In September 2019, I wrote “NFIB Survey Trips Economic Alarms,”  Of course, it was just a few short months later the U.S. economy fell into the deepest recession since the “Great Depression.” The latest NFIB survey is sending a strong warning to investors piling into small-cap stocks.

While the mainstream media overlooks the NFIB data, they really shouldn’t. There are currently 30.7 million small businesses in the United States. Small businesses (defined as fewer than 500 employees) account for 99% of all enterprises, employ 60 million people, and account for nearly 70% of employment. The chart below shows the breakdown of firms and jobs from the 2019 Census Bureau Data.

Despite all the headlines about Microsoft, Apple, Tesla, and others, small businesses drive the economy, employment, and wages. Therefore, what the NFIB says is relevant to what happens in the economy.

NFIB Shows Confidence Drop

In December, the survey declined to 95.9 from a peak of 108.8. Notably, many suggest the drop was “politically driven” by conservative owned businesses. While there was indeed a drop following the election, the decline continues what started in 2018.

As I discussed when the index hit its record high previously:

“Record levels of anything are records for a reason. It is the point where the sustainability of activity can not be increased further. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY, of a cycle.” 

That point of “exuberance” was the peak of the economy.

Before we dig into the details, let me remind you this is a “sentiment” based survey. Such is a crucial concept to understand as “Planning” to do something is a far different factor than actually “doing” it.

An Economic Boom Will Require Participation

Currently, many analysts expect a massive economic boom in 2021. The basis of those expectations is massive “pent-up” demand when the economy reopens.

I would agree with that expectation had there been no stimulus programs or expanded unemployment benefits. Those inflows allowed individuals to spend during a recession where such would not usually be the case. Those artificial inputs dragged forward future or “pent-up” consumption into the present.

However, the NFIB survey also suggests much the same.

Small businesses are susceptible to economic downturns and don’t have access to public markets for debt or secondary offerings. As such, they tend to focus heavily on operating efficiencies and profitability.

If businesses were expecting a massive surge in “pent up” demand, they would be doing several things to prepare for it. Such includes planning to increase capital expenditures to meet expected demand. Unfortunately, those expectations peaked in 2018 and are lower again.

There are important implications to the economy since “business investment” is a GDP calculation component. Small business capital expenditure “plans” have a high correlation with real gross private investment. The plunge in “CapEx” expectations suggests business investment will drop sharply next month.

As stated, “expectations” are very fragile, and reality is often quite different.

Employment To Remain Weak

If small businesses think the economy is “actually” improving over the longer term, they would also be increasing employment. Given business owners are always optimistic, over-estimating hiring plans is not surprising. However, reality occurs when actual “demand” meets its operating cash flows.

To increase employment, which is the single most considerable cost to any business, you need two things:

1. Confidence the economy is going to continue to grow in the future, which leads to;
2. Increased production of goods or services to meet growing demand.

Currently, there is little expectation for a strongly recovering economy. Such is the requirement for increasing employment and expanding capital expenditures.

Now you can understand the biggest problem with artificial stimulus.

Yes, injecting stimulus into the economy will provide a short-term increase in demand for goods and services. When the funds are exhausted, the demand fades. However, small business owners understand the limited impact of artificial inputs. As such, they will not make long-term hiring decisions, an ongoing cost, against a short-term artificial increase in demand. 

Also, given President Biden is focused on more government regulation and higher taxes (which falls squarely on the creators of employment), increased costs will further deter long-term hiring plans.

The Big Hit Is Coming

Retail sales make up about 40% of personal consumption expenditures (PCE), which comprises roughly 70% of the GDP calculation. Each month the NFIB tracks both actual sales over the last quarter and expected sales over the next quarter. There is always a significant divergence between expectations and reality.

While stimulus may lead to a short-term boost in consumption, the impact of higher taxes, more regulations, and weak employment growth will suppress consumption longer-term.

The weakness in actual sales explains why employers are slow to hire and commit capital for expansions. As noted, employees are among the highest costs associated with any enterprise, and “capital expenditures” must pay for themselves over time. The actual underlying strength of the economy, despite cheap capital, does not foster the confidence to make long-term financial commitments to anything other than automation.

Despite mainstream hopes, business owners must deal with actual sales at levels more commonly associated with ongoing recessions rather than recoveries. 

Of course, this remains an argument of ours over the last couple of years. While the media keeps touting the strength of the U.S. consumer, the reality is quite different. If such were indeed the case, there would be no requirement to inject billions of dollars in stimulus to keep individuals afloat.

So what does all this have to do with small-caps?

Small Caps May Disappoint

With this background, it is easier to understand why the recent exuberance in chasing small-cap stocks may be premature. While small-cap companies do historically perform well coming out of recession, the basis was an organic recovery cycle of increasing productivity.

Currently, the run-up remains the assumption that the stimulus-fueled recovery is sustainable. Such is only the case if the stimulus becomes a regular benefit and increases in size annually. However, since deficit-based spending is deflationary, the outcome will fall well short of expectations.

“in 1998, the Federal Reserve “crossed the ‘Rubicon,’ whereby lowering interest rates failed to stimulate economic growth or inflation as the ‘debt burden’ detracted from it. When compared to the total debt of the economy, monetary velocity shows the problem facing the Fed.”

Such is a critical point as it relates to small-cap companies given their high correlation to small-business confidence. There has only been one other period in history that small-caps detached from underlying confidence, and the outcome for investors was not good.

Given that investors continue to push the small-cap index to historical deviations from long-term means, the risk of disappointment is extremely high. The data above suggests the economic recovery won’t be strong enough to justify current prices for small-cap companies.

Furthermore, small-cap companies’ valuations on a 2-year forward estimate all but guarantee a poor outcome for investors in the future.

Conclusion

Given that debt-driven government spending programs have a dismal history of providing the economic growth promised, disappointment over the next year is almost a guarantee.

However, suppose additional amounts of short-term stimulus deliver higher rates of inflation and higher interest rates. In that case, the Federal Reserve may become contained in its ability to continue to provide an “insurance policy” to investors.

There are risks to assuming a strong economic and employment recovery over the next couple of quarters. The damage from the shut-down on the economy, and most importantly, small business, suggests recovery may remain elusive.

While there is nothing wrong with being optimistic, when it comes to your investment portfolio, keeping a realistic perspective on the data will be essential to navigating the risks to come. For small-cap investors, the time to take profits and move to “safer pastures” has likely arrived.

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

Commentary 1-15-21

• The banking sector (XLF) remains the most overbought sector on a relative basis, closely followed by energy and materials. Again, more inflation and a resulting steeper yield curve will boost earnings for most companies in those sectors. The risk is that the deflationary trend of the last decade rears its head. On the flip side of the reflation trade are staples, real estate, and utilities.
• The communications sector traded about 3% weaker than the S&P 500 last week. Google and Facebook represent 40% of the sector. Recent censorship actions they have taken and the potential repercussions weighed on those stocks and given their huge weighting, the entire sector.
• This analysis provides what appears to be a clear road map for the weeks and months ahead. Tracking TIP breakevens, Treasury yields, the U.S. dollar, and the inflation/deflation mindset over the coming months should help dictate if current trends continue or not.
• Small-cap and mid-cap, along with emerging markets are the most overbought indexes. Emerging markets benefit from a weaker dollar and inflation as many emerging economies are commodity producers. RSP, the equal-weighted S&P 500, is now well overbought versus the S&P 500. This is in large part due to the outperformance of smaller companies and the relatively weak performance of the FANG stocks.
• The correlation graph in the lower right of the sector graph remains very high. As such, if you think the inflation trade stays in vogue, those sectors and indexes with high scores and sigmas should continue to do well on a relative basis, and vice versa.
• The broad themes are very similar in the absolute graphs. Energy, transports, banks, materials, health care, small/mid caps, and emerging/ developed foreign markets are extremely overbought. The NASDAQ remains the weakest index for a second week. If we think the reflation trade reverses and the markets fall, it is not implausible to think of the tech sector as a safety trade, similar to the way utilities and staples traditional act in down markets.
• The S&P, like the NASDAQ, is near fair value on an absolute basis.
• Energy, small cap, and emerging markets are above two standard deviations over their 50 dma and 200 dma respectively. Communications and staples are close to two standard deviations below their 20 dma.
• The “spaghetti” chart shows how XLF (brown) and XLE (blue) are pushing into the extreme upper right of the graph. They can keep going up, but we frequently see a rotation at such levels to fairer valued sectors.

Graphs (Click on the graphs to expand)

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Users Guide

The score is a percentage of the maximum/minimum score, as well as on a normalized basis (sigma) for the last 200 trading days. Assets with scores over or under +/-60% and sigmas over or under +/-2 are likely to either consolidate or change trend. When both the score and sigma are above or below those key levels simultaneously, the signal is stronger.

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

The technical value scorecard report is just one of many tools that we use to assess our holdings and decide on potential trades. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

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

We can’t predict the future. If we could, fortune tellers would all win the lottery.  They don’t, we can’t, and we aren’t going to try. However, this doesn’t stop the annual parade of Wall Street analysts from putting out forecasts on the S&P 500.

The Problem With Forecasts

In reality, all we can do is analyze what has happened in the past, weed through the noise of the present and try to discern the possible outcomes of the future.

The biggest single problem with Wall Street, both today and in the past, is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.

Ed Yardeni annually publishes the two following charts which also show analysts are always overly optimistic in their estimates.

This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic roughly 33% on average.

Furthermore, the reason that earnings only grew at 6% over the last 70-years is that the companies that make up the stock market are a reflection of real economic growth. Stocks cannot outgrow the economy in the long term. 

“Since 1947, earnings per share have grown at 6.21% annually, while the economy expanded by 6.47% annually. That close relationship in growth rates should be logical, particularly given the significant role that consumer spending has in the GDP equation.”

We can see this correlation even better when looking at the corporate profits versus stocks.

Conflicted Forecasters

The McKenzie study noted that on average “analysts’ forecasts have been almost 100% too high” and this leads investors into making much more aggressive bets in the financial markets. Wall Street is a group of highly conflicted marketing and PR firms. Companies hire Wall Street to “market” for them so that their stock prices will rise and with executive pay tied to stock-based compensation you can understand their desire.

However, if analysts are bearish on the companies they cover – their access to information to the company they cover is cut off. This reduces fees from the company to the Wall Street firm hurting their revenue. Furthermore, Wall Street has to have a customer to sell their products to – that would be you.

Talk about conflicted. Just ask yourself why Wall Street spends billions of dollars each year in marketing and advertising just to keep you invested at all times.

Since optimism is what sells products, it is not surprising, as we head into 2021, to see Wall Street’s average expectation ratcheted up another 6.5% this year. Of course, comparing your portfolio to the market is often a mistake anyway.

Comparison Is The Root Of Disappointment

“Comparison” is the root of unhappiness. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. The social comparisons come in many different guises. “Keeping up with the Joneses,” is one well-known way.

But let me give you an example of why you should stop comparing yourself to everything, or everyone, else.

Let’s assume your boss gave you a Mercedes as a yearly bonus. You would be thrilled—right up until you found out everyone else in the office got two cars. Now, you are upset. But really, are you deprived of getting a Mercedes? Isn’t that enough?

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

It is this ongoing “measurement complex” that remains the key reason why investors have trouble being patient and allowing the investment process to work for them. They get waylaid by some comparison along the way and lose their focus.

If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that “everyone else” made 14%, you have made them upset. The whole financial services industry is constructed to make people upset. When they are upset they will move their money to chase the next promise of riches. Money in motion creates fees and commissions. The constant push of comparison to benchmarks is nothing more than to keep individuals in a perpetual state of outrage.

A Note On Risk Management

What is important is to focus on what is important to you. Your specific goals, risk tolerance, time frames, and conservatively growing your savings to outpace inflation.

Such is why we always focus on the management of risks. Greater returns are generated from the management of “risks” rather than the attempt to create returns. Although it may seem contradictory, embracing uncertainty reduces risk while denial increases it.

Another benefit of acknowledged uncertainty is it keeps you honest.

“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions.  It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”  – Robert Rubin

The reality is that we can’t control outcomes; the most we can do is influence the probability of certain outcomes. Such is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

Shades Of 1999

“Maybe this time is different. Those words, supposedly the most dangerous to utter in the investing realm, came to mind amid the frenzied pops in the highly anticipated initial public offerings recently.”

That quote was from Randall Forsyth discussing why the current market mania reminds him of the “Shades of 1999.”

There are certainly many similarities between today and 1999. From exceedingly high valuations to a rush by private equity investors to IPO overly priced companies as quickly as possible. As discussed previously, “valuations” are a representation of market excesses. However, it requires a supportive underlying narrative, a “siren’s song” to lure “sailors onto the rocks.” 

“I discovered what I believe to be the strongest bull case in an article by Rothko Research:

• In the past cycle, the Fed has become very sensitive to a sudden tightening in financial conditions, especially when equities start to fall aggressively
• Another $5 trillion USD is expected to resume in the coming months.
• Such would send US equities to new all-time highs
• Any bear retracement in the near term is a good opportunity to “buy the dip.”
• It is not a good time to try to short equities

One crucial thing that we have learned over the past 12-years is that the Fed has become very sensitive to a sudden tightening in financial conditions, especially when equities start to fall aggressively.” – Greg Frierman

If price acceleration in the market is a sign of investor optimism, then this chart should raise some alarms.

The only other time in history where the Dow advanced this rapidly was during the 1995-1999 period of “irrational exuberance.” 

Maybe it’s just coincidence.

Maybe “this time is different.”

Or it could just be the inevitable beginning of the ending of the current bull market cycle.

Risk Is Building

While analysts rushing to “out-predict” the other guys, it is worth noting:

• Markets are pushing historic levels of extreme overbought conditions,
• 2nd highest levels of valuation on record,
• Extreme deviations from long-term growth trend lines,
• Investor sentiment and confidence pushing extreme bullishness,
• Investors fully committed to the market with low levels of cash, and;
• High levels of leverage in terms of margin debt and corporate debt.

In other words, after 11-straight years of a bull market advance, what is the “risk” you are taking to garner additional returns?

While the odds of a positive year in 2021 are more, or less, evenly balanced, one should not dismiss the potential for a decline. With the current market already well advanced, pushing more extreme overvaluations, and significant deviations from long-term means, the risk of a decline is not minuscule.

Conclusion

I read most of the mainstream analyst’s predictions to get a gauge on the “consensus.”  This year, more so than most, the outlook for 2021 is universally, and to some degree exuberantly, bullish.

What comes to mind is Bob Farrell’s Rule #9 which states:

“When everyone agrees…something else is bound to happen.”

The real economy is not supportive of asset prices at current levels. The more extended prices become, the greater the potential for a future market dislocation. For investors that are close to, or in retirement, some consideration should be given to capital preservation over chasing potential market returns.

Will 2021 turn in another positive performance? Maybe. But, honestly, I don’t really know.

#PortfolioHedgesMatter

What You Missed On RIA This Week Ending 1-15-21

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

Here is this week’s rundown of what you missed.

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RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors now has the capability to manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes we can get you in the “right lane” for retirement.

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What You Missed This Week In Blogs

Each week, RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risks that may negatively impact our client’s capital. These are the risks we are focusing on now.

#MacroView: El-Erian & The Two Primary Risks In 2021

Yes, Virginia. There Is A Stock Market Bubble.

Technically Speaking: 2021 Investor Resolutions & January Stats

Is Inflation In Your Best Interest, Or The Feds?

