Last week, Jeff Desjardins of Visual Capitalist wrote in a post:

“While it’s true that putting your money on the line is never easy the historical record of the stock market is virtually irrefutable: U.S. markets have consistently performed over long holding periods, even going back to the 19th century.”

This goes back to Wall Street’s suggestion of “buy and holding” investments because over 10- and 20-year holding periods, investors always win.

There are two major problems with this myth.

First, on an inflation-adjusted, total return basis, long-term holding periods regularly produce near zero or negative return periods.

Secondly, given that most individuals don’t start seriously saving for retirement until later on in life (as our earlier years are consumed with getting married, buying a house, raising kids, etc.,) a 10- or 20-year period of near zero or negative returns can devastate retirement planning goals.

It should be obvious, when looking at the two charts above, that WHEN you start in investment journey, relative to current valuation levels, is the most critical determinant of your outcome.

(We have written a complete series on the Myths Of Investing For Long-Run. Chapters 1, 2 & 3 cover the concepts above in much more detail)

Baby Boom Generation Should Be Rich

Let’s look at this differently for a moment.

The financial media and blogosphere is littered with advice on how easy it is to invest. As noted above, over long-periods of time there is absolutely nothing to worry about, right?

Okay, let’s assume that is true.

The “Baby Boom” generation are those individuals born between the years of 1946 and 1964.  This means that this group of individuals entered the work force between 1966 and 1984. If we assume a bit of time from obtaining employment and starting the saving and investing process, most should have entered the markets starting roughly in 1980.

So, despite the little “flatish” period of the markets between 2000 and 2013, the markets have been in a extremely long rising trend. (One could argue the bull market which began in 1980 is still going.)

And, if we look at it the way the financial media and most financial advisors show it, the bull markets have exploded personal wealth historically. (The chart below is the cumulative percentage gain (real total return) of the S&P 500 index.)

Despite those two little minor percentage drawdowns, baby boomers have been fortunate to participate in two massive bull markets over the last 38-years.

So, given this steadily rising trend of the market, most individuals should be well prepared for retirement, right?

The why isn’t that case. Let’s take a look at some of the myths and facts.

Myth: Everyone contributes to a retirement plan.

Fact: Not so much. 

According to a recent NIRS study only 51% of Americans have access to a 401k plan.

More importantly, only 40% of individuals actually contribute to one.

Here is another way to look at it. Almost 60% of ALL WORKING AGE individuals DO NOT own assets in a retirement account. 

And of those that do own retirement accounts the majority are of the wealth, unsurprisingly is owned by those with the highest incomes.

It’s actually worse than that.

The typical working-age household has only ZERO DOLLARS in retirement account assets. Importantly, “baby boomers” who are nearing retirement had an average of just $40,000 saved for their “golden years.”

Lastly, only 4-0ut-of-5 working-age households have retirement savings of less than one times their annual income. This does not bode well for the sustainability of living standards in the “golden years.”

Myth: Individuals save money in lot’s of other ways.

Fact: Not so much.

According to the study by MagnifyMoney:

“Although the average American household has saved roughly $175,000 in various types of savings accounts, only the top 10 percent to 20 percent of earners will likely have savings levels approaching or exceeding that amount. 29 percent of households have less than $1,000 in savings.”

So, What Happened?

If investing is as easy as the financial media and advisors portray it to be, then why is the vast majority of American literally broke?

Go back up to that S&P 500 cumulative percentage gain and loss chart above.

That is the most deceiving chart ever made to convince individuals to plunk their money down in the market and leave it.

As Mark Twain once quipped:

“There are three kinds of lies. Lies, damned lies, and statistics.” 

Using percentages to dispel the impact of losses during bear market declines false into the “statistics” category.

If the market rises from 1000 to 2000, it is up 100%. However, if it then falls by 50%, you don’t lose just 50% of what you gained. You lose 50% of everything.

If we revise the chart of the real, total-return, S&P 500 chart above to display the cumulative gains and losses in points, rather than percentages, the reality of damages from bear markets is revealed.

You will notice that in every case, the entirety of the previous bull market advance was almost entirely wiped out by the subsequent decline.

So, what happened to all those baby boomers? Well, let’s walk through the sequence:

1. Age 30’s: In 1980 the “baby boomer” generation is working, saving, and participating during one the 80-90’s bull market.
2. Age 50’s: From 2000 to 2002, the “Dot.Com” crash cuts their savings by 50%.
3. Age 53-57: From 2003-2007 the full market grows savings back to their previous level in 2000.
4. Age 57-58:  The 2008 “Financial Crisis” wipes out 100% of the gains of the previous bull market and resets savings values back to 1995 levels.
5. Age 58-63: From 2009-2013 financial markets rise growing savings back to the same levels in 2000.

At the age of 63, “baby boomers” are staring retirement in the face. Yet, because of the devastation of two major bear markets they are no closer to their retirement goals than they were 13-years earlier.

This problem is clearly shown in the retirement statistics above.

But it is actually worse than that.

From 2008 to present, the S&P 500 has more than tripled in value. Yet, as shown by the table from Fidelity investments below which is a great sample size for most Americans, 401k accounts and IRA’s barely even doubled.

The reason, of course, is psychology. Despite the best of intentions, psychology makes up fully 50% of the reason investors underperform over time. But notice, the other 50% relates to lack of capital to invest. (See this)

These biases come in all shapes, forms, and varieties from herding, to loss aversion, to recency bias and are the biggest contributors to investing mistakes over time.

These biases are specifically why the greatest investors in history have all had a very specific set of rules they followed to invest capital and, most importantly, manage the risk of loss.  (Here’s a list)

The problem that is unfolding for investors going forward is that while the mainstream financial press continues to extol the virtues of investing in the financial markets for the “long-term”, the assumptions are based on historical data which is not likely to repeat itself in the future. 

Jeff Saut, Liz Ann Sonders, and others have continued to prognosticate the financial markets have entered into the next great “secular” bull market. As explained previously, this is not likely to the be case based upon valuations, debt, and demographic headwinds which currently face the economy.

More importantly, as John Mauldin recently noted:

“When that next recession and bear market hit, it will take even longer to bounce back. The recovery will be even slower than this last one. As the research I’ve shared in previous letters shows, large amounts of debt slows recoveries. Very large amounts create flat economies. We are approaching large amounts in the US…but I think the recovery will be much slower, at a minimum. A double dip recession is clearly possible, making those stock market index fund losses even worse.”

John goes on to restate what I have detailed many times previously,

“You must have some kind of strategy for dealing with market volatility. 

Invest in programs that give you at least a chance to dodge bear markets. Buy and hold works in theory, but not for most people because we are humans with emotions. We should recognize that and take steps to control it. “

Bingo.

He’s right. Combine high levels of debt, with high valuations, and psychological impediments and the outlook for investors isn’t great.

Does this mean you should NOT invest at all when valuations are high?

No. What it means is that you have to CHANGE the way you invest.

• When valuations are low and rising, you absolutely should be a “buy and hold, dollar cost averaging, investor.”
• Conversely, when valuations are high, you have to shift your thinking more to capital preservation and being more opportunistic on how you invest.

