Discretionary, Communications, Etc.) A correction is coming, and it will likely be large.
• There is currently little support for oil and a break of $35 will lead to a retest in the $20’s. 
• Long-Term Positioning: Bearish

Despite the decline in oil prices earlier this year, it is worth noting crude oil positioning is still on the bullish side with 543,826 net long contracts. While not the highest level on record, it is definitely on the “extremely bullish” side.

Oil Leads Stocks & The Economy

Importantly, there is a decent correlation to the rise, and fall, of oil prices and the S&P 500 index. If oil begins to correct again, it will be in conjunction with an economic downturn. Stocks will follow suit.

As we wrote back in February:

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

The rest, as they say, is history.

U.S. Dollar Extreme

Another index we track each week at RIAPRO.NET is the U.S. Dollar.

Speaking of hedges, we began to accumulate a long-dollar position in portfolios this past week. There are several reasons for this:

1. When the financial media discusses the dollar’s demise, such is usually a good contrarian signal. 
2. The dollar has recently had a negative correlation to stocks, bonds, gold, commodities, etc.
3. The surging exuberance in gold also acts as a reliable contrarian indicator of the dollar.  
4. The dollar is currently 3-standard deviations below the 200-dma, which historically is a strong buy signal for a counter-trend rally. 

Given our portfolios are long weighted in equities, bonds, and gold currently, we need to start hedging that risk with a non-correlated asset. We also trimmed some of our holdings in conjunction with adding a dollar hedge.

• As noted previously: “The dollar has rallied back to that all-important previous support line. IF the dollar can break back above that level, and hold, then commodities, and oil, will likely struggle.
• That is precisely what happened over the last two weeks. The dollar has strengthened that rally as concerns over the “coronavirus” persist. With the dollar close to testing previous highs, a break above that resistance could result in a sharp move higher for the dollar.
• The rising dollar is not bullish for oil, commodities or international exposures.
• The “sell” signal has begun to reverse. Pay attention.

Much of the bulls rallying cry has been based on the dollar weakening with the onset of QE. However, over the last couple of months, the long-dollar bias has reverted to a net “short” positioning. Historically, these reversals are markers of more important peaks in the market, and subsequent corrections. 

Interest Rate Extreme

One of the biggest conundrums for the financial market “experts” is why interest rates fail to rise. In March of last year, I wrote “The Bond Bull Market” which was a follow up to our earlier call for a sharp drop in rates as the economy slowed. We based that call on the extreme “net-short positioning” in bonds which suggested a counter-trend rally was likely.

Since then, rates fell to the lowest levels in history as economic growth collapsed. Importantly, while the Federal Reserve turned back on the “liquidity pumps” in March, juicing markets back toward all-time highs, bonds have continued to attract money for “safety” over “risk.” 

Not surprisingly, despite much commentary to the contrary, the number of contracts “net-short” the 10-year Treasury, while reduced, remains at levels that have preceded further declines in rates. Such suggests we are “not out of the woods” yet, economically speaking.

Importantly, even while the “net-short” positioning in bonds has reversed, rates have failed to rise correspondingly. The reason for this is due to rising levels of Eurodollar positioning. Such is due to foreign banks pushing reserves into U.S. Treasuries for “safety” and “yield.”

There is a probability for rates to fall in the months ahead coinciding with further deterioration in economic growth. 

Conclusion

Amazingly, investors seem to be residing in a world without any perceived risks and a strong belief that financial markets can only rise further. The arguments supporting those beliefs are based on comparisons to previous peak market cycles. Unfortunately, investors tend to be wrong at market peaks and bottoms.

With retail positioning very long-biased, the implementation of QE-4 has once again removed all “fears” of a correction, recession, or bear market. Historically, such sentiment excesses form around short-term market peaks.

Such is a excellent time to remind you of the other famous “Bob Farrell Rule” to remember: 

“#5 – The public buys the most at the top and the least at the bottom.”

What investors miss is that while a warning doesn’t immediately translate into a negative consequence, such doesn’t mean you should not pay attention to it.

As I concluded in our recent newsletter:

“There remains an ongoing bullish bias that continues to support the market near-term. Bull markets built on ‘momentum’ are very hard to kill. Warning signs can last longer than logic would predict. The risk comes when investors begin to ‘discount’ the warnings and assume they are wrong. 

It is usually just about then the inevitable correction occurs. Such is the inherent risk of ignoring risk.'”