Five Forces Driving The 2021 Economy

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What You Missed In Our Newsletter

Every week, our newsletter delves into the topics, events, and strategies we are using. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how we plan to trade it.

Bulls Loving The “Heads I Win, Tails I Win” Market 01-08-21

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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 for 30-days free) If you are a DIY investor, this is the site for you. RIA PRO has all the tools, data, and analysis you need to build, monitor, and manage your own money.

Real-Time Commentary Heat Maps

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The Best Of “The Real Investment Show”

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

Best Clips Of The Week Ending 1-15-21

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What You Missed: Video Of The Week

Michael Lebowitz and I dig into why more stimulus will likely not create either economic growth or the inflationary pressures many expect. In fact, more stimulus may actually be deflationary.

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Our Best Tweets For The Week: 1-15-21

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.

The title of this chart is incorrect (chart via @SoberLook) It should read:
"US Household Net Worth has increased by $5.2 Trillion from home price and stock increases…for the Top 10% of income earners." pic.twitter.com/vyolNDim1R

— Lance Roberts (@LanceRoberts) January 14, 2021

Margin Debt, Options, Dealer Gamma all contribute to pushing stocks higher……but also accelerates the move lower when it occurs. (@soberlook) pic.twitter.com/EFJiyPdg3x

— Lance Roberts (@LanceRoberts) January 13, 2021

“We want to see American citizens pay higher prices for milk, butter, eggs, bread, and toilet paper. To reach our goal, we will adjust monetary policy to make these goods and other goods and services more expensive in the future.”

A preview of tomorrow's article…

— Michael Lebowitz, CFA (@michaellebowitz) January 12, 2021

Have you ever lied to someone about the quality of their cooking?
Uh…yes….because as a kid I wanted to eat. As an adult I want to stay married. pic.twitter.com/JlnD90PkTX

— Lance Roberts (@LanceRoberts) January 12, 2021

👇 https://t.co/vzLVwGWYGZ

— Lance Roberts (@LanceRoberts) January 13, 2021

No comment necessary. pic.twitter.com/2ZPgbYRgza

— Lance Roberts (@LanceRoberts) January 13, 2021

See you next week!

We talk a lot about valuations and their importance, but such discussions can be hard to put into context. Therefore, I have produced a series of charts that visualize various valuations of the S&P 500 companies. Not surprisingly, such also corresponds to the current behavior of Wall Street analysts and investors. Instead of cluttering up the commentary space on RIAPro.Net, we thought you would better appreciate the charts and share them more easily in an article format.

The charts below are called heat maps. What we like about heat maps is their ability to show two data points in one easy to read format. The following maps show the S&P 500 components market cap and along with a second factor. The larger the company’s market cap is in relation to other companies in the sector, the larger the square. Each graph has a scale on the bottom right relating to the second factor. In the first graph (Price to Earnings), the brighter the red, the more overvalued a company is. Conversely, green is relatively cheaper. The companies are sorted by their respective sector and sub-sectors.

The first three graphs are popular measures of valuation. The fourth graph shows that analyst recommendations, despite what valuations tell us, are pretty bullish. As shown in the fifth graph, investors are also overly bullish as there is a very low percentage of short positions in general. Lastly, the sixth graph shows this is not just domestic, but high valuations are occurring in many other countries.

1. Price to Earnings:

You have to look pretty hard to find stocks that are not very overvalued.

2. Price to Sales:

A ratio between 2-3 is considered somewhat normal, especially for well established mature companies.

3. Price to Book:

P/B is also typically in the lower single digits for mature companies.

4. Analyst Recommendations

You have to look pretty closely to find stocks that do not have buy recommendations.

5. Short Interest as a % of total float:

The continual grind higher has scared away almost all short sellers.

6. World Price to Earnings:

These are not as extreme as the U.S., but P/E ratios around the world are very high. Keep in mind that historical P/E ratios in most countries are lower than in the U.S. for many reasons. But importantly, P/E ratios are relative to the country in which the company is domiciled. Therefore, just because it may appear cheap relative to the U.S. does not necessarily mean it is a value.

No matter how you look at the markets, either from a technical or fundamental point of view, the risk/reward long-term is clearly not favorable.

What eventually derails the bullish bias is unknown. However, what is certain is that when it occurs, given the more extreme levels of leverage combined with a lack of liquidity, the reversion will be swift.

During a bull market advance, investors always take on substantially more risk than they realize. Unfortunately, it is a painful lesson taught quickly and repeatedly throughout history.

A reader from Brussels asks they the Euro is so strong.

Reader Question

Why is the Euro currency so strong? It is not that everything is hunky-dory here because it definitely isn’t. But this counterfeit currency was created with the one and only purpose: to benefit export-driven Germany.

The euro is flawed. It’s a currency too weak for Germany and too strong for the other countries allowing them to ‘happily’ buy German products.

Fatally Flawed

The Euro is indeed fatally flawed.  But what about the US dollar?

I am asked far more frequently “What’s holding the US dollar up?“

Hated Dollar

The “dollar is so extremely oversold, over-hated, and over-shorted that it all but has to rally for a while at some point soon.”

Wrong. Maybe short term but dollar weakness is structural

— Peter Tchir (@TFMkts) January 11, 2021

Dollar Weakness is Structural 

Regarding the dollar, the Fed is set to print, and print, and print. If you prefer, it’s QE until the cows come home. 

Right now those cows are somewhere over the moon. 

The US dollar index surged above 100 in belief the Fed was on a tightening cycle. 

Then it wasn’t and now short-term treasury yields are back close to zero.

But at least they are above zero. 

Note that the yield on the 10-year treasury is +1.1%.

The yield on the 10-year German bond is -0.53%. Yes, that is a negative sign. 

And note there are no Euro bonds to speak of. It’s every county for itself. that’s part of the fatal flaws of the Euro.

Target2 Imbalances

Chart from the ECB Statistical Warehouse.

What is Target2?

Target2 represents creditors and debtors in the EMU Eurozone Monetary Union.

It represents goods purchased by debtors in Spain, Italy, Portugal, and Greece owed to creditors in Germany, Luxembourg, etc. 

It is also a measure of capital flight. 

Some, me included, believe the -330.7 ECB number hides loans to Italy and Spain. 

Regardless of what the ECB is doing, it’s an imbalance of some sort.

Do you really believe these debts will be paid back? I don’t. 

And if Italy left the Eurozone as it once threatened, the whole mess cascades. Spain and even Greece would be responsible to make good on the default.

Mutualized Debt

Target2 is one of the biggest fundamental flaws in the Eurozone. The Euro founders were well aware of it. But it was the only way to get Germany to go along. 

The Maastricht Treaty that created the Euro excluded mutualized debt at Germany’s instance. There are no Eurobonds. 

The debt of each county is supposed to be equally good. But the Euro crisis proved the debt of EMU countries is not equally solvent. If it were, German bonds, Greek bonds, and Portuguese bonds would all trade at the same interest rate.

Don’t Be So Centric

Whenever I get asked “What’s holding the dollar up?” I tend to reply don’t be so US centric.

My response to “What’s holding the Euro up?” is don’t be so Euro centric.

ECB and Fed Balance Sheets 

The above Balance Sheet Chart is from Brookings.

The ECB is papering over Target2 imbalances, interest rate imbalances, etc., and is killing banks with negative interest rates, perhaps on purpose.

The Fed is more open in its mischief.

Structural Weakness vs Fatal Flaws

The dollar weakness is “structural” but the euro was “fatally flawed by design” as an appeasement to Germany.

Those are the competing forces. 

Meanwhile, we have an ECB out of control with negative interest rates and QE vs a Fed out of control with QE while pledging to ignore inflation and stock market bubbles.

Sentiment

Whether the dollar or euro is rising or falling is determined by sentiment at the moment.

Right now, the market is focused on US structural weaknesses including trillion dollar deficits and a Biden election.

At times, the market is more worried about Target2 imbalances, fatal flaws of the Euro, negative interest rates, or a eurozone breakup.

Take your pick. 

Tell me what the more important concern will be a year from now and I will tell you which one will be sinking faster. 

Currencies Don’t Float

Meanwhile, please note that fiat currencies don’t float. They sink at varying rates. Right now the dollar is sinking faster. 

Got Gold?

What is Price Stability?

Congress delegates responsibility for monetary policy to the Fed but maintains oversight. They are supposed to ensure the Fed adheres to its statutory mandate of “maximum employment, stable prices, and moderate long-term interest rates.”

What are stable prices? Merriam Webster defines the word stable when used as an adjective, as follows:

• firmly established: fixed, steadfast stable opinions
• not changing or fluctuating: unvarying in stable condition

If the price of a dozen eggs rises from $4.00 today to $5.12 in a decade, would you say the price did not change or fluctuate?

Does firmly established characterize a 28% increase in the price of eggs over ten years (2.5% inflation rate).

In July 1996, Fed Chairman Greenspan opined on the definition of price stability. He stated- “I would say the number is zero if inflation is properly measured.”

In a paper from 2006, Fed economists Robert Rasche and Daniel Thornton lend credence to his opinion: “In so doing, he (Greenspan) confirmed that the rate of inflation that results in the maximum sustainable growth rate of output is zero.”

So if stable prices mean no inflation, why does the Fed crave more inflation?

Why Inflation?

• “In a move that Chairman Jerome Powell called a “robust updating” of Fed policy, the central bank formally agreed to a policy of “average inflation targeting.” That means it will allow inflation to run “moderately” above the Fed’s 2% goal “for some time” following periods when it has run below that objective.”-CNBC 8/27/2020

• “If we generated some modest inflation, I think we would consider that a success,” –Neel Kashkari 12/2020

• “If we got 3 percent inflation that would not be so bad.” Charles Evans 1/2021

• “By committing to achieve inflation outcomes that average 2 percent over time, the Committee would make clear in advance that it would accommodate rather than offset modest upward pressures to inflation in what could be described as a process of opportunistic reflation. This approach will help move inflation expectations back to our 2 percent objective, which is critical to preserve conventional policy space.” – Lael Brainard 2/2020

Debt is the principal reason Fed members are increasingly troubled with low inflation. Debt has increasingly become an economic engine. Some of it went toward productive purposes. Most of this debt results in growth and pays for itself. Slowing productivity, GDP, corporate earnings, and wage growth argue a large percentage was put to non-productive use.

Non-productive debt boosts economic activity for a short period. That is what makes it attractive to the Fed in times of sub-optimal economic growth. The flaw of this logic is that it does not produce enough income to pay off future debt. Accordingly, it weighs on future economic growth and requires ever more debt to keep the economy rolling.

Currently, there is $83 trillion of total debt outstanding, powering a $21 trillion economy. Include future liabilities such as social security, and the amount of debt nearly doubles.

Solving a Debt Problem

With the debt growing substantially faster than the ability to pay for it, there are three options to deal with the problem.

• Austerity
• Default
• Inflation

The Fed shuns options one and two above. Austerity would squash economic growth, which the Fed and lawmakers will not tolerate. Defaulting on a moderate share of debt will devastate the financial markets and hurt the economy. While both options require severe short-term pain, they promote more robust growth in the future.

That leaves inflation. Inflation deflates the real value of debt. Higher wages, profits, and taxes resulting from inflation make debt payments less onerous.

The Fed is trapped. They want robust economic activity and soaring asset prices. In the current environment, this can only occur with more debt and leverage. To make existing and additional debt manageable and appealing, they must reduce interest rates.

With interest rates near zero, inflation becomes a more critical tool. QE and recent programs with the Treasury are how they hope to generate inflation. The graph below comparing QE to GDP shows the effect of the Fed’s herculean efforts to keep the debt scheme going.

Inflation Benefits Few At the Expense of Many

Not only is the Fed perpetuating and making the debt problem larger, but importantly the benefits and costs of such policy are not equally distributed.

In Two Percent For The One Percent, we explain how inflation benefits the wealthy and crushes the low and middle class. To wit:

Summary- Is Inflation in the Greater Good?

Now you know why the Fed desperately wants you to pay more for milk, butter, eggs, bread, and toilet paper. They are deep in a trap of their own making. They can keep digging deeper into the trap, or they can change their ways.

Despite rhetoric to the contrary, change is not politically palatable to the political ruling class on both sides of the aisle. As such, years of fiscal and monetary negligence leave the Fed with one option- inflation. If the Fed does not make us pay more for goods and services, the scheme comes to an end.

The growing economic and societal rifts of the last few years are only just beginning. Each dollar of QE and basis point reduction in interest rates enforce the inequalities of monetary policy. When QE fails to serve its purpose, the Fed will find a new trick. We fear it will be literal money printing.

With 2021 already off to a good start, with the market up almost 2% in January, such is an excellent time to review our “investor resolutions.”

So Goes January

There is an abundance of “Wall Street Axioms” surrounding the first month of the New Year as investors anxiously try and predict what is in store for the next twelve months. You are likely familiar with the “Superbowl Indicator” to “So Goes The First 5-days. So Goes The Month.”

Considering that trying to predict the markets more than just a few days in advance is mostly an exercise in “folly,” it is nonetheless a traditional ritual as the old year passes into the new. While Wall Street espouses their always overly optimistic projections of year-end returns, reality has often tended to be somewhat different.

However, from an investment management perspective, we can look at some of the statistical evidence for January to gain insight into performance tendencies looking ahead. From this analysis, we can potentially gain some respect for the risks that might lay ahead.

According to StockTrader’s Almanac, the direction of January’s trading (gain/loss for the month) has predicted the course of the rest of the year 75% of the time. Starting from a broad historical perspective, the chart below shows the January performance going back to 1900.

Furthermore, twelve of the last sixteen presidential election years followed January’s direction. Speaking of Presidential election years, the first year of a new President statistically has the lowest average return rate with roughly a coin toss of being a positive year.

Digging In

The table and chart below show the statistics by month for the S&P 500. As you will notice, there are some significant outliers like August with a 50% one-month return. These anomalies occurred during the 1930s following the crash of 1929.

The critical point is that January tends to be one of the best return months of the year. Interestingly, the first week of January has already surpassed the historical average and median monthly returns.

January also holds the title for the most favorable return months, followed only by December and April.

But January is not always a winner. While the statistical odds are high, particularly after a strong start, it does not always end that way. It is worth noting that while January’s maximum positive return 9.2%, the maximum drawdown for the month was the lowest for all months at -6.79%.

An Overly Excited Beginning

While I don’t directly make asset allocation decisions based on monthly returns from a portfolio management perspective, the statistical weight of evidence suggests a couple of things worth considering.

The odds of January being a positive month greatly outweigh those of it being negative.

With the market already extremely extended, overbought, and euphoric, a mid-month reversal would not be surprising. The panic/euphoria index is at an all-time high.

February is potentially a different animal with only 50/50 odds of being positive. So, with investors overly allocated to equities, leveraged, and unhedged, the potential for a negative catalyst to spark a reversion is high.

Speaking of leverage, whenever margin debt has spiked sharply from its 12-month low, such has usually been associated with short- to intermediate-term market peaks.

Importantly, given the length of the uninterrupted bull market run from 2009 to the present, the risks are mounting the current bull market cycle has entered into the “mania” phase. Such fundamental realities suggest a more conservative approach to investment allocations.

The Battle Of Wits

“Wait, so you are saying January tends to be a good month, but it could correct.”

Yes.

The dichotomy reminds me of the scene from “The Princess Bride” where the “Sicilian” is in a “Battle Of Wits” with “The Dread Pirate Roberts.” 

While it may seem confusing for investors, it comes down to time frames.