Controlling risk, reducing emotional investment mistakes and limiting the destruction of investment capital will likely be the real formula for investment success in the decade ahead.

With this in mind, individuals need to carefully consider the factors that will affect their future outcomes.

• Expectations for future returns and withdrawal rates should be downwardly adjusted.
• The potential for front-loaded returns going forward is unlikely.
• The impact of taxation must be considered in the planned withdrawal rate.
• Future inflation expectations must be carefully considered.
• Drawdowns from portfolios during declining market environments accelerate the principal bleed. Plans should be made during rising market years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
• The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for retirement income planning. Caution is advised.
• Expectations for compounded annual rates of returns should be dismissed in lieu of plans for variable rates of future returns.

Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you likely want. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money – the TIME that was needed to reach their retirement goals.

Yes, you can do better. 

You just have to turn off the media to do so.

There should be no one more concerned about YOUR money than you, and if you aren’t taking an active interest in your money – why should anyone else?

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

• The rally off of the 200-dma, as we previously discussed, was expected and the break above 2800 resistance sets up a test of all-time highs.
• Longer-term “buy signal” is in place which is bullish
• The break above resistance sets up a tradeable entry but keep stops very tight due to the overbought condition of the market.
• Short-Term Positioning: Bullish
  • Last Week: Hold 1/2 position
  • This Week: Add 1/2 position, bring to full weight.
  • Stop-loss moved up to $275
• Long-Term Positioning: Neutral

Dow Jones Industrial Average

• Recent rally failed at the January highs and remains very overbought.
• DIA remains well above its 200-dma but that will be critical support.
• A “buy signal” is in place
• Market is back to extreme overbought, so break above resistance is key before taking on additional exposure. Most of the underperformance can be attributed to BA last week, and due to its impact on the index, focus on SPY and QQQ for now until there is so resolution with BA.
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss remains at $250
• Long-Term Positioning: Neutral

Nasdaq Composite

• The rally last week, took QQQ above resistance and set up a test of all-time highs. With technology leading the charge currently, the probability of a test of all-time highs is very possible.
• A buy signal was triggered last week.
• Market remains very overbought but support held at the 200-dma.
• Short-Term Positioning: Bullish
  • Last Week: Hold 1/2 of position
  • This Week: Add 1/2 of position going back to full weight.
  • Stop-loss moved up to $170
• Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

• Recent rally failed at the 200-dma and is now testing important support at the Oct-Nov lows.
• A “buy” signal was triggered last week.
• Small-caps have reversed about half of its overbought condition so there is still downside risk currently.
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss remains at $66 – could break next week.
• Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

• Like it’s small-cap brethren, the recent rally failed to hold the 200-dma.
• Currently, Mid-caps are testing support at the Oct-Nov highs
• Mid-caps have recently flipped back onto a buy signal. However, the recent correction has not reduced the overbought condition we noted last week.
• Short-Term Positioning: Neutral
  • Last Week: After taking profits previously, hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss is adjusted to $337.50
• Long-Term Positioning: Neutral

Emerging Markets

• EEM is currently testing its 200-dma which is still declining currently.
• The extreme overbought condition is being worked off, so it will be important for EEM to maintain support over the next week. So far that has been the case with a second successful test of the 200-dma last week.
• After adding a 1/2 position to portfolios we suggested a short-term corrective action was likely. If the position holds support and turns up and breaks recent highs, we will add to our holdings.
• Short-Term Positioning: Bullish
  • Last Week: Hold current position.
  • This Week: Hold current position.
  • Stop-loss moved to $41
• Long-Term Positioning: Bearish

International Markets

• Recent rally finally pushed above the 200-dma.
• The downtrend from all-time highs and remains and international markets are extremely overbought.
• While a “buy signal” has been triggered, EFA reamins very overbought in the short-term.
• Short-Term Positioning: Neutral
  • Last Week: After taking profits, hold 1/2 of position
  • This Week: Hold 1/2 of position, looking to add second 1/2 on pullback to support.
  • Stop-loss moved up to $63
• Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

• Oil showed some muscle by breaking above the 3-year trend channel and above the 38.2% Fibonacci retracement.
• $60 is the next major resistance level at the 50% retracement which will coincide with the downward trending 200-dma.
• Oil is very close to triggering a “buy” signal which will allow us to add exposure if some of the short-term overbought condition can be worked off.
• Short-Term Positioning: Neutral
  • Last Week: After taking profits, hold 1/2 position
  • This Week: Hold 1/2 position, look for a break above the 50% retracement.
  • Stop-loss adjusted to $55
• Long-Term Positioning: Bearish

Gold

• As we noted last week, the sell-off tested support at the 61.8% retracement of the decline and is now back to oversold.
• Gold turned up last week and remains on a “buy” signal.
• Currently on “buy” signal (bottom panel) so positions can be added.
• Short-Term Positioning: Bullish
  • Last week: Added 1/2 position and carrying a full weight.
  • This week: Hold positions
  • Stop-loss for whole position set at $120
• Long-Term Positioning: Improving From Bearish To Bullish

Bonds (Inverse Of Interest Rates)

• Support continues to build along the 720-dma. The rally following the recent sell-off is testing resistance within this current consolidation.
• Currently on a buy-signal (bottom panel), bonds have once again swung from oversold to overbought.
• Entry point was triggered at $120 with reversal of overbought condition.
• Resistance remains from $122 to $124
• Strong support at the 720-dma (2-years) (green dashed line) which is currently $118.
• Short-Term Positioning: Bullish
  • Last Week: Recommended adding to holdings.
  • This Week: Hold positions.
  • Stop-loss adjusted to $119
• Long-Term Positioning: Bullish

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• Market Review & Recap
• The Goldilocks Warning
• Sector & Market Analysis
• 401k Plan Manager

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Market Review & Recap

Over the last couple of weeks we discussed the “wild swings” in the market in terms of price movements from overbought, to oversold, and now back again. The quote below is from two week’s ago but is apropos again this week.

“Despite the underlying economic and fundamental data, the markets have surged back to extremely overbought, extended, and deviated levels. The chart table below is published weekly for our RIA PRO subscribers (use code PRO30 for a 30-day free trial)

On virtually every measure, markets are suggesting the fuel for an additional leg higher in assets prices is extremely limited.”

Just for visual sake, the chart below compares the last three weeks of wild gyrations. (Click To Enlarge)

The chart below also shows the short-term reversal of the market as well. Note how in just a few days the market went from overbought, to oversold, back to overbought. 

Importantly, as I specifically noted last week:

“This short-term oversold condition, and holding of minor support, does set the market up for a bounce next week which could get the market back above the 200-dma. The challenge, at least in the short-term, remains the resistance level building at 2800.”

On that analysis, we did increase equity exposure early last week in both our ETF and Equity Portfolios. In the RIA PRO version of this letter we gave specific recommendations to add exposure particularly to Healthcare due to the recent sell-off over concerns of “Medicare for all.”