The cost of not paying attention to risk can be extraordinarily high.

Note from the RIAPro Team:

We are proud to offer TPA Analytics to you at a deeply discounted price. TPA has been serving institutional clients with their trading ideas and strategies. Now you can add the same long-short strategies and ideas to your portfolio as well.

Click on RIAPro+ today to add TPA Research to your subscription for just $20/month. 

As a subscriber you will receive real-time alerts of trading activity by TPA and a minimum of 2-reports each week.

Turning Point Analytics utilizes a time-tested, real-world strategy that optimizes the clients entry and exit points and adds alpha. TPA defines each stock as Trend or Range to identify actionable inflection points.

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Top 10 Buys & Sells As Of 08-03-20

These are high conviction stocks that TPA has recommended recently. They are technically positive for “buys,” or negative for “sells.” They are also trading at, or near, the recommended action price levels.

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 2020 Review

E-Mini S&P 500 Futures

We begin with a review of E-Mini S&P 500 Futures (ESU0) during July 2020. In our July 2020 edition of The Cartography Corner, we wrote the following:

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

• M4                 3693.65
• M1                 3388.40
• PMH              3226.95
• M3                 3138.50
• Close            3090.25      
• M2                3087.25
• MTrend        2933.44
• PML              2923.75      
• M5               2782.00

Active traders can use M2: 3087.25 as the pivot, maintaining a long position above that level and a flat or short position below it.

Figure 1 below displays the daily price action for July 2020 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The month of July began with the market price overcoming early-session weakness to settle above our isolated pivot level at M2: 3087.25.  Over the following two trading sessions, the market price ascended to and settled above our first isolated resistance level at M3: 3138.50.  The three-session cumulative gain, relative to June’s settlement price, totaled 2.65%.  Collective patriotism is not limited to fireworks and barbeques.

The following six trading sessions saw the market price trade in a range, bound on the upside by our next isolated resistance level at PMH: 3226.95 and on the downside by M3: 3138.50 now acting as support.  Despite some long upper and lower shadows on the candles, the market price settled above M3: 3138.50 on five of six trading sessions by an average of 0.64%.  Energy was building for the next move.   

Figure 1:

Starting on July 15^th, the market price experienced a mini “phase-shift” higher, with our next isolated resistance level at PMH: 3226.95 acting as a magnet.  The final thirteen trading sessions were spent with the market price oscillating in a 3.01% range around that level.

Market participants following our analysis ended the month, on a mark-to-market basis, with a 5.7% gain on their positions.

Silver Futures

We continue with a review of Silver Futures (SIU0) during July 2020.  In our July 2020 edition of The Cartography Corner, we wrote the following:

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

• M4         23.140
• M2         19.610
• M1         19.365
• PMH       18.950
• M3         18.775
• Close       18.637
• PML        17.185             
• MTrend  16.868                         
• M5           15.835

Active traders can use 18.950 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Figure 2 below displays the daily price action for July 2020 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first five trading sessions of July saw the market price ascend to, and settle above, our isolated pivot level at PMH: 18.950.  First hurdle cleared.

The following seven trading sessions saw the market price ascend towards and surpass our next isolated clustered-resistance levels at M1: 19.365 / M2: 19.610.  Last hurdle cleared.

The following three trading sessions saw the market price make a quick ascent to our isolated Monthly Upside Exhaustion Level at M4: 23.14.  Monthly objective achieved.

With seven trading sessions remaining in the month, our analysis had one level remaining to be achieved.  On June 30^th, our analysis isolated the 3Q2020 Quarterly Upside Exhaustion Level at Q4: 26.215.  On July 28^th, the high price for the month was achieved at 26.275.  Quarterly objective achieved.

We anticipate a two-month low AND a two-quarter low over the following four to six periods, respectively.

At a minimum, market participants following our analysis realized a 22.0% gain.   

Figure 2:

August 2020 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESU0).  The same analysis can be completed for any time-period or in aggregate.

Trends:

• Current Settle         3263.50       
• Daily Trend             3240.47
• Weekly Trend         3219.36       
• Monthly Trend        3079.94       
• Quarterly Trend      2913.69

The relative positioning of the Trend Levels is as bullish as possible.  Think of the relative positioning of the Trend Levels like you would a moving-average cross; the Trend Levels are higher as the time-periods decrease.  In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures are in “Consolidation”, after having been “Trend Up” for four quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures are “Trend Up”, having settled for three months above Monthly Trend.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures are “Trend Up”, having settled for five weeks above Weekly Trend.