For short-term traders, the odds are high that January will post a positive trading month, therefore, allocations should remain tilted towards equity related exposure. If you are a nimble trader and can adjust for the swings in the market, the “odds are in your favor.” 

For longer-term investors, particularly those that are nearing retirement, risks are mounting for at least a short-term correction. Such potential outcomes suggest a more cautious approach to equity allocations in portfolios.

No one knows about “mania driven markets” is how long the mania will last. It is often the case that they tend to last longer than you would logically expect.

Such is why it is vital to have a set of guides to follow. As we kick off the New Year, it is an excellent time to set out our “investing resolutions” for the year.

Investor Resolutions For 2021

Here are my annual resolutions for the coming year to be a better investor and portfolio manager:

I will:

• Do more of what is working and less of what isn’t. 
• Remember that the “Trend Is My Friend.”
• Be either bullish or bearish, but not “hoggish.” (Hogs get slaughtered)
• Remember it is “Okay” to pay taxes.
• Maximize profits by staging my buys, working my orders, and getting the best price.
• Look to buy damaged opportunities, not damaged investments.
• Diversify to control my risk.
• Control my risk by always having pre-determined sell levels and stop-losses.
• Do my homework. I will do my homework. I will do my homework.
• Not allow panic to influence my buy/sell decisions.
• Remember that “cash” is for winners.
• Expect, but not fear, corrections.
• Expect to be wrong, and I will correct errors quickly. 
• Check “hope” at the door.
• Be flexible.
• Have the patience to allow my discipline and strategy to work.
• Turn off the television, put down the newspaper, and focus on my analysis.

These are the same resolutions I attempt to follow every year. There is no shortcut to being a successful investor. There are only the basic rules, discipline, and focus that is required to succeed long-term.

A Year Of Challenges

At the moment, every analyst is wildly optimistic about the new year. Expectations are high for explosive economic growth, more stimulus, debt-driven infrastructure spending, and 4100-4500 on the S&P by year-end.

Maybe that will be the case. However, investors have priced the market for perfection with high valuations, low interest-rates, and low inflation. Any shortfall in earnings growth, economic recovery, or a rise in interest rates or inflation could have an immediate and negative impact on investors.

The biggest problem for investors is the bull market itself.

When the “bull is running,” we believe we are smarter and better than we actually are. We take on substantially more risk than we realize as we continue to chase market returns and allow “greed” to displace our rational logic. Just as with gambling, success breeds overconfidence as the rising tide disguises our investment mistakes. 

Unfortunately, during the subsequent completion of the full-market cycle, our errors return to haunt us. Always too painfully and tragically as the loss of capital exceeds our capability to “hold on for the long-term.” 

Conclusion

While most of the financial media and blogosphere suggest that investors should only “buy and hold” for the long-term, the reality of capital destruction during major market declines is a far more pernicious issue.

With market valuations elevated, leverage high, economic weakness pervasive and profit margins deteriorating, investors should be watching the month of January carefully for clues. The weight of evidence suggests that despite ongoing “bullish calls” for the markets in the year ahead, this could be a year of disappointment.

Pay attention. Things may start to get interesting.

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“Yes, Virginia. There is a stock market bubble. “

In 1897, an 8-year girl named Virginia O’Hanlon sent a letter to the New York Sun questioning Santa Claus’s existence. Why? Because her friends had all told her that Santa Claus didn’t exist.

As we enter 2021, there are two myths told to investors to support the bull market narrative. The first, as we debunked recently, is that low-interest rates justify high valuations. The second is that since valuations are not as high as the “dot.com” crisis, there is no “stock market bubble.”

Both of these views are rationalizations by investors to continue overpaying for assets during a liquidity-fueled bull market. Unfortunately, as investors pile further into risk assets, driven by herd mentality and confirmation bias, the eventual outcomes have been less than kind.

“My confidence is rising quite rapidly that this is, in fact, becoming the fourth ‘real McCoy’ bubble of my investment career. The great bubbles can go on a long time and inflict a lot of pain, but at least I think we know now that we’re in one.” – Jeremy Grantham

That was a comment he made during a CNBC interview when discussing the market’s rapid rise following the March correction. 

What Is A Bubble?

What is the definition of a bubble?  According to Investopedia:

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

While this definition is suitable for our discussion, there are three components of a “bubble.” The first two, price and valuation, are often discussed and readily dismissed during the inflation phase.

Jeremy Grantham recently produced the following chart of 40-years of price bubbles in the markets. During the inflation phase, each was readily dismissed under the guise “this time is different.” 

Valuations are also quickly dismissed with “new metrics,” like Shiller’s recent endeavor into “earnings yield.” 

But what we do know is that valuations have a massive impact on expected returns.

Here is “the thing.”

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

The Rudimentary Theory Of Bubbles

Let me explain.

If market bubbles are about “psychology,” as represented by investors’ herding behavior, then price and valuations are reflections of that psychology.

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

Notice that except for only 1929, 2000, and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently.  As shown in the table below from Tavi Costa at Crescat Capital, markets are currently trading in the top decile of valuations on many levels.

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

Bubbles Are About Psychology

We previously touched on George Soros’ theory on bubbles.

“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 relatively insignificant. At other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, the markets are far from equilibrium conditions.

Every bubble has two components:

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

When positive feedback develops between the trend and the misconception, such sets a boom-bust process into motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, will reinforce both the trend and the misconception. Eventually, market expectations become so far removed from reality that it forces people to recognize that a misconception is involved. A twilight period ensues during which doubts grow, 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, we reach a tipping point as 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, then 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.

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

We see the asymmetric bubble pattern at every bull market peak in history.

The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis with an overlay of the asymmetrical bubble shape.

As Soro’s went on to state:

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

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

When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the other’s 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.”

There is a strong belief that the financial markets are not in a bubble. However, those beliefs use flawed comparisons to past market bubbles.

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

In other words, the markets are in a bubble.

Evidence Of A Bubble

One does not have to dig too deeply to find evidence of the “psychology” driving the current stock market bubble.

Speak with almost any retail investor, and you will hear a common refrain from “the Fed won’t like markets decline” to common justification catch-phrases like the “Fear Of Missing Out (F.O.M.O)” or “There Is No Alternative (T.I.N.A.)”

There is also plenty of anecdotal evidence of a market bubble in investor’s actions. Investors are currently exhibiting all of the behaviors associated with previous stock market bubbles, from aggressive equity allocations to risk leverage.

Currently, investors are holding nearly the highest levels of equities on record.

At the same time, they are leveraging their investment risk by carrying the highest levels of “call options” in history.

Of course, they are doing this because they are too “confident” the market will not be allowed to correct.

Yes, Virginia. We are in a stock market bubble.

Reflections

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

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

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

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

This Time Is Different

Such is an essential point. 

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

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

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

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

This “time IS different.” 

However, “this time” is only different from the standpoint the variables are not the same as they have been previously.

The variables never are. But the outcome is always the same.

But maybe it is the very “denial” of the bubble that suggests we are indeed in one.

Five Forces Driving the 2021 Economy

Social, cultural, and behavioral patterns create economic forces evident in the buying and selling of goods and services. The pandemic shocked demand and supply channels of the real economy causing social, relationship, geographic and financial dislocations.  These dislocations have changed social behavior, desires, relationships, and expectations temporarily and, in other cases, permanently.  The crisis created profitable opportunities for some businesses and jobs for workers. Yet, other companies experienced losses, debt, and threats to survival.  The pandemic is a once in one hundred year event. As such, there is limited experience and knowledge about the economic consequences of shelter in place lockdowns and health policy. However, we can see critical social, cultural, and behavioral forces begin to emerge.

Looking Back At 2020 To Look Ahead at 2021

To understand how the 2021 economy may unfold, we have identified five fundamental driving forces that shaped the real economy in 2020. Some of these forces are driving the economy while others are weak retarding growth. The key forces are the virus, jobs engine, work-from-home migration, housing debt bubble, and trade. The status of each force is examined with suggested indicators to monitor.

1. Virus

The virus continues to be the controlling factor in the economy as it penetrates every aspect of social life. The virus fractures the U.S. economy as it suffocates social activity. Health care providers are in crisis mode as I.C.U. capacity is at near-zero levels across hotspot states like California and New York. As such, Health officials implemented more restrictive lockdowns of non-essential businesses, indoor gathering places like restaurants and bars, and entertainment venues.  The rate of infections is at the highest level recorded since the March emergency declaration. Dr. Jeff Smith, medical officer for Santa Clara County, California, summarized the staggering number of deaths in this way: “It’s as if we have the loss of life that we had for 9/11 each day.”

Source: The New York Times – 12/31/20

Vaccinations Fail To Hit Inoculation Targets

COVID-19 vaccines from Pfizer and Moderns were produced in record time and approved for distribution in early December.  Federal officials set a goal of vaccinating 20M health workers and the elderly by December 31st.  Yet, the distribution and injection program has been a failure by achieving only 15% of that goal or 2.8M doses by year-end.

The Biden administration has set a goal of 100M doses in the first 100 days after the presidential inaugural on January 20th.  If state and federal government vaccination programs come close to 90% of the 100M goal in inoculating people, it may reach the tipping point of control.  Thus, the impact of the virus may decline by late spring or summer. We can recognize the tipping point when people stop worrying about catching the virus and venture out of their homes. The boost in consumer confidence will trigger new economic activity.

Indicators To Monitor:  Look for a steady decline in virus cases and deaths over weeks and months, increased capacity of I.C.U.s, rapid rise in vaccinations, the achievement of 70 – 80% of the population vaccinated for herd immunity, and a steady rise in consumer mobility as people begin to venture out into the community.

2. Jobs Engine

The executives’ expectations that business revenues, profits, and markets will show consistent long term growth fuels the jobs engine. Job losses have surged to extent that 19M workers are on continuing unemployment rolls. Yet, most professional employees can work from home and maintain employment.  The number of jobs increased for warehouse workers, transport workers, and couriers supporting e-commerce.  Yet, steep job declines of 70 – 80% occurred in the hospitality industry, including restaurants, bars, gift shops, and rental car firms. Small businesses in core cities like New York and San Francisco experienced 70 – 80% declines in sales.  And, as the pandemic wore on, workers furloughed began to see their jobs permanently terminated.  Accordingly, the shift to permanent layoffs is evident in the increasing number of workers on extended unemployment benefits programs.

Sources: Oxford Economics, Haver Analytics, The Daily Shot – 12/18/20

10.7M Jobs Gap

The economy has lost 22M jobs since February.  The CARES Act and Federal Reserve injections of liquidity have spurred job growth to regain about 12M jobs.  Therefore, there still is a 10.7M job growth gap since the pandemic hit the U.S. This gap in job growth will continue to put a drag on the recovery.

Source: Bureau of Labor Statistics – 11/15/20

Congress moved to close the job loss gap by passing the $900B Bipartisan COVID Relief Act in December.  The law includes a one-time $600 payment to most Americans, an extension of unemployment benefits for 11 weeks, an additional $300 weekly unemployment benefit,  and $319B in Payroll Protection Loans and small business funding.

Will The $900B Stimulus Bill Increase Hiring?

The question remains, will the $900B stimulus bill be enough to increase hiring?  Consumers did increase spending with CARES Act $1, 200 checks buying cars, appliances, and internet services. But, executives lack confidence in consistent business growth, which would trigger hiring. A recent survey of 238 CEOs showed that 64% planned labor force reductions in the next year.  The survey responses were collected before the relief bill passed.  But, experts at the Philadelphia Federal Reserve analyzed hiring in past recessions and found that recessions accelerated automation and slowed hiring. The report noted:

“Since the 1980s, almost all employment losses in routine occupations, which are relatively easier to be automated, occurred during recessions.  Automatable jobs held by minority workers were hit particularly hard by the pandemic, putting these workers who were already vulnerable in the job market at a greater risk of permanent job loss.”

Executives will remain hesitant to resume hiring until substantial domestic spending growth is evident for 3 – 6 months.  Also, management at S&P 100 companies dependent on international sales for 60 – 70% of their growth will be looking for global markets to open, travel to resume, and orders to increase consistently. We are skeptical that executives will quickly ‘bounce back’ into firm hiring action even after vaccinations reach herd immunity levels.  The herd immunity level is a necessary first step in recovery. But it is not sufficient to shift a manager’s perspective that sales are on a strong growth track.

There Are Growth Opportunities 

However, there are growth opportunities amid the crisis and its aftermath. The economy’s growth is likely to be highly unevenly, skewed to upper-income consumer spending and work from home digitally based markets.  New small business applications are up 20 – 25% as entrepreneurs identify new business opportunities for services businesses, and pandemic triggered demand.  Plus, the Biden campaign has proposed a $2.4T clean energy infrastructure investment in bridges, roads, renewable energy systems, and grid improvements. If enacted, Moody’s Analytics estimates that it will create 18.6M jobs to focus on small business development while holding major corporations accountable for clean energy standard compliance. A slim Democrat majority in the House of 5 votes and a divided Senate make the passage of a significant bill unlikely.

Indicators To Monitor: C.E.O. Confidence in sales growth, and hiring, Department of Labor State Unemployment reports for decreases in initial and continuing unemployment in parallel to increases in job openings, small business hiring reporting from Homebase, surveys of worker expectations for having a job in the next 6 – 12 months. The Census Household Pulse Survey, Opportunity Insights Track the Recovery.

3. Work-From-Home Migration

Sixty-seven million workers are estimated to be working from home today, or about 44% of the workforce. Over 240k workers have moved out of the top five metro urban cities since the pandemic started.  Professionals who had saved up to buy a home saw an opportunity to move to a less expensive area and spend more time with their families.  New and existing home sales have surged through the spring and summer and are now declining as this buyer segment has made the moves they plan to make.

The latest report from Kastle Systems, a key fob security firm, shows 2,600 buildings in the top ten metro areas at an average occupancy rate of 22.9% for the week of December 21st.  Occupancy rates range from 37% in the Dallas metro to 12% for New York City.

Source: Kastle Systems – 12/21/20

Small Businesses Struggle, CRE Valuations Drop

The work-from-home (WFH) migration has impacted small businesses in core cities like New York and San Francisco, where sales dropped 60 -70%.  We noted in our post on commercial real estate valuations, that there is a real probability that property valuations will drop due to high vacancy rates.  A recent survey by the Society for Human Resource Management (SHRM) of 238 corporations showed that executives expect 20% of their employees to permanently work from home. The lack of office space demand is a massive headwind for the commercial real estate market and a drag on the recovery.  In our post, we noted:

“Thus, if 20% of employees WFH will mean a 20% reduction in office space requirements nationwide. In the same survey, employers expected to bring back only 16% of permanently laid-off workers. Managers will look for ways to reduce office space costs by increasing the number of employees who WFH. Executives will find WFH an excellent way to increase profit margins.  Therefore, corporations are interested in leveraging WFH culture and are doing it with fewer employees overall.”

The Long Term Impact of WFH Is Unknown

The economic impact of millions of employees working from home has yet to be determined. However, trends are emerging, showing permanently working from home professionals, accelerated software automation, and small business sales losses.  Offsetting these trends are entrepreneurs working on attractions to bring people back into core cities and managers requiring workers to return to the office. The recently passed stimulus bill will provide relief to workers and help to stabilize the economy. But, the funding will not change the migration out of core cities. Conversely, the relief money may trigger a second wave of moves from additional employees looking to lower living costs.

Indicators to Monitor:  Kastle Systems Occupancy Barometer, surveys of employee interest in working from home, social mobility tracking data gathered from smartphones as people travel to inner cities, commercial real estate company delinquency rates, rate of defaults on office space loans, bond values for office space companies.