Despite the rally, the bounce is still largely at risk for the three following reasons:

1. As noted previously, the market has not reversed to levels which normally signals short-term bottoms. The red lines in the bottom four panels denote periods where taking profits, and reducing risk, has been ideal. The green lines have been prime opportunities to increase exposure. As you will note, these indicators tend to swing from extremes and once a correction process has started it is usually not completed until the lower bound is reached. 

Important Note: This does not mean the market will decline sharply in price. The current overbought conditions can also be resolved by continued consolidation within a range as we have seen over the last two weeks. 

2) The divergence between stocks and bonds still signals that “smart money” continues to seek “safety” over “risk.” Historically, these bond market generally has it right.

3) As discussed in “Will The Next Decade Be As Good As The Last,” the weekly chart below shows the S&P 500 hitting an all-time high last September before falling nearly 20% into the end of 2018. While the first two months of 2019 has seen an impressive surge back to its November highs, the market is starting to build a pattern of lower highs, and lower bottoms. More importantly, both relative strength and the MACD indicators are trending lower and negatively diverging from the markets price action.

As John Murphy noted last week for StockCharts:

• The bull market that ended in March 2000 preceded an economic downturn by a year.
• The October 2007 stock market peak preceded the December economic peak by two months.
• The March 2009 stock upturn led the June economic upturn by three months.
• Historically, stocks usually peak from six to nine months ahead of the economy. Which is why we look for possible stock market peaks to alert us to potential peaks in the economy that usually follow. And we may be looking at one.

If you are a longer-term investor, these issues should be weighted into your investment strategy. While we did add exposure to our portfolios early last week, we are still overweight cash and fixed income.

• In the RIA PRO Equity Model – we bought Boeing (BA) on the initial plunge, and added positions in JPM, AAPL and PPL. 
• In the RIA PRO ETF Model – we added Healthcare (XLV), Energy (XLE) and Gold (IAU). 

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As always, we start with trading positions which have very tight stop-loss parameters. If our thesis on the position is proved correct, the position size is increased and is moved into a longer-term holding status with widened safety protocols. 

This is how we approach linking longer-term views to short-term opportunities. Managing a portfolio of investments is simply measuring risk and reward and placing bets when reward outweighs the potential risk. Tweaking exposure to “risk” over time improves performance tremendously over the long-term. 

The Goldilocks Warning

Lately, there has been an awful lot of talk about a “Goldilocks economy” here in the U.S. Despite a rather severe slow down globally, it is believed currently the domestic economy is going to continue to chug along with not enough inflation to push the Fed into hiking rates, but also won’t fall into recession. It is a “just right” economy which will allow corporate profits to grow at a strong enough rate for stocks to continue to rise at 8-10% per year. Every year…into eternity.

Does that really make any sense? 

Particularly as we are looking at the longest expansion cycle in the history of the U.S. The problem is in the rush to come up with a “bullish thesis” as to why stocks should continue to elevate in the future, they have forgotten the last time the U.S. entered into such a state of “economic bliss.” 

You might remember this:

“The Fed’s official forecast, an average of forecasts by Fed governors and the Fed’s district banks, essentially portrays a ‘Goldilocks’ economy that is neither too hot, with inflation, nor too cold, with rising unemployment.” – WSJ Feb 15, 2007

Of course, it was just 10-months later that the U.S. entered into a recession followed by the worst financial crisis since the “Great Depression.”

The problem with this “oft-repeated monument to trite” is that it’s absolute nonsense. As John Tamny once penned:

A “Goldilocks Economy,” one that is “not too hot and not too cold,” is very much the fashionable explanation at the moment for all that’s allegedly good. “Goldilocks” presumes economic uniformity where there is none, as though there’s no difference between Sausalito and Stockton, New York City and Newark. But there is, and that’s what’s so silly about commentary that lionizes the Fed for allegedly engineering “Goldilocks,” “soft landings,” and other laughable concepts that could only be dreamed up by the economics profession and the witless pundits who promote the profession’s mysticism.

What this tells us is that the Fed can’t engineer the falsehood that is Goldilocks, rather the Fed’s meddling is what some call Goldilocks, and sometimes worse. Not too hot and not too cold isn’t something sane minds aspire to, rather it’s the mediocrity we can expect so long as we presume that central bankers allocating the credit of others is the source of our prosperity.”

John is correct. An economy that is growing at 2%, inflation near zero, and Central banks globally required to continue dumping trillions of dollars into the financial system just to keep it afloat is not an economy we should be aspiring to. But despite commentary the financial system has been “put back together again,” then why are Central Banks acting? Via Bloomberg:

“Led by the Fed, many central banks have either held back on tightening monetary policy or introduced fresh stimulus, soothing investor fears of a slowdown. Fed Chairman Jerome Powell says he and colleagues will be patient on raising interest rates again, while European Central Bank President Mario Draghi has ruled out doing so this year and unveiled a new batch of cheap loans for banks.

Elsewhere, authorities in Australia, Canada and the U.K. are among those to have adopted a wait-and-see approach. China, at its National People’s Congress this month, signaled a willingness to ease monetary and fiscal policies to support expansion.”

Unfortunately, today’s “Goldilocks” economy is more akin to what we saw in 2007 than most would like to admit.

Job growth is slowing down.

Along with economic growth.

And recession risks are rising sharply.

However, it isn’t just the economy that is reminiscent of the 2007 landscape.  The markets also reflect the same. Here are a couple of charts worth reminding you of. 

Notice that at the peaks of both previous bull markets, the market corrected, broke important support levels and then rallied to new highs leading investors to believe the bull market was intact. However, the weekly “sell signal” never confirmed that rally as the “unseen bear market” had already started.

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Currently, relative strength as measured by RSI on a weekly basis has continued to deteriorate. Not only was such deterioration a hallmark of the market topping process in 2007, but also in 2000.

The problem of suggesting that we have once again evolved into a “Goldilocks economy” is that such an environment of slower growth is not conducive to supporting corporate profit growth at a level to justify high valuations.

It is true that the bears didn’t eat Goldilocks at the end of the story…but then again, there never was a sequel.

Simple Actions To Take Now, You Will Appreciate Later

1. Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits)
2. Sell underperforming positions. If a position hasn’t performed during the rally over the last three months, it is weak for a reason and will likely lead the decline on the way down. 
3. Positions that performed with the market should also be reduced back to original portfolio weights. Hang with the leaders.
4. Move trailing stop losses up to new levels.
5. Review your portfolio allocation relative to your risk tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

How you personally manage your investments is up to you. I am only suggesting a few guidelines to rebalance portfolio risk accordingly. Therefore, use this information at your own discretion.

See you next week. 

 

Believe it or not, any domestic bond trader under the age of 55 has never traded in a bond bear market. Unlike the stock market, which tends to cycle between bull and bear markets every five to ten years, bond markets can go decades trending in one direction. These long periods of predictable rate movements may seem easy to trade, especially in hindsight, but when the trend changes, muscle memory can trump logic leaving many traders and investors offside.