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.  Recall, these two-period highs may occur at higher levels but can also occur from lower levels.  We now anticipate a two-period high in the quarterly time-period over the next three to five quarters.  If this were to be achieved in 3Q2020, a trade to a new all-time high is required. To reiterate, it can also be achieved in another quarter at lower levels.

Our timing-cycle work reaches its local apex, meaning it is most supportive of the market price, on August 16, 2020.  It then declines rapidly, reaching its local trough on January 7, 2021.

The 1929 analog is also reaching its apex.

Support/Resistance:

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

• M4                 3645.25
• M3                 3436.75
• M1                 3342.05
• PMH              3284.50
• Close            3263.50      
• M2                3201.75
• MTrend        3079.94
• PML              3062.75      
• M5               2898.55

Active traders can use PMH: 3284.50 as the pivot, maintaining a long position above that level and a flat or short position below it.

Euro FX Futures

For August, we focus on Euro FX Futures (“the Euro”).  We provide a monthly time-period analysis of 6EU0.  The same analysis can be completed for any time-period or in aggregate.

Trends:

• Daily Trend           1.1807           
• Current Settle       1.1800
• Weekly Trend       1.1593           
• Monthly Trend      1.1305           
• Quarterly Trend    1.1135

The relative positioning of the Trend Levels is as bullish as possible.  Think of the relative positioning of the Trend Levels like you would a moving-average cross; the Trend Levels are higher as the time-periods decrease.  As can be seen in the quarterly chart below, the Euro is in “Consolidation”.  Stepping down one time-period, the monthly chart shows that the Euro is “Trend Up”, having settled above Monthly Trend for three months.  Stepping down to the weekly time-period, the chart shows that the Euro is “Trend Up”, having settled above Weekly Trend for four weeks.

Support/Resistance:

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

• M4         1.2736
• M1         1.2397
• M3         1.2346
• PMH       1.1920
• Close      1.1800
• MTrend   1.1305
• M2         1.1301             
• PML        1.1202                         
• M5           1.0962

Active traders can use 1.1920 as the pivot, whereby they maintain 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.

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HOW TO READ THE MAJOR MARKET BUY SELL REVIEW 08-03-20

There are three primary components to each Major Market Buy/Sell chart in this RIAPro review:

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

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

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

Major Market Buy/Sell Review 08-03-20

S&P 500 Index

• SPY is overbought short-term, but continues to run along its bullish uptrend from the lows. For now, the bulls remain in control of the upside.
• While there is immediate support below Friday’s close, there is limited upside due to the overbought condition.
• As noted above, the buy signal at the highest level in 25-years, a correction is more likely than not over the next month. 
• Caution is advised. 
• Short-Term Positioning: Bullish
  • Last Week: No holdings.
  • This Week: No holdings
  • Stop-loss set at $300 for trading positions.
  • Long-Term Positioning: Bullish

Dow Jones Industrial Average

• The Dow continues to underperform other major indices due to its lack of the 5-major FANG stocks.
• With the buy-signal extremely extended, and underperforming other assets, we are going to focus our attention elsewhere for now.
• Short-Term Positioning: Bearish
  • Last Week: No position..
  • This Week: No position.
  • Stop-loss moved up to $260
• Long-Term Positioning: Bullish

Nasdaq Composite

• QQQ’s outperformance of SPY turned up a bit last week as expected. We added to our tech exposure on Thursday.
• The QQQ’s remain massively overbought, the buy signal is extremely extended, and QQQ is still pushing 3-standard deviations above the 200-dma. 
• However, for now, tech really is about the “only game in town.”
• Take profits and rebalance as needed.
• Short-Term Positioning: Bearish – Extension above 200-dma.
  • Last Week: No positions
  • This Week: Added to tech holdings (MSFT, AAPL, NFLX, AMZN, ADBE, CRM, XLK)
  • Stop-loss moved up to $240
• Long-Term Positioning: Bullish

S&P 600 Index (Small-Cap)

• Small-caps attempted a very weak rally but remain below the 200-dma.
• With the buy-signal extremely extended, and the market under-performing, the risk is still too high.
• With small-caps very susceptible to weak economic growth, we are still avoiding this area of the market. 
• Support is critical at the $58 level.
• Short-Term Positioning: Bearish – Market Risk Is High
  • Last Week: No positions
  • This Week: No positions.
  • Stop-loss reset at $58
• Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