4. Housing Debt Bubble

A $90 – 100B debt bubble has grown since March for renters and low-income homeowners out of work. This debt bubble is above the ongoing payments that renters and homeowners need to pay monthly.  About 12M renters faced eviction for January 2021.  The December relief bill extended an eviction moratorium signed by President Trump in August based on C.D.C. virus containment to January 31st. Also, the bill provides $25B in funding for a renter assistance fund.  The move does not offer much time for renters to pay back debt and bring monthly payments current.  The total amount of aid is inadequate for the massive size of the debt bubble.  Unemployed renter households have an average of $5,379 of debt accrued since March.

Sources: Federal Reserve Bank of Philadelphia, The Washington Post – 12/7/20

Sixty-five percent of renters behind on payments have resorted to credit cards to pay their rent bill.  Credit card debt is surging for renters. The predicament creates the possibility that renters will be evicted and become delinquent on their credit cards. Delinquency on their credit cards will trigger a reduction in their credit rating.  With a low credit rating, renters will have difficulty renting again once the economy begins growing.

Small Business Landlords Are Financially Stressed

Landlords receive no funding from the December relief act.  Small business landlords who own 22M of the 44M multi-unit buildings gaining new funding or loans are crucial.  A November UC Berkeley study reported that 40% of small business landlords were not confident they could make mortgage payments in the next few months.   We noted in our post about the Housing Debt Bubble that a solution must be found fast:

“…, small business landlords may evict tenants to find a paying renter… finding another paying tenant could be problematic.  Small business landlords facing declining income and poor prospects for new paying tenants will likely default on their mortgage. There is likely to be a surge in multi-unit buildings for sale, causing a decline in multi-unit building construction.”

The $25B in aid to renters and $600 stimulus checks may mitigate a wave of evictions over the next few months. However, the huge debt remains.

Homeowner Delinquencies Are Increasing

Low-income homeowners continue to have difficulty making payments as mortgage delinquencies jumped to 8.2% last August from 6.1% in July. Delinquencies have stabilized with more forbearance lender agreements.

Black Knight reports that 3M mortgages were in forbearance as of last November.  Eighty percent of those homeowners have requested a six-month extension providing more time to find funding until March 2021.  Without further assistance, they will likely default on their mortgage and causing a forced sale or foreclosure.

Indicators to Monitor:  renter surveys of percentage missing next month’s payments, Mortgage Banker Association reports on total mortgage debt, forbearance totals, and delinquencies and defaults, landlord multi-unit outstanding debt, landlord defaults, number of evictions.

5. Trade

Broad-based tariffs on China have resulted in the highest trade deficit in U.S. – China trade history.  The trade imbalance with China was supposed to grow smaller due to broad tariffs on Chinese goods. Instead, the trade imbalance surged as U.S. consumers continued to buy Chinese goods. While U.S. companies faced declining market share and sales as a result of retaliatory tariffs.

Source: Bloomberg, The Daily Shot – 12/5/20

‘America First’ Has Become ‘America Isolated’

The program to put ‘America First’ has become ‘America Isolated’ while other countries set up new trade ties. On December 30th, the European Union and China announced a trade investment agreement negotiated over the past decade.  The agreement paves the way for German car manufacturers to lower costs while making it easier to access Chinese buyers.  China is now the European Unions’ number one trade partner with $590B in total trade in 2020. The U.S. fell out of first place as an EU trade partner.

Four years ago, when the U.S. left the Transpacific Partnership Pact, the Chinese took America’s place with 12 South East Asian countries.  As a result, China has expanded the agreement to include three more countries in a new pact. The pact is called the Regional Comprehensive Economic Partnership or RCEP.  The agreement calls for lowering trade tariffs, easing customs entry, and standardizing trade protocols. The deal includes all the ASEAN trade countries, Australia and New Zealand, along with China. The RCEP is the world’s largest trade bloc of 2.2 billion people and G.D.P. of 26.2T.

To improve trade, the Trump administration successfully renegotiated the NAFTA agreement with Canada and Mexico. Accordingly, the new agreement provides more access for U.S. farmers to North American markets, ensures job protections domestically, and increases U.S. content of manufactured goods.

World trade will fall by 13 to 32 %, depending on whether the optimistic or pessimistic forecasts prove true for 2020. The World Trade Organization (W.T.O.) forecast 2021 calls for a year to year increase of 5%.

Source: W.T.O. – 6/12/20

However, the W.T.O. sees virus containment, increased trade restrictions, and general deterioration of trade relations as significant headwinds for trade growth.

World Trade Growth Is Critical To Global U.S. Corporations

World trade growth has been a critical growth engine for U.S. multi-national corporations.  S & P 100 companies realize 60 % of their sales and 70 – 80% of total profits from overseas operations.  With world trade uncertain, U.S. corporations will seek to replace weak international sales with domestic customers.  But, the U.S. economy is in a deep recession now and will likely take at least a year or two to recover fully.  It is likely to be 4 or 5 years to return to pre-pandemic employment levels based on previous deep recession history.  The U.S. consumer provides 30% of world consumer spending. Thus, executives looking for growth overseas to jump-start U.S. sales may be disappointed.

Biden Administration Will Focus on Rebuilding Global Partnerships

The Biden campaign proposes to bring the U.S. back into the international world order. The first step is rejoining the Paris Climate Agreement.  Plus, the Biden government will fulfill obligations to fund the World Health Organization and the World Trade Organization. Yet, the new Democratic administration has signaled that it will not reverse all the present trade barriers with China.  So, U.S. companies will have difficulty navigating an uncertain trade relationship in a 1 billion consumer market. It will be a slow grind to retool trade relations with China. Trade relationships take years to build and sustain, so we do not expect international trade to provide economic tailwinds anytime soon.

Indicators to Watch: W.T.O. trade volume, Canada and Mexico to U.S. trade volume and sales, U.S. company international sales, multi-national trade agreements, trade deficit – export and imports, global sales and profits for companies like Apple, Microsoft, Applied Materials, Intel, and other high technology firms.

Major Obstacles Remain To Achieve a Solid 2021 Recovery

The $900B stimulus bill is a band-aid for the 2021 economy.  The liquidity injection is not a cure for the pandemic induced recession.  Intelligently structured, innovative initiatives are required.  Plus, to shift the economy onto a recovery track, trillions of dollars need to be invested.

Mohamed El-Erian, Chief Economist at Allianz, notes the need for policymakers to do the economic structural work necessary for a healthy recovery:

“The immediate injection of fiscal relief should help moderate what recent data suggest is an accelerating loss of momentum for the economic recovery. But it will not alter significantly the general direction of the bumpy road in the short term. Nor will it do much to offset the longer-term risks to economic, social, and institutional well-being.”

 Significant headwinds are picking up strength:

• Too Slow A Vaccination Program To Achieve Herd Immunity by Summer
• The Jobs Engine Is Stalled or Shut down For Many Sectors
• WFH Migration Hollows Out Core Cities:

              – Creating Huge Vacant CRE and Driving Small Business Closings

• Housing Debt Bubble Ready to Burst
• Trade Sales & Profits Will Be Slow to Return

The bottom line is the virus still is in control of the economy.  Until the virus is under control, the recovery will continue to sputter.  Plus, permanent changes to social, geographic, and spending patterns will dislocate existing companies if they don’t change their business models quickly.  The Federal Reserve will continue to provide liquidity.  However, the Federal Reserve is propping up zombie companies, speculative hedge funds, junk bonds, and high risk real estate loans.   Will the Fed have enough monetary firepower to support real investment initiatives if they pass in the next Congress?

Will the Biden Administration Be Successful in Passing Stimulus Bills?

If the Biden Administration can pass major fiscal legislation, then the economy will likely recover quickly. The first six months of the new administration’s work to control the virus, pass fiscal initiatives, and apply innovative policymaking will set the stage for a recovery. Or, a lack of federal leadership will lead to a stalling economy that continues to lose jobs, cut profits, and undermine asset valuations.

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

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

Commentary 1-08-21

• The relative value graphs show the amazing divergence in fortunes that occurred over the past few weeks. Banks (XLF) are about as extreme overbought versus the S&P 500 as we witnessed this past year, while Staples (XLP) the most extreme oversold. In theory, banks benefit from the relation trade as the yield curve steepens and boosts profit margins. Conversely, many staples have to pay higher input costs to produce their goods and may find it difficult to fully pass the costs on to consumers, thus weaker profit margins.
• Materials are decently overbought, and Realestate is strongly oversold. Both sectors are also heavily affected by a perceived ramp-up in inflation. Most other sectors are close to their fair value versus the S&P.
• Not surprisingly, small-caps and mid-caps are deeply overbought versus the S&P. Emerging markets and Developed foreign markets are also overbought as the dollar continues to languish.
• We haven’t discussed bonds in a while but it’s worth noting that TLT (20yr UST) is about as deeply oversold versus IEI (5-7yr UST) as is possible. Again, as long as inflation remains a concern we can expect such underperformance. The same is true on the absolute level analysis in the second set of graphs.
• The sector score scatter plot has a very high R-squared of .814 denoting that most sector returns are in line with their respective relative performance versus the S&P.
• On an absolute basis, most sectors are decently overbought with healthcare and banks leading the way. Staples, despite being grossly oversold versus the S&P, is fairly valued on an absolute basis. Utilities and Realestate are slightly oversold.
• On a factor/index level almost everything is nearing extreme overbought levels (>80%). The S&P 500, shown in the bottom right of the second set of graphs is also nearing the most extreme levels of the last year.
• The third graph below shows that many sectors, and all but one factor/index, are trading above 2 Bollinger bands versus their 20 day ma. There are also a handful trading 2 bands above their respective 50 and 200 day ma’s.
• It may be a little early to bottom fish in the staples sector, but if you are interested in keeping an eye on a few companies, the fourth table below shows the relative score of XLP’s leading companies against each other as well as against the sector ETF (XLP). Using this analysis, Colgate Palmolive (CL) appears to be the most oversold versus XLP and every other company. That said, its relative underperformance versus XLP over the last 20 days of -2.29% is not as bad as we would have guessed based on its score. The underlying companies are by and large trading in line with each other.

Graphs (Click on the graphs to expand)

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Users Guide

The score is a percentage of the maximum/minimum score, as well as on a normalized basis (sigma) for the last 200 trading days. Assets with scores over or under +/-60% and sigmas over or under +/-2 are likely to either consolidate or change trend. When both the score and sigma are above or below those key levels simultaneously, the signal is stronger.

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

The technical value scorecard report is just one of many tools that we use to assess our holdings and decide on potential trades. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

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

In 2019, I discussed the disconnect between the markets and the economy. After years of Central Bank interventions, stock markets have soared to record highs, while economic growth has remained weak. Mohamed El-Erian recently discussed the two primary risks heading into 2021.

El-Erian began his article by asking the most relevant question.

“What, if anything, will happen to the great disconnect between Wall Street and Main Street?”

The Great Disconnect

Currently, Wall Street analysts are projecting record stock markets in 2021, with stock prices rising another 10% and earnings surging toward record levels.

Main Street, however, believes the economy is heading in the wrong direction.

Such is the question we have discussed previously, given that the “stock market is ultimately a reflection of the economy.”

“The detachment of the stock market from underlying profitability guarantees poor future outcomes for investors. But, as has always been the case, the markets can certainly seem to ‘remain irrational longer than logic would predict.’

However, such detachments never last indefinitely.

The stock market is NOT the economy. But the economy is a reflection of the very thing that supports higher asset prices – corporate profits.”

Importantly, this detachment is now a key consideration for policy-makers and investors as we head into 2021.

A Remarkable Gap

“Throughout this pandemic year, we have experienced a further sharp widening of an already remarkable gap between financial markets and the economy. A rapid recovery in asset prices from the March 23 lows took major US indices to record levels, even before the recent good news on Covid-19 vaccines. Combined with even more accommodative central bank policies, this enabled record debt issuance at historically low levels of compensation for creditors.” – El-Erian

There is no doubt that corporations did indeed take the Federal Reserve up on both near-zero interest rates and a guaranteed buyer of bond issuance. In 2020, investment-grade bond issuance hit a record with total non-financial debt soaring to all-time highs. Such was occurring at a time when revenues and profits were plunging.

That data includes the record levels of “junk bond” issuance in the market.

“Issuance in 2020 through August was $291.9 billion, up 71% year over year. Credit strategists at BofA Global Research now project a full-year primary volume of $375 billion. Such would shatter the current record total of $344.8 billion in 2012, according to LCD.”

Of course, the issue is that over the next few years, there is a tremendous amount of debt coming due. If rates risk markedly, or if the market demands payment for the relative risk, refinancing could become problematic.

The other problem is if the economy fails to have a robust economic recovery as Wall Street currently expects.

Expectations For Recovery May Fall Short

There is a significant problem currently which we discussed in “Recessions Are A Good Thing:”

“‘Zombies’ are firms whose debt servicing costs are higher than their profits but are kept alive by relentless borrowing. 

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

The number of “Zombie” companies in the market has hit decade highs in 2020. The massive Federal Reserve interventions, bailouts, and zero rates provided the life support failing companies needed. From a market perspective, the Federal Reserve’s liquidity flows increased speculative appetites, and investors piled into “zombies” with reckless abandon.

These companies’ survivability is based upon a continued low rate environment, a robust debt market, and economic recovery to ensure the ability to repay debt holders.

However, the “recovery” may not be nearly as strong as Wall Street currently expects.

An uncertain economic outlook with notable dispersion among systemically important countries is but one of the Covid-19 legacies that markets have set aside due to sky-high faith in central banks’ ability to shield asset prices from unfavorable influences.” – Mohamed El-Erian

Even with a “Second Stimulus,” the underlying erosion of economic growth from rapidly rising debts and deficits leaves little margin for error.

“[The economy] requires increasing levels of debt to generate lower rates of economic growth. The chart shows both CARES Acts and the impact on GDP growth.”

Such is why the Federal Reserve has found itself in a “liquidity trap.”

Rates MUST remain low, and debt MUST grow faster than GDP, to keep the economy from stalling out.

Moral Hazard

In the short-term, however, market participants have been lulled into a false sense of security. Currently, investors are paying astronomical prices for “risk” assets. At the same time, they accept low rates on “high yield” debt (aka junk bonds) relative to the risk of default.

The detachment of investor attitudes from the underlying risk is precisely the definition of “Moral Hazard:”

“Noun – ECONOMICS

The lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.”

As Mohammed El-Erian specifically noted:

Markets being markets, investors have readily extended the protective nature of the umbrella to asset classes that, at best, are only indirectly supported by central bank funding (such as emerging markets).

It is an extremely powerful dynamic, and one that inevitably overshoots.

In other words, investors “believe” they have an insurance policy against “risk.”

Nothing is more reassuring to an investor than the knowledge that central banks, with much deeper pockets, will buy the securities they own — particularly when these buyers are willing to do so at any price and have unlimited patient capital.

The rational investor response is not just to front-load their buying but also to look for related opportunities where return-seeking funds will be pushed to. The result is not just seemingly endless liquidity-driven rallies regardless of fundamentals.

Such does seem to be the case until an unexpected exogenous event occurs, or if the Fed tries to normalize monetary policy. In either event, the underlying “risk” becomes quickly realized as a “financial crisis.”

The resulting destruction of household net worth requires an immediate response by the Fed of zero interest rates and liquidity. Subsequently, they are forced to create the next “bubble” to offset the deflation of the last.