If you believe higher yields are upon us in the near future, there are many ways to protect your bond portfolio. In this article, we present one idea applicable to municipal bonds. The added benefit of this idea is it does not detract from performance if rates remain stubbornly low or fall even lower.  Who says there is no such thing as a free lunch?

Munis

Municipal bonds, aka Munis, are debt obligations issued by state and local government entities. Investors who seek capital preservation and a dependable income stream are the primary holders of munis. In bear markets, munis can offer additional yield over Treasury bonds, still maintain a high credit quality, and avoid the greater volatility present in the corporate bond or equity markets.

Munis are unique in a number of ways but most notably because of their tax status. Please note, munis come in taxable and tax-exempt formats but any reference to munis in this article refers to tax-exempt bonds.

Because of their tax status, evaluating munis involves an extra step to make them comparable to other fixed income assets which are not tax-exempt. When comparing a muni to a Treasury, corporate, mortgage backed security, or any asset for that matter, muni investors must adjust the yield to a taxable equivalent yield. As a simple example, if you are in a 40% tax bracket and evaluating a muni bond yielding 2%, the taxable equivalent yield would be 3.33% (2.00% / (1-40%). It is this yield that should be used to equate it to other fixed income securities.

Negative “Tax” Convexity Matters

Thus far, everything we have mentioned is relatively straight-forward. Less well-understood is the effect of the tax rate on muni bonds with different prices and coupons. Before diving into tax rates, let’s first consider duration. Duration is a measure that provides the price change that would occur for a given change in yield. For instance, a bond with a duration of 3.0 should move approximately 3% in price for every 1% change in yield.

While a very useful measure to help quantify risk and compare bonds with different characteristics, duration changes as yields change. Convexity measures the non-linear change in price for changes in yield. Convexity helps us estimate duration for a given change in yield.

For most fixed rate bonds without options attached, convexity is a minor concern. Convexity in the traditional sense is a complex topic and not of primary importance for this article. If you would like to learn more about traditional convexity, please contact us.

Munis, like most bonds, have a small amount of negative convexity. However, because of their tax status, some muni bonds have, what we call, an additional layer of negative tax convexity. To understand this concept, we must first consider the complete tax implications of owning munis.

The holder of the muni bond receives a stream of coupons and ultimately his or her invested principal back at par ($100). The coupons are tax free, however, if the bond is sold prior to maturity, a taxable capital gain may occur.

The table below illustrates three hypothetical muni bonds identical in structure and credit quality. We use a term of 1 year to make the math as simple as possible.

In the three sample bonds, note how prices vary based on the range of coupons. Bond A has the lowest coupon but compensates investors with $2.41 ($100-$97.59) of price appreciation at maturity (the bond pays $100 at maturity but is currently priced at $97.59). Conversely, Bond C has a higher coupon, but docks the holder $2.41 in principal at maturity.

For an uninformed investor, choosing between the three bonds is not as easy as it may appear. Because of the discounted price on bond A, the expected price appreciation ($2.41) of Bond A is taxable and subject to the holder’s ordinary income tax rate. The appropriate tax rate is based on a De minimis threshold test discussed in the addendum. Top earners in this tax bracket pay approximately 40%.

Given the tax implication, we recalculate the yield to maturity for Bond A and arrive at a net yield-to-maturity after taxes of 4% (2.50% + (2.50 *(1-.40). Obviously, 4% is well below the 5% yield to maturity offered by bonds B and C, which do not require a tax that Bond A does as they are priced at or above par. Working backwards, an investor choosing between the three bonds should require a price of 95.88 which leaves bond A with an after tax yield to maturity of 5% and on equal footing with bonds B and C.

Implications in a rising yield environment and the role of “tax” convexity

Assume you bought Bond B at par and yields surged 2.50% higher the next day. Using the bond’s stated duration of .988, one would expect Bond B’s price to decline approximately $2.47 (.988 * 2.5%) to $97.53. Based on the prior section, however, we know that is not correct due to the tax implications associated with purchasing a muni at a price below par. Since you purchased the bonds at par, the tax implication doesn’t apply to you, but it will if anyone buys the bond from you after the 2.5% rise in yields. Therefore, the price of a muni bond in the secondary market will be affected not just by the change in rates, but also the associated tax implications. Assuming the ordinary income tax rate, the price of Bond B should fall an additional $1.65 to $95.88.  This $1.65 of additional decline in Bond B’s price is the penalty we call negative tax convexity.

The graph below shows how +/- 2.50% shifts in interest rates affect the prices of bonds A, B, and C. The table below the graph quantifies the change in prices per the shocks. For simplicity’s sake, we assume a constant bond duration in this example.

It is negative tax convexity that should cause investors, all else being equal, to prefer bonds trading at a premium (such as bond C) over those trading at par or a discount. It is also worth noting that the tax convexity plays an additional role in the secondary market for munis. Bonds with prices at or near par will be in less demand than bonds trading well above par if traders anticipate a near term rise in yields that will shift the par bond to a discounted price.

Summary

Yields have fallen for the better part of the last thirty years, so muni investors have not had to deal with discounted bonds and their tax implications often. Because of this, many muni investors are likely unaware of negative tax convexity risk. As we highlighted in the table, the gains in price when yields fall are relatively equal for the three bonds but the negative deviation in price in a rising yield environment is meaningful. Given this negative divergence, we recommend that you favor higher coupon/ higher priced munis. If you currently own lower priced munis, it may be worth swapping them for higher priced (higher coupon) bonds.

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Addendum: De minimis

The tax code contains a provision for munis called the de minimis rule. This rule establishes the proper tax rate to apply to capital appreciation. The following clip from Charles Schwab’s Bond Insights provides a good understanding of the rule.

The de minimis rule

The de minimis rule says that for bonds purchased at a discount of less than 0.25% for each full year from the time of purchase to maturity, gains resulting from the discount are taxed as capital gains rather than ordinary income. Larger discounts are taxed at the higher income tax rate.

Imagine you wanted to buy a discount muni that matured in five years at $10,000. The de minimis threshold would be $125 (10,000 x 0.25% x five years), putting the dividing line between the tax rates at $9,875 (the par value of $10,000, minus the de minimis threshold of $125).

For example, if you paid $9,900 for that bond, your $100 price gain would be taxed as a capital gain (at the top federal rate of 23.8%, that would be $23.80). If you received a bigger discount and paid $9,500, your $500 price gain would be taxed as ordinary income (at the top federal rate of 39.6%, that would be $198).

It is important to note that some bonds are issued at prices below par. Such bonds, called original issue discount (OID), use the original offering price and not par as the basis to determine capital gains. If you buy a bond with an OID of $98 at a price of $97.50, you will only be subject to $0.50 (the difference between the OID price and the market price) of capital gains or ordinary income tax.

It’s hard to go anywhere these days without coming across some mention of artificial intelligence (AI). You hear about it, you read about it and it’s hard to find a presentation deck (on any subject) that doesn’t mention it. There is no doubt there is a lot of hype around the subject.