• The relative performance remains poor as with SLY. However, MDY is trying once again to break above the 200-dma resistance. It failed the last attempt.
• We are also avoiding mid-caps for the time being until relative performance improves.
• The $320 stop-loss remains. Use this rally to reduce if needed. 
• Short-Term Positioning: Bearish
  • Last Week: No holding
  • This Week: No holding
  • Stop Loss reset at $320
• Long-Term Positioning: Bearish

Emerging Markets

• Emerging markets have performed better on a relative basis but are now extremely extended. As with all other markets, the buy signal is at the highest level on record.  
• Look for a correction that does not violate the 200-dma to add a trading position. Target is $41. 
• There dollar decline, responsible for EEM performance, is well overdone. Look for a counter-trend rally which will push EEM lower. 
• Short-Term Positioning: Bullish
  • Last Week: No position
  • This Week: No position.
  • Stop-loss remains at $40 for trading positions.
• Long-Term Positioning: Bearish

International Markets

• EFA was holding up better but took a sharp dive on Friday with the bounce in the dollar.  
• It will be important for EFA to hold support at the 200-dma, but the overbought condition puts this at risk. 
• We had previously added a 3% trading position previously, but we sold that position last Tuesday which worked out well. on an expectation of a dollar rally. 
• As with EEM, EFA is dollar sensitive, so we also added a dollar hedge. 
• Short-Term Positioning: Bearish
  • Last Week: No position.
  • This Week: Sold position in EFA.
  • Stop-loss set at $62
• Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

• Oil prices are struggling to move higher and are running into the 200-dma resistance. 
• We suggested last: “Look for a correction to reverse some of the extreme overbought.” That correction may have started last week, we will see.
• Oil is also subject to a reversal in the dollar, another reason we are adding a dollar hedge.
• Energy stocks are underperforming oil prices currently which suggests more trouble in the sector. However, there remains relative value in some energy companies which may perform better than oil prices in the near-term. 
• Oil should hold support between $30 and $35 and we will look to increase our holdings on pullbacks.
• Short-Term Positioning: Bearish
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop for trading positions at $32.50
• Long-Term Positioning: Bearish

Gold

• We remain long our current position in IAU, but did take some profits last week due to the risk of a counter-trend rally in the dollar. 
• Gold is extremely overbought and starting to push 4-standard deviations above the 200-dma. 
• We suggest taking some profits for now and look for a pullback to increase our sizing. 
• We believe downside risk is fairly limited, but as always maintain stops.
• Short-Term Positioning: Bullish
  • Last week: Hold positions.
  • This week: Hold positions
  • Stop-loss moved up to $165
  • Long-Term Positioning: Bullish

Bonds (Inverse Of Interest Rates)

• Two weeks ago we noted that “there is more room for TLT to rally this next week.” That occurred over the last two weeks, and the “sell signal” continues to head towards a “buy signal.”
• While bonds are overbought short-term, with every other market extremely extended into overbought territory, if a correction occurs, TLT should hedge risk to some degree as rates push towards zero. 
• The is potentially some short-term risk of a short-term correction, but given the extreme extension of the equity markets, dips should be bought. 
• There is still upside potential in bonds if there is a dollar rally or a correction in equities as we move into August. 
• Short-Term Positioning: Neutral
  • Last Week: Hold positions
  • This Week: Hold positions
  • Stop-loss moved up to $155
  • Long-Term Positioning: Bullish

U.S. Dollar

• Previously we stated, “While the dollar has sold off, and helped fuel a rather torrid stock and commodity rally, we are likely closer to a bottom. That is still the case this week with the dollar pushing 3-standard deviations oversold.
• The dollar bounced off support on Friday, so we will see if we get some follow through next week.
• Given the large number of analysts with “bearish” forecasts on the dollar the probability of a dollar rally has risen. We have started building a trading position for such a counter rally and to hedge our international, energy and gold holdings.
• Trading positions can be added to hedge portfolios but there is not a huge move available currently given the current market dynamics. 
• Stop-loss adjusted to $93

 

Safety, Liquidity, Or Return. Why Cash Is An Important Hedge.

Over the past few months, we have been writing a series of articles highlighting our concerns of increasing market risk.  Here is a sampling of some of our more recent posts on the issue.