Irrational Exuberance

Importantly, what the Federal Reserve did accomplish was creating a demand for “risk” assets by distorting market functions and price discovery. As El-Erian noted:

“While investors will continue to surf a highly profitable liquidity wave for now, things are likely to get trickier as we get further into 2021. Central banks’ deepening distortion of markets will be harder to defend in a recovering economy amid rising inflationary expectations.

Nowhere is this more evident than in recent surveys that show an extremely high level of investor exuberance despite the underlying detachment from fundamentals.

“The chart below shows the combined average of institutional and individual investor valuation confidence subtracted from future returns confidence. When the reading is positive, the confidence the market will be higher one year from now is more elevated than the confidence in the market’s valuation.  The opposite is the case when the reading is in negative territory.

The key takeaway is that investors think simultaneously, the market is over-valued but likely to keep climbing.” – Charting 2020’s Speculative Mania

Such is the same phenomenon famously described by former Fed Chair Alan Greenspan in a December 1996 speech on “Irrational Exuberance.” 

Whenever such detachments between the real economy and markets have previously occurred, investor outcomes have not been kind. It is unlikely this time will be different.

Investors might rue the day they ventured into asset classes far from their natural habitat that lack sufficient liquidity in a correction. Navigating such a landscape will require analytical tools that would, ironically, have detracted from returns during the bulk of the liquidity-driven rally.” – El-Erian

The Wealth Gap Explodes

The problem of the disconnect between the economy and the markets is that it is unsustainable long-term. According to the Economic Policy Institute, the top 1% take home 21% of all income in the United States, the largest share since 1928.

There are various social, political, and economic factors driving this growing discrepancy, but one critical factor is ignored – The Federal Reserve. When the Fed inserted itself into the economic equation, their contribution led to rising imbalances between economic classes.

Over the last decade, as stock markets surged, household net worth reached historic levels. If one just looked at the data, it was clear the economy was booming. However, for the vast majority of Americans, it wasn’t. The WSJ showed this previously:

“The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000.”

Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A full 33% of that gain—$19 trillion—went to the wealthiest 1%, according to a Journal analysis of Fed data.

No Longer Sustainable

What policy-makers, and the Federal Reserve missed, is the “stock market” is NOT the “economy.” 

This “wealth gap” can be directly traced back to a decade of monetary policy that almost solely benefited those who either had money to invest in the financial markets or were compensated through increases in corporate asset prices. However, those policies failed to produce substantial rates of either wage growth or full-time employment.

The reality is that we have likely reached the efficacy of monetary interventions. As such, El-Erian’s concluding comment is most important.

“Already, the great disconnect has continued much longer than most expected. This illustrates, yet again, the unintended consequences of a policy approach that places an excessive burden on central banks.

There are two risks, and not just for markets.

First, what is desirable may not be politically feasible, and second, what has proven feasible is no longer sustainable.”

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What You Missed On RIA This Week Ending 1-8-21

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

Here is this week’s rundown of what you missed.

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RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors now has the capability to manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes we can get you in the “right lane” for retirement.

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What You Missed This Week In Blogs

Each week, RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risks that may negatively impact our client’s capital. These are the risks we are focusing on now.

Why There Is Literally No “Cash On The Sidelines.”

Technically Speaking: Navigating Market Lingo In 2021

Technically Speaking: S&P 500 – Trading At Historical Extremes

S&P 500 – EOY 2020 Valuation & Analysis Review

The Fed is Juicing Stocks

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What You Missed In Our Newsletter

Every week, our newsletter delves into the topics, events, and strategies we are using. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how we plan to trade it.

So Far, The Bulls Are Disappointed In “Santa” (Full Version)

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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 for 30-days free) If you are a DIY investor, this is the site for you. RIA PRO has all the tools, data, and analysis you need to build, monitor, and manage your own money.

Viking Analytics: Weekly Gamma Band Update 1/04/2021

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The Best Of “The Real Investment Show”

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

Best Clips Of The Week Ending 1-8-21

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What You Missed: Video Of The Week

Jeremy Grantham is right. We are in a stock market bubble, but its NOT about valuations.

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Our Best Tweets For The Week: 1-8-21

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.

#Goldman boosted their #GDP growth estimates yesterday based on another $750b is #stimulus.
– Stimulus only drags forward future consumption.
– It does not increase #productivity which creates organic #economic growth.
– Economic growth will weaken when stimulus ends. pic.twitter.com/NnOeLHqE51

— Lance Roberts (@LanceRoberts) January 7, 2021

Hasn’t even started yet and she is bought. https://t.co/qIoe4WGtlp

— Michael Lebowitz, CFA (@michaellebowitz) January 1, 2021

Higher interest rates
Higher energy prices
Rising inflationary pressures.
Not a great backdrop for an $18 Trillion #economy with $85 Trillion in #debt. @SoberLook pic.twitter.com/mjUYVfmXVJ

— Lance Roberts (@LanceRoberts) January 7, 2021

Here is my prediction of how the market reacts tomorrow.
– Dem's win…market up.
– Rep's win…market up.
– Split win…market up

It really doesn't matter because they are all the same. Regardless of who wins inequality will wide, and economy will weaken. pic.twitter.com/tdR2Bu19Jq

— Lance Roberts (@LanceRoberts) January 6, 2021

Well…..here's a positive note….if you don't like the way things are going now….they could be worse. pic.twitter.com/E7l3Q61sUK

— Lance Roberts (@LanceRoberts) January 7, 2021

See you next week!

Draining the Asset Pool

The Fed conducts monetary policy by governing the Fed Funds Rate. To do this, they buy and sell Treasury securities via open market operations. When the Fed wants to lower rates, they buy Treasury debt. In doing so, they reduce the supply of investible debt, making remaining debt more expensive (lower yield). They most often buy or sell short term Treasury Bills to affect the short term Fed Funds rate. Open market operations also add or drain the banking system’s liquidity to help further hit their target.

More recently, with Fed Funds at zero percent, they have conducted QE or large-scale asset purchases. These operations help manipulate rates across the maturity curve and not just Fed Funds. QE, as with traditional open market operations, reduces supply, boosts prices, and lowers yields.

With knowledge of the Fed’s modus operandi, let’s go swimming.

Think of the asset markets as a big swimming pool. The kiddie pool is for risk-averse investors, and the deep end is home for the riskiest of investors. While the depth of the water varies extensively, the water level is the same throughout the pool.

Imagine the Fed comes to our pool with a giant bucket and removes gallons of water from the shallow end. What happens to the water level for the entire pool? It falls, and consequently, there is less water to swim in. The effect is more obvious in the shallow end as the depth was lower to begin with. Regardless of appearances, the water level in the deep end falls by the same amount.

Some of our risk-averse shallow end swimmers will now take a step or two towards the deep end.  They may move from Treasury Bills to short term corporate bonds or mortgages. As investors take on more risk, they start crowding out other investors and pushing everyone toward the deep end.

Less water means less supply of investible assets. The basic laws of supply and demand clearly state that less supply and the same demand result in higher prices.

Leverage

One of the Fed’s recent accomplishments during this economic crisis is fostering easy financial conditions. Such an environment allows companies to borrow and reduce the possibility of default. Another benefit is it encourages investors to use more leverage as borrowing is easier to attain and cheaper.

The two graphs below show borrowing conditions have rarely been easier. Typically a recession has the exact opposite effect on lending conditions.

“U.S. financial conditions are the easiest they’ve been in more than a quarter century as stock markets scale new heights on hopes of an end to the Covid-19 pandemic, according to an index compiled by Goldman Sachs Group Inc.” – Bloomberg 12/14/2020

More leverage allows speculators and traders to amass larger holdings than would otherwise be possible. Much of this leverage comes from the repo markets. Repurchase transactions, or repo, is a loan collateralized with an asset. For example, an investor buys a security, pledges it as collateral, and uses the borrowed funds to buy more assets. The investor holds more assets with the same original investment.

The Fed has been actively providing funds to the repo markets resulting in more liquidity and lower borrowing rates since the fall of 2019. At its peak in March, the Fed supplied over $400 billion in repo funding to the market. This source of funds allowed for the increased demand for assets, and as you would expect, this includes stocks.

Fed Put

Investors are like Pavlov’s dogs. Increasingly they associate Fed actions with more stimulus, easier financial conditions, and higher asset prices. The Fed has responded by becoming more verbally accommodative via talking up policy options when markets hit rough patches.

Fed actions or even words of encouragement become buying opportunities. As such, prices do not decline as much as they might have, and volatility is muted as a result. Muted volatility encourages more investment and speculation as risks, measured using common financial math, such as standard deviation, are perceived to be lower.

More return with less perceived risk encourages more risk-taking, ergo more interest in stocks.

Fed Supports Passive Investing

Reduced volatility and eye-popping returns are increasingly leading investors to focus on momentum and passive strategies. Active investors, forecasting economic and earnings trends, and assessing valuations get left behind in momentum-driven markets. As these investors lose assets or switch to more passive strategies, passive strategies by default play a more prominent role in asset pricing. For more, please read our article: The Market’s Invisible Guardrails Are Missing.

Active investors tend to hold cash to take advantage of opportunities that may occur in the future. Further, at times like today, when valuations are historically extreme, active investors take profits and may not find suitable replacements, also increasing their cash balances.

Passive investors are typically fully invested. Cash, after all, is a performance drag in upward trending markets. They do not sell because of high valuations but switch from one index to another based on momentum.

Due to the steady gravitation from active to passive strategies over the last decade, system-wide cash balances are reduced, and there is more demand to buy assets. As shown below, courtesy SentimentTrader, equity mutual fund cash balances are 70-year lows.

Summary

Our summary is short and sweet, so even a five-year-old can understand.

The Fed juices stocks!

Welcome to 2021. As we kick off a new year, we begin with the S&P 500 trading at historical extremes. It is essential to have some perspective to set reasonable expectations for future returns and quantify the “risk” of something going wrong.

As we discussed with our RIAPRO.NET subscribers yesterday, the real risk to the market in 2021 is over-confidence.

“Currently, Wall Street analysts are wildly exuberant on expectations of explosive economic growth, rising interest rates, and inflation. The problem with those expectations is that in an economy that is $85 Trillion in debt, higher rates and inflation are a ‘death knell’ to economic growth.

Yes, while the Fed may come to the rescue with more QE, with markets already trading at 36x times earnings it is becoming increasingly difficult to justify overpaying for earnings. Eventually, corporate earnings are going to have to markedly improve, or prices will revert.”

There is a high long-term correlation between the index and earnings of 88%. As shown, extreme deviations from the long-term correlation have always preceded short- to intermediate-term corrections.

Short-Term It’s A Coin Toss

In the short-term, which equates from a few days to a few weeks, markets are sentiment-driven. As we showed in “2020-A Year Of Speculative Mania,” investor sentiment is just about as “bullish” as it can get.

“The chart below shows the combined average of institutional and individual investor valuation confidence subtracted from future returns confidence. When the reading is positive, the confidence the market will be higher one year from now is more elevated than the confidence in the market’s valuation.  The opposite is the case when the reading is in negative territory.

The key takeaway is that investors think simultaneously, the market is over-valued but likely to keep climbing.” 

“Such is the same phenomenon famously described by former Fed Chair Alan Greenspan in a December 1996 speech on ‘Irrational Exuberance.'”

However, it is that “sentiment,” or more commonly known as the “Fear of Missing Out,” that can continue to drive prices higher in the short-term.

As shown, the S&P index is currently overbought and trading significantly above its 200-dma. However, with the Bollinger Bands narrowing, the market could trade higher over the next month.

Such a move higher would align with our expectations of the current bullish trade to continue into January.

However, with the more extreme deviation from the 225-day moving average, somewhere between February and March, we could see a correction take hold. Such would be akin to what we saw during the first half of the last 3-years.

Intermediate-Term Is Worrisome

For investors, the outlook becomes much more troubling as we look further out.

The market is trading 3-standard deviations above its long-term mean and is incredibly overbought on a weekly basis. At the same time, there is a negative divergence in relative strength (RSI), which is also a cause of concern.

Since weekly charts are slower moving, such does not mean the markets will crash immediately. Long-term charts indicate that price volatility will likely be higher in the months ahead, and investors should monitor their risk accordingly. While momentum-driven markets can remain irrational much longer than logic would predict, eventually, a reversion has always occurred.

The chart below shows the price deviation from the one-year weekly moving average. Given the deviation is above 15%, price corrections have always been nearby. (Such does not mean a market crash. A correction of 10-20% is well within norms.)

Long-Term View Is Bearish

The monthly chart of the S&P 500 is likewise just as problematic. Again, long-term charts predict long-term outcomes and are NOT SUITABLE for trading portfolios short-term. As shown, the deviation from long-term monthly means and negative divergences in relative strength has previously been warning signs for more significant corrections.

We see the same problematic setup when viewing the market’s current deviation from its 2-year monthly moving average. The current deviation has only occurred 5-times since 1960 and has always led to a correction over the next several months. (Some worse than others.)

However, since 1900, using QUARTERLY analysis, the picture is bearish for returns over the next decade. The research below aligns valuation, relative strength, and deviations into one chart.

There is little to suggest investors who are currently extremely “long equity risk” in portfolios now won’t eventually suffer a more severe “mean-reverting event.” 

While valuations and long-term deviations suggest problems for the markets ahead, such can remain the case for quite some time. It is this long lead time that always leads investors to believe “this time is different.” 

Because of the time required for long-term data to revert, monthly and quarterly data is more useful as a guide to managing expectations, allocations, and long-term exposures. In other words, this data is not as valuable as a short-term market-timing tool.

What Could Cause A Correction In 2021? 

Lots of things.

The market is currently priced for perfection betting on explosive economic growth, a falling dollar, interest rates remaining low, consumer spending surging sharply, and inflation remaining muted. The reality is that none of those things will likely turn out to be the case.

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

That is the risk we are paying attention to right now.

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In the later stages of a bull market advance, the financial media and Wall Street analysts start seeking out rationalizations to support their bullish views. One common refrain is “there are trillions of dollars in cash sitting on the sidelines just waiting to come into the market.” 

For example, Barron’s recently penned the following:

“There is record amounts of cash sitting in checking accounts of American households—and for optimistic investors, it’s just one more reason the stock market should keep pushing higher. 

Yahoo! Finance also jumped on the claim:

“It should also come as no surprise that there’s never been so much cash sitting on the sidelines — nearly $5 trillion, as a matter of fact. This is significantly above the record $3.8 trillion in cash set back in January 2009 during the financial crisis!”

McKinsey & Co also published the following graphic.

See. There are just tons of “cash on the sidelines” waiting to flow into the market.

Except there isn’t.

The Myth Of Cash On The Sidelines

Despite 10-years of a bull market advance, one of the prevailing myths that seemingly will not die is that of “cash on the sidelines.” To wit:

“A growth bomb”: 3.5$ trillion of excess cash on the sidelines” – Forbes

Please stop it.

Such is the age-old excuse why the current “bull market” rally is set to continue into the indefinite future. The ongoing belief is that at any moment, investors are suddenly going to empty bank accounts and pour them into the markets. However, the reality is if they haven’t done it by now, following 4-consecutive rounds of Q.E. in the U.S., a 400% advance in the markets, and ongoing global Q.E., precisely what is it going to take?

But here is the other problem.

For Every Buyer

For every buyer, there MUST be someone willing to sell. As noted by Clifford Asness:

“There are no sidelines. Those saying this seem to envision a seller of stocks moving money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Every transaction in the market requires both a buyer and a seller, with the only differentiating factor being at what PRICE the transaction occurs. Since this is necessary for there to be equilibrium in the markets, there can be no “sidelines.” 