While the hype does increase awareness of AI, it also facilitates some pretty silly activities and can distract people from much of the real progress being made. Disentangling the reality from the more dramatic headlines promises to provide significant advantages for investors, business people and consumers alike.

Artificial intelligence has gained its recent notoriety in large part due to high profile successes such as IBM’s Watson winning at Jeopardy and Google’s AlphaGo beating the world champion at the game “Go”. Waymo, Tesla and others have also made great strides with self-driving vehicles. The expansiveness of AI applications was captured by Richard Waters in the Financial Times [here}: “If there was a unifying message underpinning the consumer technology on display [at the Consumer Electronics Show] … it was: ‘AI in everything’.”

High profile AI successes have also captured people’s imaginations to such a degree that they have prompted other far reaching efforts. One instructive example was documented by Thomas H. Davenport and Rajeev Ronanki in the Harvard Business Review [here]. They describe, “In 2013, the MD Anderson Cancer Center launched a ‘moon shot’ project: diagnose and recommend treatment plans for certain forms of cancer using IBM’s Watson cognitive system.” Unfortunately, the system didn’t work and by 2017, “the project was put on hold after costs topped $62 million—and the system had yet to be used on patients.”

Waters also picked up on a different message – that of tempered expectations. In regard to “voice-powered personal assistants”, he notes, “it isn’t clear the technology is capable yet of becoming truly useful as a replacement for the smart phone in navigating the digital world” other than to “play music or check the news and weather”.

Other examples of tempered expectations abound. Generva Allen of Baylor College of Medicine and Rice University warned [here], “I would not trust a very large fraction of the discoveries that are currently being made using machine learning techniques applied to large sets of data.” The problem is that many of the techniques are designed to deliver specific answers and research involves uncertainty. She elaborated, “Sometimes it would be far more useful if they said, ‘I think some of these are really grouped together, but I’m uncertain about these others’.”

Worse yet, in extreme cases AI not only underperforms; it hasn’t even been implemented yet. The FT reports [here], “Four in 10 of Europe’s ‘artificial intelligence’ startups use no artificial intelligence programs in their products, according to a report that highlights the hype around the technology.”

Cycles of inflated expectations followed by waves of disappointment come as no surprise to those who have been around artificial intelligence for a while: They know all-too-well this is not the first rodeo for AI. Indeed, much of the conceptual work dates to the 1950s. In reviewing some of my notes recently I came across a representative piece that explored neural networks for the purpose of stock picking – dated from 1993 [here].

The best way to get perspective on AI is to go straight to the source and Martin Ford gives us that opportunity through his book, Architects of Intelligence. Organized as a succession of interviews with the industry’s leading researchers, scholars and entrepreneurs, the book provides a useful history of AI and highlights the key strands of thinking.

Two high level insights emerge from the book. One is that despite the disparate backgrounds and personalities of the interviewees, there is a great deal of consensus on important subjects. The other is that many of the priorities and concerns of the top AI researches are quite noticeably different from those expressed in mainstream media.

Take for example, the concept of artificial general intelligence (AGI). This is closely related to the notion of the “Singularity” which is the point at which artificial intelligence matches that of humans – on its path to massively exceeding human intelligence. The idea has captured people’s concerns about AI that include massive job losses, killer drones, and a host of other dramatic manifestations.

AI’s leading researchers have very different views; as a group they are completely unperturbed by AGI. Geoffrey Hinton, Professor of computer science at the University of Toronto and Vice president and engineering fellow at Google said, “If your question is, ‘When are we going to get a Commander Data [from the Star Trek TV series]’, then I don’t think that’s how things are going to develop. I don’t think we’re going to get single, general-purpose things like that.”

Yoshua Bengio, Professor of computer science and operations research at the University of Montreal, tells us that, “There are some really hard problems in front of us and that we are far from human-level AI.” He adds, “we are all excited because we have made a lot of progress on climbing the hill, but as we approach the top of the hill, we can start to see a series of other hills rising in front of us.”

Barbara Grosz, Professor of natural sciences at Harvard University, expressed her opinion, “I don’t think AGI is the right direction to go”. She argues that because the pursuit of AGI (and dealing with its consequences) are so far out into the future that they serve as “a distraction”.

Another common thread among the AI researches is the belief that AI should be used to augment human labor rather than replace it. Cynthia Breazeal, Director of the personal robots group for MIT media laboratory, frames the issue: “The question is what’s the synergy, what’s the complementarity, what’s the augmentation that allows us to extend our human capabilities in terms of what we do that allows us to really have greater impact in the world.” Fei-Fei Li, Professor of computer science at Stanford and Chief Scientist for Google Cloud, described, “AI as a technology has so much potential to enhance and augment labor, in addition to just replace it.”

James Manyika, Chairman and director of McKinsey Global Institute noted since 60% of occupations have about a third of their constituent activities automatable and only about 10% of occupations have more than 90% automatable, “many more occupations will be complemented or augmented by technologies than will be replaced.”

Further, AI can only augment human labor insofar as it can effectively work with human labor. Barbara Grosz pointed out, “I said at one point that ‘AI systems are best if they’re designed with people in mind’.” She continued, “I recommend that we aim to build a system that is a good team partner and works so well with us that we don’t recognize that it isn’t human.”

David Ferrucci, Founder of Elemental Cognition and Director of applied AI at Bridgewater Associates, said, “The future we envision at Elemental Cognition has human and machine intelligence tightly and fluently collaborating.” He elaborated, “We think of it as thought-partnership.” Yoshua Bengio reminds us, however, of the challenges in forming such a partnership: “It’s not just about precision [with AI], it’s about understanding the human context, and computers have absolutely zero clues about that.”

It is interesting that there is a fair amount of consensus regarding key ideas such as AGI is not an especially useful goal right now, AI should be applied to augment labor and not replace it, and AI should work in partnership with people. It’s also interesting that these same lessons are borne out by corporate experiences.

Richard Waters describes how AI implementations are still at a fairly rudimentary stage in the FT [here]: “Strip away the gee-whizz research that hogs many of the headlines (a computer that can beat humans at Go!) and the technology is at a rudimentary stage.” He also notes, “But beyond this ‘consumerisation’ of IT, which has put easy-to-use tools into more hands, overhauling a company’s internal systems and processes takes a lot of heavy lifting.”

That heavy lifting takes time and exceptionally few companies are there. Ginni Rometty, head of IBM, characterizes her clients’ applications as “Random acts of digital” and describes many of the projects as “hit and miss”. Andrew Moore, the head of AI for Google’s cloud business, describes it as “Artisanal AI”. Rometty elaborates, “They tend to start with an isolated data set or use case – like streamlining interactions with a particular group of customers. They are not tied into a company’s deeper systems, data or workflow, limiting their impact.”

While the HBR case of the MD Anderson Cancer Center provides a good example of a moonshot AI project that probably overreached, it also provides an excellent indication of the types of work that AI can materially improve. At the same time the center was trying to apply AI to cancer treatment, its “IT group was experimenting with using cognitive technologies to do much less ambitious jobs, such as making hotel and restaurant recommendations for patients’ families, determining which patients needed help paying bills, and addressing staff IT problems.”