• Navigating A Tech Bubble (& Living To Tell About It)
• Looking For A Sellable Rally To Reduce Risk
• 15-Bullish Beliefs (Or Not) About The Market
• This Is Nuts…Again. Reducing Risk

The common thread among these articles was to encourage our readers to evaluate the current market “risks” and take some relevant actions. To wit:

“There remains an ongoing bullish bias that continues to support the market near-term. Bull markets built on “momentum” are very hard to kill. Warning signs can last longer than logic would predict. The risk comes when investors begin to “discount” the warnings and assume they are wrong.

It is usually just about then the inevitable correction occurs. Such is the inherent risk of ignoring risk.

In reality, there is little to lose by paying attention to “risk.”

The current deviation between the stock market, the economy, corporate profits, and earnings suggests something isn’t quite right.

“While the rally off the March lows has been substantial, there is still a vast disconnect between the markets and the underlying economic fundamentals. Given the divergence was driven by unprecedented monetary policy, the eventual reversion could be climatic.”

Equity prices are currently outpacing expectations for near-term profits, forming a price-earnings melt-up akin to what was seen in the late 1990s. Furthermore, the S&P 500’s price-sales ratio is also flashing a similar warning.

The Difficult Part

Despite many clear warnings that suggest that current risk outweighs the reward, investors fail to act due to the “Fear Of Missing Out.” (aka FOMO) I recently received an interesting email which makes this point clearly:

“The market is going higher and will continue to do so indefinitely, as long as the Fed is injecting liquidity into the market. If you are removing risk, you are missing out.”

As stated above, the most significant risk to investor capital is “ignoring the risk”. 

Just because you see a bear in the woods, and choose to ignore it, doesn’t mean it will ignore you. 

“The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a ‘topping process.’ As the saying goes, a market-top is not an event; it’s a process.” – RIA

It’s Your Brain

There are several psychological factors which make managing risk extremely difficult:

• Investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late-cycle stages.
• The “herding” effect ultimately drives investors. A rising market leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.
• Lastly, as the markets turn, the “disposition” effect takes hold, and winners are sold to protect gains, but losers are held in the hopes of better prices later. 

In our portfolio management practice, technical analysis is a critical component of the overall process. It carries just as much weight as the fundamental analysis. As I have often stated:

“Fundamentals tell us WHAT to buy or sell. Technicals tell us WHEN to do it.”

Currently, our analysis suggests there is a deteriorating technical backdrop, combined with our outlook for continued disappointment in earnings and corporate profits recovery.

Such suggests that we reduce equity risk modestly, and further increase our cash hedge, until there is more “clarity” with respect to where markets are heading next.

This brings me to the most important point.

The 3-Components Of All Investments

In portfolio management, you can ONLY have 2-of-3 components of any investment or asset class:  Safety, Liquidity & Return. The table below is the matrix of your options.

The takeaway is that cash is the only asset class which provides safety and liquidity. Obviously, the safety comes at the cost of return. This is basic.

But what about other options?

• Fixed Annuities (Indexed) – safety and return, no liquidity. 
• ETF’s – liquidity and return, no safety.
• Mutual Funds – liquidity and return, no safety.
• Real Estate – safety and return, no liquidity.
• Traded REIT’s – liquidity and return, no safety.
• Commodities – liquidity and return, no safety.
• Gold – liquidity and return, no safety. 

You get the idea. No matter what you chose to invest in – you can only have 2-of-the-3 components. Such is an important, and often overlooked, consideration when determining portfolio construction and allocation. The important thing to understand, and what the mainstream media doesn’t tell you, is that “Liquidity” gives you options. 

I learned a long time ago that while a “rising tide lifts all boats,” eventually, the “tide recedes.” I made one simple adjustment to my portfolio management over the years, which has served me well. When risks begin to outweigh the potential for reward, I raise cash.

The great thing about holding extra cash is that if I’m wrong, I simply make the proper adjustments to increase the risk in my portfolios. However, if I am right, I protect investment capital from destruction and spend far less time ‘getting back to even.’ Despite media commentary to the contrary, regaining losses is not an investment strategy. 

8-Reasons To Hold Cash

1) We are speculators, not investors. We buy pieces of paper at one price with hopes of selling at a higher price. Such is speculation in its purest form. When risk outweighs rewards, cash is a good option. 