Think of this dynamic like a football game. Each team must field 11 players despite having over 50 players on the team. If a player comes off the sidelines to replace a player on the field, the substituted player will join the other sidelined players’ ranks. Notably, at all times, there will only be 11 players per team on the field. Such holds equally true if teams expand to 100 or even 1000 players.

Furthermore, despite this very salient point, a look at the stock-to-cash ratios (cash as a percentage of investment portfolios) also suggests there is very little available buying power for investors currently. As we noted just recently with charts from Sentiment Trader:

The Lack Of Cash

As asset prices have escalated, so has an individual’s appetite to chase risk. The herding into equities suggests that investors have thrown caution to the wind. Such also means they have deployed most of their investible cash.

Of course, once you run out of cash to invest, the next step is to “borrow cash” to increase equity allocations. With professional investors leveraging their bets, there isn’t much excess cash sitting around.

Mutual fund managers are also holding record low levels of cash.

With net exposure to equity risk by individuals at historically high levels, it suggests two things:

1. There is little buying left from individuals to push markets marginally higher, and;
2. The stock/cash ratio, shown below, is at levels ordinarily coincident with more important market peaks.

The reality is investors are holding very little ‘cash’ as they have gone “all-in” to chase the market higher.

So, Where Is All This Cash Then?

The statement is correct in that money market cash levels have indeed been climbing. The chart from the Office Of Financial Research shows this:

There are a few things we need to consider concerning money market funds.

1. Just because I have money in a money market account doesn’t mean I am saving it for investing purposes. It could be an emergency savings account, a down payment for a house, or a vacation fund on which I want to earn a higher rate of interest. 
2. Also, corporations use money markets to store cash for payroll, capital expenditures, operations, and various other uses not related to investing in the stock market. 
3. Foreign entities also store cash in the U.S. for transactions processed in the United States, which they may not want to repatriate back into their country of origin immediately.

The list goes on, but you get the idea.

If you look at the chart above, you will notice that the bulk of the money is in Government Money Market funds. These particular types of money market funds generally have much higher account minimums (from $100,000 to $1 million), suggesting these funds are not retail investors. (Those would be the smaller balances of prime retail funds.)

Corporations Are Hoarding Cash

As noted, much of the “cash on the sidelines” is held by corporations. As we said in “A Major Support For Assets Has Reversed,” such isn’t a surprise:

CEO’s make decisions on how they use their cash. If concerns of a recession persist, companies will become more conservative on the use of their cash, rather than continuing to repurchase shares.” – September 2019

As we also stated in that article:

“When stock prices do eventually fall, companies that performed un-economic buybacks would find themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the many CEO’s who sanctioned buybacks, are much wealthier and unaccountable for their actions.”

As we saw, the same companies which have spent billions on “share buybacks” over the last decade were the first ones in line for a Government bailout earlier this year. Now, companies are hoarding cash as we approach the end of the year to ensure their survival against a weaker economic environment in 2021.

Debt-Driven Cash Levels

The other problem is that record debt issuance by corporations was the driver of record-cash levels. As per the WSJ:

“Cash hoards swelled this year after companies issued record-breaking amounts of debt to bolster their balance sheets against the Covid-19 pandemic’s disruptions. As of Nov. 30, U.S. companies had sold more than $2 trillion of investment-grade and high-yield bonds—the most on record in data going back to 2006—according to LCD, a unit of S&P Global Market Intelligence.

At the same time, many cut share repurchases, dividends or capital expenditures.”

Of course, the problem with debt is that it is not “free” money even at low-interest rates. The interest on the debt diverts capital from productive investments. Companies must use their cash to make “productive” investments that will generate a return higher than the debt cost or pay down debt. Given that economic growth will likely remain weak, along with revenue growth, the former will be difficult. If inflationary pressures and interest rates rise, as many expect, cash will get used to pay off debt rather than invest.

While the bulls are certainly hoping the “cash hoard” will flow into U.S. equities, the reality may be quite different.

What Changes The Game

As noted above, the stock market is always a function of buyers and sellers, each negotiating to make a transaction. While there is a buyer for every seller, but the question is always at “what price?” 

In the current bull market advance, few people are willing to sell, so buyers must keep bidding up prices to attract a seller to make a transaction. As long as this remains the case, and exuberance exceeds logic, buyers will continue to pay higher prices to get into the positions they want to own.

Such is the very definition of the “greater fool” theory.

However, at some point, for whatever reason, this dynamic will change. Buyers will become more scarce as they refuse to pay a higher price. When sellers realize the change, there will be a rush to sell to a diminishing pool of buyers. Eventually, sellers begin to “panic sell” as buyers evaporate and prices plunge.

Sellers live higher. Buyers live lower.

What causes that change? No one knows.

But that is how bear markets begin.

Slowly at first. Then all of a sudden.

S&P 500 EOY 2020 Valuation & Analysis Review

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

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

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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December 2020 Review

E-Mini S&P 500 Futures

We begin with a review of E-Mini S&P 500 Futures (ESH1) during December 2020. In our December 2020 edition of The Cartography Corner, we wrote the following:

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

• M4                 4111.00
• M3                 3981.75
• M1                 3795.00
• PMH              3668.00
• Close            3623.25      
• MTrend        3410.87
• M2                3261.50
• PML              3243.25     
• M5                 2945.50

Active traders can use PMH: 3668.00 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 December 2020 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  December consisted of five swing trades with returns, on a settlement basis, of 2.13%, (1.63%), 2.00%, (0.96%), and 1.94%.

Liquidity and volume typically decline in the month of December, magnifying the actions of market participants with an ax to grind, and this December was no exception.  On December 21^st, during the Asian and European market hours, some market participants had a “sell ax”.  That session’s trading range equaled 128 points, or 3.47%, eclipsing the cumulative month-to-date range.  By the end of the session, the market price had recovered most of the overnight decline.

Conservatively, active traders following our analysis realized a gain of 0.75%.  

Figure 1:

E-Mini Russell 2000 Futures

We continue with a review of E-Mini Russell 2000 Futures (TFH1) during December 2020.  In our December 2020 edition of The Cartography Corner, we wrote the following:

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

• M4         2236.50
• M3         2103.40
• M1         2075.50
• PMH       1863.60
• Close      1820.10
• MTrend   1601.52
• M2         1561.30           
• PML        1526.00                       
• M5           1400.30

Active traders can use PMH: 1863.60 as the pivot, maintaining a long position above that level and a flat or short position below it.

Figure 2 below displays the daily price action for December 2020 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first three trading sessions of December saw the market price ascend to our isolated pivot level at PMH: 1863.60.  On the fourth trading session, the market price settled above that level.  It was not tested for the remainder of the month.

Active traders following our analysis realized a gain of 4.4%.

Figure 2:

January 2021 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESH1).  The same analysis can be completed for any time-period or in aggregate.

Trends:

• Current Settle         3748.75       
• Daily Trend             3730.89
• Weekly Trend         3695.36       
• Monthly Trend        3518.11       
• Quarterly Trend      3274.01

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.  In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures are “Trend Up”, having settled above Quarterly Trend for three quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures are in “Consolidation”, after having settled six of the previous seven months above Monthly Trend.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures have been “Trend Up” for nine weeks.

One rule we have is to anticipate a two-period high (low), within the following four to six periods, after a Downside (Upside) Exhaustion level has been reached.  The two-period low that we were anticipating in the weekly time-period was achieved during the week of December 21^st.

Our timing-cycle work indicates January 7, 2021, as the next important cycle date (Strength: 100/100).  Often, the price action of the trading session before the cycle date establishes a key range that is exceeded, confirming the direction of the trend change (or acceleration of the current trend).  Hence, there are a few clues before the cycle date.  Once the direction is established, market participants can anticipate a trend into the next projected cycle date, or a move to a price that represents an Exhaustion Level.  Given that the next cycle date occurs in 2Q2021, we suggest focusing on the Q4: 4433.25 and Q5: 2867.40 as upside and downside Exhaustion Levels.

It is worth noting that the Georgia Senate runoff election is on January 6th, with January 7th being the first trading session with the election results known.  Given that the balance of the Senate is at stake, we suggest paying close attention to the cycle date.

Support/Resistance:

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

• M4                 4262.75
• M2                 3948.75
• M3                 3874.25
• M1                 3838.00
• PMH             3753.00      
• Close             3748.75
• PML               3596.00
• M5                 3524.00    
• MTrend         3518.11

Active traders can use PMH: 3753.00 as the pivot, maintaining a long position above that level and a flat or short position below it.

Gold Futures

For January, we focus on Gold Futures.  We provide a monthly time-period analysis of GCG1.  The same analysis can be completed for any time-period or in aggregate.

Trends:

• Current Settle       1895.10         
• Daily Trend           1889.44
• Weekly Trend       1882.01         
• Monthly Trend      1864.24         
• Quarterly Trend    1839.99

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, Gold Futures have been “Trend Up” for nine quarters.  Stepping down one time-period, the monthly chart shows that Gold Futures are in “Consolidation”.  Stepping down to the weekly time-period, the chart shows that Gold Futures have been “Trend Up” for four weeks.

Our timing-cycle work indicates January 7, 2021, as the next important cycle date (Strength: 100/100).  Often, the price action of the trading session before the cycle date establishes a key range that is exceeded, confirming the direction of the trend change (or acceleration of the current trend).  Hence, there are a few clues before the cycle date.  Once the direction is established, market participants can anticipate a trend into the next projected cycle date, or a move to a price that represents an Exhaustion Level.

The cycle dates for this cycle are fixed without regard for a particular market.  They are applicable across all markets.

Support/Resistance:

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

• M4         2056.80
• M3         2009.30
• PMH       1912.00
• Close      1895.10
• MTrend  1864.24
• M1           1857.90
• M2         1789.60           
• PML        1778.40                       
• M5           1590.70

Active traders can use M1: 1857.90 as the pivot, maintaining a long position above that level and a flat or short position below it.

Risk Appetite Index

We have constructed a Risk Appetite Index for our clients.  The index measures the normalized relative twelve-week price returns between an equal-weight portfolio of risk assets and an equal-weight portfolio of apex assets.  Risk assets include E-Mini S&P 500 Futures, High Yield Corporate Bond ETF (HYG), Emerging Markets ETF (EEM), and Emerging Markets Bond ETF (EMB).  Apex assets include Gold Futures, U.S. Dollar Futures, Five-Year Treasury Note Futures, and U.S. Treasury Bond Futures.  We can interpret this as a Risk-On / Risk-Off gauge.

As shown below in Figure 3, the index has just turned lower from a local peak of 80.6 reached during the week of December 21^st.  From the 80-100 percentile, historically, risk assets have underperformed apex assets by an average of 8.43%.

Figure 3:

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.

What You Missed On RIA This Week Ending 12-31-20

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

Here is this week’s rundown of what you missed.

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We Need You To Manage Our Growth.

Are you a strong advisor who wants to grow your practice? We need 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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What You Missed This Week In Blogs

Each week, RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risks that may negatively impact our client’s capital. These are the risks we are focusing on now.

Shades Of 1999 As “Market Mania” Returns In 2020

Technically Speaking: Navigating Market Lingo In 2021

Plus ça change: A French Lesson in Monetary Debauchery

David Robertson: “Bonfire Of Money” & The Distortion Of Capital

What Will Your 2021 Be ‘About?’

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What You Missed In Our Newsletter

Every week, our newsletter delves into the topics, events, and strategies we are using. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how we plan to trade it.

All I Want For Christmas Is A Bull Market (Full Version) 12-25-20

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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 for 30-days free) If you are a DIY investor, this is the site for you. RIA PRO has all the tools, data, and analysis you need to build, monitor, and manage your own money.

Technical Value Scorecard Report For The Week of 12-31-20

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The Best Of “The Real Investment Show”

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

Best Clips Of The Week Ending 12-31-20

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What You Missed: Video Of The Week

Michael Lebowitz and I discuss why there really is “no cash on the sidelines.”

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Our Best Tweets For The Week: 12-31-20

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.

Consensus of the vast majority of #analysts is that #markets will continue their #bullish advance in #2021 (I hope so as our #portfolios are overweight #equity at the moment.) Worth considering that a #correction back to the running mean is 23% lower. pic.twitter.com/adnSKdVRNC

— Lance Roberts (@LanceRoberts) January 1, 2021

Hasn’t even started yet and she is bought. https://t.co/qIoe4WGtlp

— Michael Lebowitz, CFA (@michaellebowitz) January 1, 2021

It's good to know that while 2020 sucked for 99% of the population, the top 1% had a great year.
h/t @zerohedge pic.twitter.com/ubt0opmI06

— Lance Roberts (@LanceRoberts) December 31, 2020

Why should Jamie Dimon, Bill Gates, and many others get $600 checks? Don't they already get enough government/Fed sponsored handouts?

— Michael Lebowitz, CFA (@michaellebowitz) December 23, 2020

Fascinating chart from #ChartsAndMarkets.com showing the 8-month rate of change in #margindebt and #market peaks. Whenever the ROC is 50% or more over an 8-month period, market peaks have not been far behind. pic.twitter.com/RrLPQ4PVsW

— Lance Roberts (@LanceRoberts) December 30, 2020

Keep a watch on $TLT. Price has been consolidating with slowly rising bottoms, and moneyflow has been surging over the last two weeks. A breakout (falling rates) might be the surprise no one is expecting in January (#riskoff trade) pic.twitter.com/yOL02ovoEk

— Lance Roberts (@LanceRoberts) December 30, 2020

See you next week!

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

Commentary 12-31-20

• On a relative basis, the S&P 500 sectors changed little over the last week. Utilities, Staples, and Real Estate are slightly less oversold, while Banks and Energy fell slightly. After being the hottest sector for the last 2 months, Energy is now marginally oversold. The third graph below compares each sector’s excess return versus the S&P over 4 time periods. The returns are normalized by dividing the period return by the number of days in each period. Over the last 10 days energy (XLE) is down .45% a day on average. Normalizing the data helps us better gauge trends in excess returns. For instance, note that the negative returns for XLU have been consecutively less negative over the 3 longer time periods, and turned slightly positive over the last five days.
• There was little change in the relative factor/index readings. Small Caps and Mid Caps retreated from grossly overbought levels as they were the worst performers on the week versus the S&P 500. The Dow 30 and Value versus Growth are the only relative oversold sectors.
• On an absolute basis, little has changed, but here too Utilities, Staples, and Real Estate improved, and sit near fair value.
• When comparing this week’s absolute factor/index to last week, it appears that all factors and indexes have gravitated to moderately overbought. For Small and Mid Caps, this was from a decline from grossly overbought levels. As shown in the bottom right, in the second series of graphs, the S&P remains overbought, but not as extreme as it was over the last two months.
• In general sectors, factors, and indexes normalized with overbought sectors underperforming and oversold sectors doing a little better. We are careful not to read too much into this due to low volume holiday trading and year-end window dressing.

Graphs (Click on the graphs to expand)

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Users Guide

The score is a percentage of the maximum/minimum score, as well as on a normalized basis (sigma) for the last 200 trading days. Assets with scores over or under +/-60% and sigmas over or under +/-2 are likely to either consolidate or change trend. When both the score and sigma are above or below those key levels simultaneously, the signal is stronger.

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

The technical value scorecard report is just one of many tools that we use to assess our holdings and decide on potential trades. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

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

Ponder in 2021. What will your New Year be about?