In this endeavor, the center had much better experiences: “The new systems have contributed to increased patient satisfaction, improved financial performance, and a decline in time spent on tedious data entry by the hospital’s care managers.” Such mundane functions may not exactly be Terminator stuff but are still important.

Leveraging AI for the purposes of augmenting human labor collaborating with humans was also the focus of an HBR piece by H. James Wilson and Paul R. Daugherty [here]. They point out, “Certainly, many companies have used AI to automate processes, but those that deploy it mainly to displace employees will see only short-term productivity gains. In our research involving 1,500 companies, we found that firms achieve the most significant performance improvements when humans and machines work together … Through such collaborative intelligence, humans and AI actively enhance each other’s complementary strengths: the leadership, teamwork, creativity, and social skills of the former, and the speed, scalability, and quantitative capabilities of the latter.”

Wilson and Daugherty elaborate, “To take full advantage of this collaboration, companies must understand how humans can most effectively augment machines, how machines can enhance what humans do best, and how to redesign business processes to support the partnership.” This takes a lot of work that is well beyond just dumping an AI system into a pre-existing work environment.

The insights from leading AI researchers combined with the realities of real-world applications provide some useful implications. One is that AI is a double-edged sword: The hype can cause distraction and misallocation, but the capabilities are too important to ignore.

Ben Hunt discusses the roles of intellectual property (IP) and AI in regard to the investment business [here], but his comments are widely relevant to other businesses. He notes, “The usefulness of IP in preserving pricing power is much less a function of the better mousetrap that the IP helps you build, and much more a function of how neatly the IP fits within the dominant zeitgeist in your industry.

He goes on to explain that the “WHY” of your IP must “fit the expectations that your customers have for how IP works” in order to protect your product. He continues, “If you don’t fit the zeitgeist, no one will believe that your castle walls exist. Even if they do.” In the investment business (and plenty of others), “NO ONE thinks of human brains as defensible IP any longer. No one.” In other words, if you aren’t employing AI, you won’t get pricing power, regardless of the actual results.

This hints at an even bigger problem with AI: Too many people are simply not ready for it. Daniela Rus, Director of the Computer science and artificial intelligence laboratory (CSAIL) at MIT, said, “I want to be a technology optimist. I want to say that I see technology as something that has the huge potential to unite people rather than divide people, and to empower people rather than estrange people. In order to get there, though, we have to advance science and engineering to make technology more capable and more deployable.” She added, “We need to revisit how we educate people to ensure that everyone has the tools and the skills to take advantage of technology.”

Yann Lecun added, “We’re not going to have widely disseminated AI technology unless a significant proportion of the population is trained to actually take advantage of it”. Cynthia Breazeal echoed, “In an increasingly AI-powered society, we need an AI-literate society.” These are not hollow statements either; there is a vast array of free learning materials for AI available online to encourage participation in the field.

If society does not catch up to the AI reality, there will be consequences. Brezeal notes, “People’s fears about AI can be manipulated because they don’t understand it.” Lecun points out, “There is a concentration of power. Currently, AI research is very public and open, but it’s widely deployed by a relatively small number of companies at the moment. It’s going to take a while before it’s used by a wider swath of the economy and that’s a redistribution of the cards of power.” Hinton highlights another consequence, “The problem is in the social systems, and whether we’re going to have a social system that shares fairly … That’s nothing to do with technology.”

In many ways, then, AI provides a wakeup call. Because of AI’s unique interrelationship with humankind, AI tends to bring out its best and the worst elements. Certainly, terrific progress is being made on the technology side which promises to provide ever-more powerful tools to solve difficult problems. However, those promises are also constrained by the capacity of people, and society as a whole, to embrace AI tools and deploy them in effective ways.

Recent evidence suggests we have our work cut out for us in preparing for an AI-enhanced society. In one case reported by the FT [here], UBS created “recommendation algorithms” (such as those used by Netflix for movies) in order to suggest trades for its clients. While the technology certainly exists, it strains credibility to understand how this application is even remotely useful for society.

In another case, Richard Waters reminds us, “It Is almost a decade, for instance, since Google rocked the auto world with its first prototype of a self-driving car.” He continues [here]: “The first wave of driverless car technology is nearly ready to hit the mainstream — but some carmakers and tech companies no longer seem so eager to make the leap.” In short, they are getting pushback because current technology is at “a level of autonomy that scares the carmakers — but it also scares lawmakers and regulators.”

In sum, whether you are an investor, business person, employee, or consumer, AI has the potential to make things a lot better – and a lot worse. In order to make the most of the opportunity, an active effort focusing on education is a great place to start. If AI’s promises are to be realized it will also take a lot of effort to establish system infrastructures and to map complementary strengths. In other words, it’s best to think of AI as a long journey rather than a short-term destination.

The new SCAN TOOL also has several new screening parameters to include both fundamental factors (Piotroski Score) and momentum factors (Mohanram Score) along with Zack’s rankings.

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

LONG CANDIDATES

CRM – Salesforce

• Two weeks ago we recommended CRM as a potential long.
• With the 50-dma crossing above the 200-dma, a breakout to new highs, and a triggered “buy” signal, the bullish trend for CRM remains.
• We said that with CRM being very overbought to look for a pullback to support to add exposure.
• We recommended buying 1/2 position and add on a on pullback to $150-155.
• That target was reached this week, and the rally this week keeps it on our long-list.
• Stop moved up to $150

ALE – Alete, Inc.

• ALE recently broke above its previous highs.
• Currently, ALE is pushing 2-standard deviations above its intermediate term trend so scaling into the position makes some sense.
• Buy 1/2 position now and 1/2 position on a pullback to $80 that holds.
• Stop-loss is currently $78

AMT – American Tower Corp.

• AMT was a buy recommendation several weeks ago, since then it has just gone parabolic and is grossly extended.
• It’s time to take profits for now.
• Sell 1/2 of the position and look for a pullback to $170 to add back holdings.
• Stop-loss is $160

BLL – Ball Corp.

• BLL was another long-recommendation we made previously which likewise has just gone vertical.
• It is time to take profits out of the position.
• Sell 1/2 of the position and look to add back to BLL on a pullback to support at $51 currently.
• Stop Loss on balance moved up to $50

VZ – Verizon Communications

• Note: We are long VZ in the Equity Portfolio
• After several months of consolidation, VZ finally broke out to the upside.
• A position can be added at current levels.
• Stop is currently $55

SHORT CANDIDATES

AMD – Advanced Micro Devices

• After a rally with the rest of the market, it looks like the trade is done for AMD.
• Global economic weakness is likely to continue weighing on the semi-conductor space for now.
• Parameters are very tight for this trade.
• Short on break, and close, below the 50-dma ($21.50 currently)
• Stop-loss is at $25

APA – Apache Corp.