2) 80% of stocks move in the direction of the market. If the market is falling, regardless of the fundamentals, the majority of stocks will decline also.

3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb, each believed in “buying low and selling high.” If you “sell high,” you have raised cash to “buy low.”

4) Roughly 90% of what we think about investing is wrong. Two 50% declines since 2000 should have taught us to respect investment risks.

5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this. 

6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also merely transfers the “risk of being wrong” from one side of the ledger to the other. Cash protects capital and eliminates risk. 

7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that without cash you can’t take advantage of opportunities.

8) Cash protects against forced liquidations. One of the biggest problems for Americans  is a lack of cash to meet emergencies. Having a cash cushion allows for handling life’s “curve-balls,” without being forced to liquidate retirement plans.Layoffs, employment changes, etc. are economically driven and tend to occur with downturns that coincide with market losses. Having cash allows you to weather the storms. 

Conclusion

Importantly, I want to stress that I am not talking about being 100% in cash.

I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.

With the political, fundamental, and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important. 

Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop, reviewing cash as an asset class in your allocation may make some sense.

Chasing yield at any cost has typically not ended well for most.

Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.

S&P 500 Monthly Valuation & Analysis Review – 08-01-20

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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.

The Next Day

The next day, we assume the value of SPY increases by $4/share to $325/share. The price changes also change the delta values for both the puts and calls. This participant wants to maintain a delta neutral position. To do so, they can buy 8-shares of SPY[1] to neutralize delta (we show the changes to the position in red in the tables below).

The important thing to emphasize is that maintaining a delta neutral hedge requires the participant to buy SPY shares when the price of SPY increases.

To illustrate the same case when the market declines, consider the case where SPY falls by $4/share the next day. In this example, the participant would sell 7-shares of SPY to maintain a delta-neutral portfolio.

Again, the important thing to emphasize is that maintaining a delta neutral position requires the participant to sell SPY shares when the price of SPY decreases.

Therefore, one outcome of delta hedging is that options market makers will buy shares when the market is rising and sell shares when it is falling.

When liquidity is weak and hedging requirements are large, a feedback loop can materialize and amplify price moves. Such occurs when hedge related buying pushes prices higher. As prices rise, hedgers must buy more, which then pushes prices even higher. The same loop can occur on the downside as well.

[1] Since 1-option in the stock markets is for 100 shares, the delta neutral position would require 800 shares of SPY. We are simplifying the calculations for reader understanding.

Risk of Cascading Declines

In the simple example above, we did not consider changes in volatility to adjust our delta hedge. In reality, implied volatilities change rapidly, particularly in a sharply declining market.

When volatility spikes, then the values, deltas, and gammas of options also spike.

Volatility is most likely to rise in falling markets and remain stable to falling in rising markets. The amount of hedging required to hedge downward moves is typically greater than upward moves.

A sharply falling market can result in a cascading feedback loop. Such occurs as delta hedgers must sell increasing numbers of shares to maintain their delta-neutral hedge. Importantly, most of this delta hedging is done by computers, which can further amplify the move as all of the delta hedgers can act simultaneously.

Stock market selling can beget more selling, and in some cases, this can result in a market that looks like a snowball heading downhill.

Gamma Triggers

In studying the options markets, one of our primary goals is to protect your retirement savings from these cascading downward events that can debilitate long term wealth.

To better assess the situation we calculate and share with our subscribers the so-called Gamma Neutral level. This level can be a trigger for follow-on selling and higher volatility in the stock market. As such, it allows us to better understand how options traders are positioned and discover market levels that could trigger a feedback loop.

The chart below shows the historical volatility of the SPX above and below Gamma Neutral levels.

Conclusion

We have provided a simple delta hedging example to emphasize that delta hedging has significant follow-on effects in the stock market. In times of questionable liquidity and record options trading, these implications become magnified. In particular, delta hedging can result in a feedback loop where stock market increases are bought, and systematic delta hedgers sell stock market decreases.

As options trading gains popularity via low or zero-commission trading, the effects of this feedback loop are gaining in importance.

The feedback loop in a market sell-off is proven to be more pronounced as volatility, delta, and gamma all spike. Such results in even larger follow-on selling by machine delta hedgers. The greatest risk of the increase in options trading is the potential for a large, cascading downward move, similar to what we saw earlier this year.

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Author

Erik Lytikainen, the founder of Viking Analytics, has over 25+ of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.