I had a friend in elementary school who would answer every question with a question.  He was the eternal QWAQ (question with a question) enigma. Only recently, I realized what a genius he was.

Hey, Tommy, how are you feeling today?

About? 

It made me crazy. About. About? Is that an answer? 

Then I thought of the word within the context of 2020 to anchor myself for 2021. Perhaps some readers will appreciate the perspective. Stay with me.

What’s Your Life About?

Will you reassess priorities for 2021?

What are all your experiences, heartaches, memories, and trials worth to you? To others? Are you up to the journey for 2021? What are your plans to forge ahead?

The “about” is a continuous change. A journey. Because the “about of life” is a moving target depending on where you are currently. It’s a culmination of experiences – past and present that inspire motivation and, ultimately, actions. Also, the “about” in all of us can expand and contract regardless of age. 

How Does ‘About’ Rise To A Life’s Surface?

All it takes is a spark or event that flips a switch in your head. Sometimes you don’t realize it until compelled to act, regardless of personal consequences. For me, it was the financial crisis and the aftermath. I realized my life was “about” the clients I served above all else, including my health.

Decades ago, I formed a mission to help people make positive money decisions and changes that would improve long-term fiscal health. I sought to help others cut through the hype, the dogma (and there are piles of dogma in financial services). Subsequently, I realized that money was much more than swapping out a portfolio’s investment A for investment B.

I Believed A Lie.

Unfortunately, I bought into the bull-market hype early in my career. In 2006, I dug deeper into market history, studied people – their motivations and emotions on the highs and lows of money.  As a result, I began to understand how imperfect everything was. Is. Even seeking to be perfect is an imperfection, a flaw. Yet, for some odd reason, young brokers were taught how the market was eternally, perfectly a rising bull.

Stocks always rebounded from significant losses and created massive wealth for participants, allegedly. Spokespeople for my former employer lamented in 2007 that a financial meltdown was a statistical impossibility, and I should ignore the signs of imminent carnage in fixed income markets.

I finally realized that market wealth for many investors doesn’t recover quickly (if at all) from significant contractions. The precious time it takes for investments to break even is worth something to households but nothing to brokerage firms. The ultimate winners are these financial organizations. In their boardrooms, clients are not flesh and blood. People, households are categorized as revenue winners or losers, reduced to numbers in financial statements. 

I sought to be a source of information, the reference point of a clear perspective. I wanted badly to offer clarity to media outlets, clients, and yes, even to mentors who shall remain smarter, more perceptive, and bigger-than-life (in my eyes anyway). 

Speaking of mentors.

Mentors Should Be Smart.

Heck, they should be better, sharper. It should be all ‘about’ them.

Perhaps 2021 is ‘about’ learning from people smarter than us. And there are a lot of intuitive humans around if you open your eyes to them.  Frankly, we can seek to learn from anyone if we’re open-minded enough.

My definition of “smart” is sparked by communication that flushes my skin and makes me feel like there’s the wind in my face even if standing in west Texas. In August. At noon. Not a breeze to be found. Also, mentors come in various sizes, colors, ages. 

Some don’t even need to be human.

My Personal ‘About’ Was Late To The Game.

I guess what I’m saying is the “about” in my life came along pretty late, and I want to make sure you don’t make the same mistake. During the 2008 financial crisis, I woke up. The lovely house of cards we call ‘the system’ was ‘about’ to fold in on itself and take most of us with it. 

My veil of ignorance lifted. The light of truth entered my thoughts. It encouraged me to dig deeper into my personal “about.” The disaster shook my world. 

I dug into the ‘about’ of lots of things, including the financial services business. Most of what I found, I didn’t like. Frankly, still, I’m not too fond of it. Subsequently, I was motivated to change my future and help form a financial firm that cuts through the bullsh*t with, thankfully, partners today who feel the same. 

Daily, I help others with decisions, correct the incorrect brokers expound (they’re called brokers for a reason; they break stuff). On the day after Christmas, I assisted a radio listener to unwind the junk his broker told him about Social Security, ran an analysis one hour later, and changed his mind.

Who Helps Me On My Journey? Who Helps You?

Make your “about” somewhat about them in 2021.

Let them know how much you appreciate their guidance. 

For me, it’s a cadre of writers, associates, academics; our employees who do everything they can to help RIA fulfill its mission. Philosophers, the stoics (more about them on my 2021 recommended reading list coming soon), academics help me think outside the financial box. 

Then, there’s a woman at a local donut shop who works the morning shift to raise four kids. She smiles and makes me laugh. I slip her a twenty. She thanks me. She smells like baked goods and sausage. She’s a professor of fortitude. 

Always thank your teachers. Gush a little in their presence. Be genuine. They’ll know if you’re not. 

The ‘About’ Of Candid Coffee.

Our Saturday Candid Coffee genesis was to create something all ‘about’ you and the health of your financial union. A series of ‘across the kitchen table’ sessions where real money ideas ignite and explored. A home-based intelligence center that mainstream financial media or the industry wouldn’t dare to enter or know what to do if you allowed them in, anyway.

We believe COVID will wage war on household finances and the economy for years. As a result, you require a battle plan, an open forum for discussion where this is no judgment, only clarification. Our mission is to help you prepare for the war ahead. Candid Coffee is one of the ways for us to tap the hearth of your finances.

Our Next Candid Coffee Is Coming Soon!

On Saturday morning, January 16th, Danny Ratliff, CFP, and I will be hosting a Candid Coffee Financial Boot Camp where we will share basic, simple tenets compiled over twenty years from our most financially fit clients and mentors.

These rules are simple but not easy to follow. We will cover the financial guardrails that need to be forged around your household balance sheets in 2021 and beyond. My hope is for you to share these rules with your children and grandchildren. You’ll be able to sign up soon and send us your questions. 

Also, recent studies outline how U.S. households will look to bolster their finances in 2021. Perhaps we’ve finally learned as a society how economic crises arise more often than irresponsibly claimed by the financial industry. After all, how many outliers do you require to be financially devastated? Only one. 

Finally, as we wave good riddance to 2020, I’ll leave you with this thought for 2021. I am overwhelmed by gratitude this year and plan to carry it forward.

Perhaps a radical acquiescence of suffering and all that is “meant to be” is truly the Holy Grail of happiness. To fight ‘Amor Fati‘ is to burn inside. Wedged within the hot space between where we wish things were in a place of gratitude for how things are, festers debilitating friction. Ironically, to fight, to wish things were different, is to fall victim to despondency and self-pity. 

I wish all readers a prosperous and healthy New Year.

I am grateful to you.

The “Bonfire Of Money” and the distortion of capital and markets.

Coming to the end of a great year, investors ponder how much longer the stock market can rally. Abundant liquidity and low-interest rates have almost forced investors into risk assets. The big question is, “How much longer can this go on?”

Part of the answer may lie in a shift that occurred in capital markets during the year. For many years, the market’s characterization for equity capital was massive share repurchases, mostly funded with debt. However, the tide turned this year as companies cranked up the issuance of new shares and dialed down repurchases. This change in net equity issuance has important implications for investors.

Capital Raising Records

An exciting and essential part of the story of returns in capital markets for the year was the rapid reversal of sentiment in March. After the Fed and Government launched a massive monetary and fiscal policy response to stanch the crisis, investors immediately flipped from “fear” to “greed.”

Shortly after that happened, another interesting phenomenon occurred. Companies began issuing new capital at a record-breaking pace. The Economist reports on the veritable feeding frenzy that ensued:

“According to Refinitiv, a data provider, this year the world’s non-financial firms have raised an eye-popping $3.6trn in capital from public investors (see chart 1). Issuance of both investment-grade and riskier junk bonds set records, of $2.4trn and $426bn, respectively. So did the $538bn in secondary stock sales by listed stalwarts, which leapt by 70% from last year, reversing a recent trend to buy back shares rather than issue new ones.“

A new wrinkle in the wave of capital raising was the increasing prominence of equity. Not only did secondary sales shoot up, but the IPO market also sprung wide open:

“Initial public offerings (ipos), too, are flirting with all-time highs, as startups hope to cash in on rich valuations lest stockmarkets lose their frothiness, and venture capitalists (vcs) patience with loss-making business models.”

Part of the zeal to raise debt was low rates and partly due to the Fed’s backstop of corporate credit. These factors provide ample rationale for the increase in debt issuance.

The Cost Of Equity Capital

The case for raising equity is a bit different, though. For one, there is no backstop for stocks, at least not at this time. There is no actual, explicit number that investors can refer to as a cost of equity capital like there is an interest rate for the cost of debt.

Of course, there are various analytical formulas for determining the cost of equity capital, but most are backward-looking and therefore provide only general approximations.

Because the cost of equity capital has more significant ambiguity, any additional insight into this vital metric can be useful. To this point, company actions reveal helpful information content. When a company issues new stock, its management team judges that the cost of equity capital is attractive.

Two Sides Of A Coin

The cost of capital for a company is the same as an investor’s expected return. If a company has a low cost of capital, it also has low expected returns.

Valuations are another way of looking at the same thing. A high valuation implies a low expected return, which means a low cost of capital. Some recent estimates of expected returns confirm that the equity cost of capital is currently attractive.

For example, GMO’s latest forecast presents expected annual returns of -5.8% for large-cap US stocks and -7.1% for small caps. Similarly, John Hussman’s latest forecast calls for expected returns of -3.6% for the S&P 500.

The negative expected returns imply that the cost of equity capital is currently better than attractive for companies. It means investors are paying companies for the privilege of giving them capital. As such, it is no surprise that companies are taking them up on the offer by increasing the supply of equity capital.

Reality Checks

If this conclusion seems stretched, the supply and demand of economics is a corroborative reality check. All else equal, if you increase the supply relative to demand, the price goes down. As such, when the supply of capital goes up, its price comes down.

It is possible to argue that all else is not equal. After all, growth opportunities are emerging from the disruption of the pandemic that arguably is best served by equity capital. While this is true in some instances, it is much less compelling in aggregate. The bigger picture shows the economy is still operating at a lower level than when the pandemic struck.

Another piece of evidence for the excessive supply of equity capital is the IPO market. While there is always some sense of opportunism with IPOs because they create liquid currency for founders, a new and different type of opportunism seems to be emerging this time around.

Byrne Hobart describes in his newsletter “The Diff,” how Roblox and Affirm have delayed their IPOs because they “are both worried that the market is too good.” Hobart hypothesizes that the strategy is something like, “wait a while, figure out what else they can spend on, and then sell significantly more stock at a higher valuation than planned.” In other words, they’ll have to do some serious thinking about how to spend all of the money they can raise in such a benign environment. Such is not an indicator that capital is scarce.

Card Sharks Or Suckers?

The emergence of significant equity capital issuance facilitates an interesting perspective on the market. One line of thinking advocates investors should have more aggressive participation. It applies the poker analogy of “playing the player” and recognizes the Fed (and other central banks) will not let the markets fall for any length of time. As a result, investors should buy dips and apply leverage liberally. After all, how else can you earn returns?

Another line of thinking, however, recognizes this view as incomplete. Yes, the Fed (and other central banks) are players in the game, but corporate CFOs have also joined the game. Further, those CFOs also happen to know their businesses better than anyone else and are privy to material nonpublic information.

This development radically changes the competitive dynamics. Before, aggressive investors were competing against less aggressive investors for return/risk opportunities. Such investors could fancy themselves cleaning up at the poker table at the expense of overly timid investors.

Now, aggressive investors are also competing against well-informed corporate CFOs. As these new players have entered the game, aggressive investors look more like unsuspecting suckers at the poker table.

Pandemic Policy Parallel

The continued runup in stocks amid substantial increases in new stock issuance has an interesting parallel to one of the pandemics related policy measures. Specifically, PPP loans were designed to assist small businesses in the US, and “bounce back” loans served a similar purpose in the UK. In both cases, there were significant flaws. The FT highlights problems in the UK:

“Launched by chancellor Rishi Sunak in May, it [the bounce back loan program] was designed to provide cash quickly for struggling businesses, but its loose rules were immediately exposed with some estimates suggesting as much as £26bn [of £43.5bn total] will be lost to defaults and fraud.”

The widespread evidence of fraud and misappropriation of funds compelled the FT to headline the story as “A giant bonfire of taxpayers’ money.” The situation is essentially the same in equity markets. With money being thrown around with little scrutiny or oversight, it is fair to expect a similar result – there will be significant losses.

The Economist arrives at a similar conclusion, albeit in more modest terms:

“In a world of near-zero interest rates, it appears, investors will bankroll just about anyone with a shot at outliving covid-19. Some of that money will go up in smoke, with or without the corona-crisis.“

Conclusion

To a significant extent, you can forgive investors for wondering how much longer the rally in stocks can continue. With low rates and ample liquidity, there are little holding stock prices back. There is just no way to know when the rally will end.

What is much less forgivable is overlooking how capital markets have changed through the course of the year. Namely, the increasing issuance of stock sends an important signal to investors. Such suggests an upper limit to where stocks can go because companies will continue to issue new stock at desirable rates until those rates become less attractive. Increasingly, the benefits of the current environment will accrue to corporations at the expense of outside investors. Keeping this in mind will go a long way in preventing your giant bonfire of money.

Before The Presses Rolled

During the 1700’s France accumulated significant debts under the reigns of King Louis XV and King Louis XVI. The combination of wars, significant financial support of America in the Revolutionary War, and lavish government spending were key drivers of the deficit. Through the latter part of the century, numerous financial reforms were enacted to stem the problem, but none were successful. On a few occasions, politicians supporting fiscal austerity resigned or were fired because belt-tightening was not popular, and the King certainly didn’t want a revolution on his hands. For example, in 1776, newly anointed Finance Minister Jacques Necker believed France was much better off by taking large loans from other countries instead of increasing taxes, as his recently fired predecessor argued. Necker was ultimately replaced seven years later when it was discovered France had heavy debt loads, unsustainable deficits, and no means to pay it back.

By the late 1780s, the gravity of France’s fiscal deficit was becoming severe. Widespread concerns helped the General Assembly introduce spending cuts and tax increases. They were somewhat effective, but the deficit was very slow to decrease. However, the problem was the citizens were tired of the economic stagnation that resulted from belt-tightening. The medicine of austerity was working but the leaders didn’t have the patience to rule over a stagnant economy for much longer. The following quote from White sums up the situation well:

“Statesmanlike measures, careful watching and wise management would, doubtless, have ere long led to a return of confidence, a reappearance of money and a resumption of business; but this involved patience and self-denial, and, thus far in human history, these are the rarest products of political wisdom. Few nations have ever been able to exercise these virtues, and France was not then one of these few.”

By 1789, commoners, politicians, and royalty alike continuously voiced their impatience with the weak economy. This led to the notion that printing money could revive the economy. The idea gained popularity and was widely discussed in public meetings, informal clubs, and even the National Assembly. In early 1790, detailed discussions within the Assembly on money printing became more frequent. Within a few short months, chatter and rumor of printing money snowballed into a plan. The quickly evolving proposal was to confiscate church land, which represented more than a quarter of France’s acreage to “back” newly printed Assignats (the word assignat is derived from the Latin word assignatum – something appointed or assigned). This was a stark departure from the silver and gold-backed Livre, the currency of France at the time.

Assembly debate was lively, with strong opinions on both sides of the issue. Those against it understood that printing fiat money failed miserably many times in the past. In fact, the French experience with the Mississippi bubble crisis of 1720 resulted from the over-issuance of paper money. That crisis caused, in White’s words, “the most frightful catastrophe France had then experienced.” History was on the side of those opposed to the new plan.