• The oil and gas drillers continue to struggle under weaker energy prices and the slowing economy doesn’t bode well for them in the near term.
• The recent rally in APA is likely done and there is a reasonable short set-up on the position.
• Short at current levels with a stop $35
• Target is $26

BMY – Bristol Meyers Squibb

• BMY continues to struggle currently.
• The recent rally failed at the 200-dma and has now broken back below the 50-dma.
• Short at current levels with a stop set at $54
• Target is $46.

Anheuser-Busch InBev

• BUD recently failed on a rally to its 200-dma which has defined its downtrend over the last 18-months.
• Short at current levels with a stop at $82.50
• Target for the trade is $65-67.50

COTY – Coty Inc.

• COTY remains in a long-term downtrend and the recent earnings related rally did nothing to change that.
• Short at current levels with a stop at $11.50
• Target for trade is $6-7

There has been a lot of commentary as of late regarding the issue of corporate share repurchases. Even Washington D.C. has chimed into the rhetoric as of late discussing potential bills to limit or eliminate these repurchases. It is an interesting discussion because most people don’t remember that share repurchases were banned for decades prior to President Reagan in 1982. 

Even after the ban was lifted, share repurchases were few and far between as during the “roaring bull market of the 90’s” it was more about increasing outstanding shares through stock splits. Investors went crazy over stock splits as they got more shares of the company they loved at half the price. Most didn’t realize, or understand the effective dilution; but for them it was more of a Yogi Berra analogy:

“Can you cut my pizza into four pieces because I can’t eat eight.” 

However, following the financial crisis stock splits disappeared and a new trend emerged – share repurchases. Like stock splits, share repurchases in and of themselves are not necessarily a bad thing, it is just the least best use of cash. Instead of using cash to expand production, increase sales, acquire competitors, or buy into new products or services, the cash is used to reduce the outstanding share count and artificially inflate earnings per share. Here is a simple example:

• Company A earns $1 / share and there are 10 / shares outstanding. 
• Earnings Per Share (EPS) = $0.10/share.
• Company A uses all of its cash to buy back 5 shares of stock.
• Next year, Company A earns $0.20/share ($1 / 5 shares)
• Stock price rises because EPS jumped by 100%.
• However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
• The next year Company A still earns $1/share and EPS remains at $0.20/share.
• Stock price falls because of 0% growth over the year. 

This is a bit of an extreme example but shows the point that share repurchases have a limited, one-time effect, on the company. This is why once a company engages in share repurchases they are inevitably trapped into continuing to repurchase shares to keep asset prices elevated. This diverts ever-increasing amounts of cash from productive investments and takes away from longer term profit and growth.

As shown in the chart below, the share count of public corporations has dropped sharply over the last decade as companies scramble to shore up bottom line earnings to beat Wall Street estimates against a backdrop of a slowly growing economy and sales.

(The chart below shows the differential added per share via stock backs. It also shows the cumulative growth in EPS and Revenue/Share since 2011)

The Abuse & Misuse 

As I stated, share repurchases aren’t necessarily a bad thing. It is just the misuse and abuse of them which becomes problematic. It’s not just share repurchases though. In “4-Tools To Beat The Wall Street Estimate Game” we discussed how companies not only use stock repurchases, but a variety of other accounting gimmicks to “meet their numbers.” 

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.“

The reason that companies do this is simple: stock-based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. A “miss” of Wall Street expectations can lead to a large penalty in the companies stock price.

As shown in the table above, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.

The use of stock buybacks has continued to rise in recent years and went off the charts following the passage of tax cuts in 2017. As I wrote in early 2018. while it was widely believed that tax cuts would lead to rising capital investment, higher wages, and economic growth, it went exactly where we expected it would. To wit:

“Not surprisingly, our guess that corporations would utilize the benefits of “tax cuts” to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks.  This is ‘financial engineering gone mad'” 

Share buybacks are expected to hit a new record by the end of 2019.

“Share repurchases aren’t bad. It is simply the company returning money to shareholders.”

There is a problem with that statement.

Share buybacks only return money to those individuals who sell their stock. This is an open market transaction so if Apple (AAPL) buys back some of their outstanding stock, the only people who receive any capital are those who sold their shares.

So, who are the ones mostly selling their shares?

As noted above, it’s the insiders, of course, as changes in compensation structures since the turn of the century has become heavily dependent on stock based compensation. Insiders regularly liquidate shares which were “given” to them as part of their overall compensation structure to convert them into actual wealth. As the Financial Times recently penned:

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

A recent report on a study by the Securities & Exchange Commission found the same:

• SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.

What is clear, is that the misuse and abuse of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:

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

In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their own shares, there have been effectively no other real buyers in the market. 

As Jesse Felder wrote:

“Without that $4 trillion in stock buybacks and in a market where trading volume has been falling for decades they never would have been able to soar as high as they have. The chart below plots ‘The Buffett Yardstick’ (total equity market capitalization relative to gross national product) against total net equity issuance (inverted). Since the late-1990’s both valuations and buybacks have been near record highs. Is this just a coincidence? I think it’s safe to say it’s not.”

The other problem with the share repurchases is that is has increasingly been done with the use of leverage. The ongoing suppression of interest rates by the Federal Reserve led to an explosion of debt issued by corporations. Much of the debt was not used for mergers, acquisitions or capital expenditures but for the funding of share repurchases and dividend issuance. 

The explosion of corporate debt in recent years will become problematic if rates rise markedly, further deterioration in credit quality locks companies out of refinancing, or if there is a recessionary drag which forces liquidation of debt. This is something Dallas Fed President Robert Kaplan warned about:

U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008.

A number of studies have concluded this level of credit could ‘potentially amplify the severity of a recession,’

The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.

This was recently noted by the Bank of International Settlements. 

“If, on the heels of economic weakness, enough issuers were abruptly downgraded from BBB to junk status, mutual funds and, more broadly, other market participants with investment grade mandates could be forced to offload large amounts of bonds quickly. While attractive to investors that seek a targeted risk exposure, rating-based investment mandates can lead to fire sales.”

Summary

While share repurchases by themselves may indeed be somewhat harmless, it is when they are coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic. 

The biggest issue was noted by Michael Lebowitz:

“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”

Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefiting senior executives paid on the basis of fallacious earnings-per-share.

As stock prices fall, companies that performed un-economic buybacks are now finding 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.

This article may be best summed up with just one word:

Fraud – frôd/ noun:

Wrongful or criminal deception intended to result in financial or personal gain.

Commercial and industrial (C&I) loan activity is watched closely by economists to gauge the strength of the economy and estimate where we are in the business cycle. C&I loans are used to finance capital expenditures or increase the borrower’s working capital. The C&I loan cycle often takes up to a couple of years to turn positive after a recession, but provides even more confirmation that an economic expansion is underway. For example, the U.S. Great Recession officially ended in June 2009, but the C&I loan cycle didn’t turn positive until late-2010. C&I loans also help to warn when the economic cycle is approaching its end (as they are now).