Those in favor looked beyond history and believed this time would be different. They believed the amount of money printed could be controlled and ultimately pulled back if necessary. It was also argued new money would encourage people to spend, and economic activity would surely pick up. Another popular argument was France would benefit by selling the confiscated lands to its people, and these funds would help pay off its debts. In addition, land ownership by the masses strengthened French patriotism.

Those in favor of printing won the debate. As we have seen many times before and after this event, hope and greed won out over logic, common sense, and most importantly, history. Per White- “But the current toward paper money had become irresistible. It was constantly urged, and with a great show of force, that if any nation could safely issue it, France was now that nation; that she was fully warned by her severe experience under John Law; that she was now a constitutional government, controlled by an enlightened, patriotic people,–not, as in the days of the former issues of paper money, an absolute monarchy controlled by politicians and adventurers; that she was able to secure every livre of her paper money by a virtual mortgage on a landed domain vastly greater in value than the entire issue; that, with men like Bailly, Mirabeau, and Necker at her head, she could not commit the financial mistakes and crimes from which France had suffered under John Law, the Regent Duke of Orleans and Cardinal Dubois.” This time was different in their collective minds!

April 1790

The final decree was passed, and 400 million Assignats, backed by confiscated church property, were issued. The notes were quickly put into circulation and “engraved in the best style of the art,” as shown below.

As one might suspect, the church decried the action, but the large majority of the French were in favor. The press and assemblymen extolled the virtues of this new money. They spoke and wrote of future prosperity and an end to the economic oppression. They thought they found a cure for their economic ills.

Upon the issuance of the new money, economic activity picked up almost immediately. As expected, the money allowed for a portion of the national debt to be paid off as well. Confidence and trade expanded. The summer of 1790 proved to be an economic boom time for France.

Fall 1790

The good times were limited. By October, economic activity was back in decline, and with it came a renewed call for more money printing. Per White- “The old remedy immediately and naturally recurred to the minds of men. Throughout the country began a cry for another issue of paper.”  The deliberations regarding money printing were rekindled with many of the same arguments on both sides of the debate re-hashed. A new argument for those in favor of printing was simply that the original 400 million Assignats was not enough.

While those favoring money printing acknowledged the dangers of their actions, they were also dismissive of them at the same time. These Assemblymen believed if a little medicine appeared to work with no side effects, why not take more. Debate this time around was easier for the pro-printing consortium. Of note were a well-respected elder statesman of the Assembly and a national hero named Gabriel Riqueti, Comte de Mirabeau (Mirabeau). During the first round of debates, Mirabeau was firmly against the issuance of the new currency. In fact, he said the following: “A nursery of tyranny, corruption, and delusion; a veritable debauch of authority in delirium” in regards to paper money. He even called the issuance of money “a loan to an armed robber.”

While Mirabeau clearly understood the effects of printing money, he was now swayed by the arguments of a stronger economy. He also appreciated the benefits of making a large class of landholders for the first time.  Mirabeau reversed his opinion and joined the ranks of those believing France could control the inflationary side effects. He now argued for one more issue of Assignats. As a precautionary measure, he insisted that as soon as paper became abundant, self-governing laws of economics would ensure the money was retired. Mirabeau went as far as recommending the new amount of printed money should be enough to pay down France’s entire debt – 2,400 million!

The naysayers warned of the ills of the proposed second printing. Of note was Necker. If you recall, he was partially responsible for the debt buildup that led to France’s problems. Necker “predicted terrible evils” and offered other means to accomplish economic growth. His opinions were not popular and Necker was “spurned as a man of the past” by the Assembly and ultimately left France forever. An influential pamphlet, written by Du Pont de Nemours was popular amongst the nays and was read to the Assembly. It declared that doubling the money supply would “simply increase prices, disturb values, alarm capital, diminishes legitimate enterprise, and so decreases the demand for both products and for labor. The only persons to be helped by it are the rich who have large debts to pay.”

The arguments of Neckar and Du Pont de Nemours fell on deaf ears. Those in favor rebutted with comments that printing more money was “the only means to ensure happiness, glory, and liberty to the French nation”. They took the prior debate a step further and now theorized that the gold and silver Livres would be undesirable as Assignats would be the only currency people demanded.

On the 29^th of September, 1790, a bill authorizing the issuance of 800 million Assignats was passed. The bill also decreed that when Assignats were paid back to the government for the land they should be burned. This added measure was thought of as a way to ensure the newly printed money was not inflationary.

White commented: “France was now fully committed to a policy of inflation; and, if there had been any question of this before, all doubts were removed” he went on discussing how “exceedingly difficult it is stopping a nation once in the full tide of a depreciating currency.”

It turns out the money returned to the government wasn’t burned but was re-issued in smaller denominations. Within a short period, 160 million was paid to the government for lands and was reissued “under the pleas of necessity.”

June 1791

Nine months after the second issue of 800 million Assignats and another cycle of good economic activity followed by bad, pressure grew for more money printing. With little fanfare or debate, a new issue of 600 million was issued. With it, once again came “solemn pledges to keep down the amount in circulation.”

Like the previous two, this experience was followed by a brief period of optimism that quickly faded. With each successive printing came currency depreciation and higher prices. Despite the beliefs of those in favor of printing, hoarding of gold and silver-backed coins was occurring. The French people were watching their paper money lose value and becoming more interested in preserving their wealth. The coins were in limited supply while paper money was being printed with increasing frequency. In their minds, gold and silver offered the stability that paper money was rapidly losing.

“Still another troublesome fact began to now appear. Though paper money had increased in amount, prosperity had steadily diminished. In spite of all the paper issues, commercial activity grew more and more spasmodic. Enterprise was chilled and business became more and more stagnant.”

With each new issue came increased trade and a more robust economy. The problem was the activity wasn’t based on anything but new money. As such, it had very little staying power, and the positive benefits quickly eroded. Businesses were handcuffed. They found it hard to make any decisions in fear the currency would continue to drop in value. Prices continued to rise. Speculation and hoarding were becoming the primary drivers of the economy. “Commerce was dead; betting took its place.” With higher prices, employees were laid off as merchants struggled to cover increasing costs.

The only ones genuinely benefiting were manufacturers producing goods for foreign countries and the stockbrokers. The rapidly declining value of their currency attracted orders from other countries that could now purchase French goods very cheaply. Those businesses and consumers that relied on goods from outside the country were battered by higher prices. With the increased money supply and economic uncertainty, the “ordinary motives for savings and care diminished.” Speculation increased significantly. While some stock investors in the urban regions were exploiting the condition, the onus fell on the working man. Inflation, weakening currency, and lack of jobs was damaging to a large majority of Frenchmen.

The economic conditions also brought on more crime and increased instances of bribery of government officials. Conditions were described by White as “the decay of a true sense of national pride.”

December 1791

A new issue of 300 million more Assignats was ordered to be printed. With that decree, it was also ordered that a previous limit on the total amount to be printed be repudiated. By this point, it was estimated the value of their currency was cut in half and inflation was rampant.

April-July 1792

Another 600 million Assignats were printed. The presses rolled on and after a few more printings it was estimated a total of 3,500 million Assignats now existed. The issuances continued through 1792 and 1793.

“The consequences of these overissues now began to be more painfully evident to the people at large. Articles of common consumption became enormously dear and prices were constantly rising. Orators in the Legislative Assembly, clubs, local meetings, and elsewhere now endeavored to enlighten people by assigning every reason for this depreciation save the true one. They declaimed against the corruption of the ministry, the want of patriotism among the Moderates, the intrigues of the emigrant nobles, the hard-heartedness of the rich, the monopolizing spirit of the merchants, the perversity of the shopkeepers, —each and all of these as causes of the difficulty.”

French Revolution

Throughout 1792 and 1793, mobs were demanding necessities such as bread, sugar, and coffee. Peaceful demonstrations turned violent, and plundering of the local shops was commonplace. The French Revolution was born.

Money printing was not the sole cause of the revolution, but it certainly helped light the fuse. In all fairness, the French people were demanding the same liberties they helped America fight for. The idea of a Monarchy was fading, and those supporting democratic principles were leading the charge. In hindsight, money printing was a last-ditch effort to create prosperity and keep the Revolution at bay. Poverty and despair spread through France. Malnutrition and hunger due to lost employment and inflation fed the Revolution. In 1792 a republic was proclaimed, and in the following year, King Louis XVI was sent to the guillotines.

Conclusion

The story retold in this article echoes that of other nations before and after it. The language, promises, and ultimately the excuses used by the politicians are a familiar refrain. There is nothing new with money printing or “quantitative easing” as modern-day central bankers call it. Despite the passing of over 200 years and substantial development globally, plus ça change (the more that changes, the more it is the same thing).

Gold has a long history serving as a tool of wealth preservation. After numerous financial crises caused by the debasement of currencies, have modern-day economists and central bankers finally figured out how to print money with no consequences? Despite our wishes to the contrary, every action still has an equal and opposite reaction (consequence). The investment pundits who see nothing wrong with the actions of the world central banks regard holding gold as ridiculous. We consider an allocation to gold as a matter of prudence given what we have seen and expect to see from central bankers desperate to maintain the status quo. 

Hopefully, after reading this you will understand a little protection may go a long way in what may not be as clear cut an economic future as some would lead us to believe.

In February, Institutional Investor published a brilliant piece entitled “Asset Manager B.S. Decoded.” As we approach the year-end of 2020, succeeding in 2021 may come down to navigating the “market lingo” successfully.

“A handy translation guide to the sales jargon and IR excuses that one family office chief is sick of hearing.” – Institutional Investor 

What They Say Versus Mean

• Now is a good entry point = Sorry, we are in a drawdown.
• We have a high Sharpe ratio = We don’t make much money.
• We have never lost money = We have never made money.
• We have a great backtest = We are going to lose money after we take your money.
• We have a proprietary sourcing approach = We invest in whatever our hedge fund friends do
• We are not in crowded positions = We missed all the best-performing stocks.
• We are not correlated = We are underperforming while the market keeps going up.
• We invest in unique uncorrelated assets = We have an illiquid portfolio that can’t be valued.
• We are soft-closing the fund = We want to raise as much money as we can right now.
• We are hard-closing the fund = We are definitely open for you.
• We are not responsible for the bad track record at our prior firm = We lost money but are blaming all our ex-colleagues
• We have a bottom-up approach = We have no idea what markets are going to do.
• We have a top-down process = We think we know what markets will do but really, who does?
• The markets had a temporary mark-to-market loss = Our fundamental analysis was wrong, and we don’t know why we lost money.
• We don’t believe in stop-loss limits = We have no risk management.

There is a lot of truth to the list and many more examples from IPO’s to SPAC’s. To successfully navigate the markets in 2021, we need to understand what we are dealing with.

Wall Street Is A Business.

The “business” of any business is to make a profit. Wall Street makes profits by building products to sell you, whether it is the latest “fad investment,” an ETF, or bringing a company public. While Wall Street tells you they are “here to help you grow your money,” three decades of Wall Street shenanigans should tell you differently.

I know you probably don’t believe that, however, but take a look at a survey of Wall Street analysts. It is worth noting where “you” rank in terms of their concern and compensation.

Not surprisingly, you are at the bottom of the list.

While the translation is satirical, it is also more than truthful. Investors often only hear what they “want” to hear. However, actions are often quite different, along with the eventual outcomes.

So, what can you do about it?

The 2021 Investing Guidelines.

You can take actions to curb those emotional biases, which lead to eventual impairments of capital. The following activities are the most common mistakes investors repeatedly make, mostly by watching the financial media, and what you can do instead.

1) Refusing To Take A Loss – Until The Loss Takes You.

When you buy a stock, it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early or just plain wrong. It amounts to the same thing.

There is no shame in being wrong, only in STAYING wrong.

Such goes to the heart of the familiar adage: “let winners run, cut losers short.”

Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in dead, or underperforming, money.

2) The Unrealized Loss

From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until you sell the stock? Nonsense!

Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.

People are reluctant to sell a loser for a variety of reasons. For some, it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is just plain stupid.

Realize that your loser may NOT come back. And even if it does, an investment down 50% has to regain 100% to get back to even. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading correctly.

Take your losses ruthlessly, put them out of mind and don’t look back, and turn your attention to your next trade.

3) More Risk

It is often touted the more risk you take, the more money you will make. While that is true, it also means the losses are more severe when the tide turns against you.

In portfolio management, the preservation of capital is paramount to long-term success. If you run out of chips, the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, even if it earns nothing in a “ZIRP” world.

Such actions give you liquid cash to buy opportunities and keep you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency:”

This is the emergency that always occurs when you have the least amount of cash available – (Murphy’s Law #73)

4) Bottom Feeding Knife Catchers

Unless you are adept at technical analysis and understand market cycles, it’s almost always better to let the stock find its bottom on its own and then start to nibble. Just because a stock is down a lot doesn’t mean it can’t go down further. A significant multi-point drop is often just the beginning of a more considerable decline. It’s always satisfying to catch the low tick, but it’s usually by accident when it happens. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”

Nobody, and I mean nobody, can consistently nail the bottom or top ticks. 

5) Averaging Down

Please don’t do it. For one thing, you shouldn’t have the opportunity as a losing investment should have already gotten stopped out.

The only time you should average into any investment is when it is working. If you enter a position on a fundamental or technical thesis that proves correct, it is generally safer to increase your stake in that position on the way up.

6) Don’t Fight The Trend

Yes, some stocks will go up in bear markets and stocks that will go down in bull markets, but it’s usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you.

It doesn’t make sense to counter trade the prevailing market trend. Don’t try and short stocks in a strong uptrend and don’t own stocks that are in a strong downtrend. Remember, investors don’t speculate – “The Trend Is Your Friend”

7) A Good Company Is Not Necessarily A Good Stock

Some great companies are mediocre investments, while some poor quality companies have been great stocks over a short time frame. Try not to confuse the two.

While fundamental analysis will identify great companies, it doesn’t take into account market and investor sentiment. Analyzing price trends, a view of the “herd mentality,” can help determine the “when” to buy a great company that is also an outstanding stock.

8) Technically Trapped

Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working.

But always be aware of the fact that as market conditions change, so will the efficacy of indicators. Indicators that work well in one type of market may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions change.

There is no “Holy Grail” indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.

9) The Tale Of The Tape

I get a kick out of people who insist that they’re long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stock drop a point or two. More likely than not, the panic was induced by listening to financial television.

Watching “the tape” can be dangerous. It leads to emotionalism and hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed. Turn off the television, get to a quiet place, and then calmly and logically execute your plan.

10) Worried About Taxes

Don’t let tax considerations dictate your decision on whether to sell a stock. Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is not to make any money.

“If you are paying taxes – you are making money…it’s better than the alternative”

The Law Of Change

Don’t confuse genius with a bull market.

It’s hard not to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. The market whips all our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.

Managing risk is the key to survival in the market and ultimately in making money. Focus on managing risk, market cycles, and exposure.

The law of change states: Change will occur, and the elements in the environment will adapt or become extinct, and that extinction in and of itself is a consequence of change. 

Therefore, even if you are a long-term investor, you have to modify and adapt to an ever-changing environment; otherwise, you will become extinct.

To navigate through this complex world, we suggest investors need to be open-minded, avoid concentrated risks, be sensitive to early warning signs, constantly adapt and always prepare for the worst.” – Tim Hodgson, Thinking Ahead Institute

Investing is not a competition.

It is a game of long-term survival.

Start by turning off the mainstream financial media. You will be a better investor for it.

I wish you a prosperous and happy 2021.

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