Total outstanding U.S. commercial and industrial loans have increased by 92% in the current cycle, which surpasses the 80% increase during the mid-2000s cycle and the 88% increase during the late-1990s cycle:

One way of determining when the C&I loan cycle (and, therefore, the overall economic cycle) is nearing its end is by charting total outstanding commercial and industrial loans as a percentage of GDP. When C&I loans are at 10% of GDP or higher (the “Danger Zone”), that is typically a sign that the cycle is long in the tooth and about to tip over into a recession. According to the chart below, recessions occurred shortly after C&I loans peaked within the “Danger Zone.” C&I loans are currently in that zone, which I see as further confirmation that we are in a Fed-driven economic bubble that will end badly.

The current C&I loan cycle has been more powerful and longer-lasting than the prior two cycles because the Fed has held interest rates at record low levels for a record length of time. As the chart below shows, credit booms and bubbles form during low interest rate periods (low interest rates encourage borrowing):

The U.S. corporate debt market (which is mostly in the form of bonds instead loans) is telling a similar message as commercial and industrial loans, as I recently discussed. To summarize, ultra-low bond yields over the past decade have encouraged a corporate borrowing bubble that has also been funding the stock buyback boom. As a result, total outstanding U.S. corporate debt has increased by $3 trillion or 45% since the last peak in 2008. U.S. corporate debt is now at an all-time high of over 46% of GDP, which is even worse than the levels reached during the dot-com bubble and mid-2000s housing bubble.

I am fully aware that both C&I loans and corporate debt may reach a higher percentage of GDP in this cycle due to how low interest rates are. Still, it is important to be aware of the risks that are building up and not be complacent. When the Fed and other central banks hold interest rates at low levels, they create market distortions and encourage malinvestment or unwise lending decisions that would not otherwise occur in a normal interest rate environment. These malinvestments are revealed once interest rates are raised and the economic cycle turns (read my piece about this in Forbes). A tremendous amount of malinvestment has accumulated after a decade of artificially low interest rates, which is going to result in serious pain when the cycle inevitably turns – make no mistake about that.

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Like many professional investors, I love companies that pay dividends. Dividends bring tangible and intangible benefits: Over the last hundred years, half of total stock returns came from dividends.
In a world where earnings often represent the creative output of CFOs’ imaginations, dividends are paid out of cash flows, and thus are proof that a company’s earnings are real.

Finally, a company that pays out a significant dividend has to have much greater discipline in managing the business, because a significant dividend creates another cash cost, so management has less cash to burn in empire-building acquisitions.

Over the last decade, however, artificially low interest rates have turned dividends into a cult, where if you own companies that pay dividends then you are a “serious” investor, while if dividends are not a centerpiece of your investment strategy you are a heretic and need to apologetically explain why you don’t pray in the high temple of dividends.

I completely understand why this cult has formed: Investors that used to rely on bonds for a constant flow of income are now forced to resort to dividend-paying companies.

The problem is that this cult creates the wrong incentives for leaders of publicly traded companies. If it’s dividends investors want, then dividends they’ll get. In recent years, companies started to game the system, squeezing out dividends even if it meant they had to borrow to pay for them.

The cult of dividends takes its toll

Take ExxonMobil for example. It’s a very mature company whose oil production has declined nine out of the last ten quarters, and it is at the mercy of oil prices that have also been in decline. Despite all that, Exxon is putting on a brave face and raising its dividend every year. Never mind that it had to borrow money to pay the dividend in two out of the last four years.

I sympathize with ExxonMobil’s management, who feel they have to do that because their growing dividend puts them into the exclusive club of “dividend aristocrats” – companies that have consistently raised dividends over the last 25 years. They run a mature, over-the-hill company with very erratic earnings that have not grown in ten years and that, based on its growth prospects, should not trade at its current 15 times earnings. ExxonMobil trades solely on being a dividend aristocrat.

It is assumed that a dividend that was raised for 25 years will continue to be raised (or at least maintained) for the next 25 years. GE, also a dividend aristocrat, raised its dividend until the very end, when it cut it by half and then cut it to a penny.

In a normal, semi-rational world, dividends should be a byproduct of a thriving business; they should be a part of rational capital allocation by management. But low interest rates turned companies that pay dividends into a bond-like product, and now they must manufacture dividends, often at the expense of the future.

Let’s take AT&T. Today, the company is saddled with $180 billion of debt; its DirecTV business is declining; and it is also losing its bread and butter post-paid wireless subscribers to competitors. It would be very rational for the company to divert the $13 billion it spends annually on dividends, using it to pay down debt, to de-risk the company and to increase the runway of its longevity. But the mere thought of a lowered or axed dividend would create an instant investor revolt, so AT&T will never lower its dividend, until, like GE, its external environment forces it to do so.

There is a very good reason why investors should be very careful in treating dividend-paying stocks as bond substitutes. Bonds are legally binding contracts, where interest payments and principal repayment are guaranteed by the company. If a company fails to make interest payments and/or repay principal at maturity, investors will put the company into bankruptcy. It is that simple.

When you start treating a stock as a bond substitute, you are making the mental assumption that the price you pay is what the stock is going to be worth at the time when you are done with it (when you sell it). Thus, your focus shifts to the shiny object you are destined to enjoy in the interim – the dividend. You begin to ignore that the price of that fine aristocrat might be less, a lot less, when you and the stampede of other aristocrat lovers will be selling it.

For the last ten years as interest rates have declined not just in the US but globally, you didn’t have to worry about that. Dividend aristocrats have consistently outperformed the S&P 500 since 2008.
However, the bulk of the aristocrats’ appreciation came from a single, unrepeatable, and highly reversible source: price to earnings expansion. If you are certain that interest rates are going lower, much lower, then you can stop reading this, get yourself some aristocrats, buy and forget them, because they’ll continue to behave like super-long-duration bonds with the added bonus of dividends that grow by a few pennies a year.

If interest rates rise, the prices of dividend aristocrats are likely to act like those of long-term bonds. The price-to-earnings pendulum will swing in the opposite direction, wiping out a decade of gains.
Analyze management, not dividends

What should investors do? View dividends not as a magnetic, shiny object but as just one part in a multivariable analytical equation, and never the only variable in the equation. Value a company as if it did not pay a dividend – after all, a dividend is just a capital-allocation decision.

I know tens of billions of dollars have been destroyed by management’s misallocation of capital, be it through share buybacks or bad acquisitions. But as corporate management continues trying to please dividend-hungry investors, value will also be destroyed when companies pay out more in dividends than they can afford.

This is why analyzing corporate management is so important. A lot of management teams will tell you the right thing; they’ll sound smart and thoughtful; but their decisions will fail a very simple test. Here is the test: If this management owned 10% or 20% of the company, would they be making the same decisions?
Would GE, ExxonMobil, or AT&T have been run differently if they were run by CEOs who owned 10% or 20% of their respective stocks? It’s safe to say they would have put their billions in dividend payments to a very different, more profitable use.

On Sunday, March 11, 2019, Federal Reserve Chairman Jerome Powell was interviewed by Scott Pelley on 60 Minutes. We thought it would be helpful to cite a few sections of their conversation and provide you with prior articles in which we addressed the topics discussed.

We have been outspoken about the role of the Fed, their mission and policy actions over the last ten years. We are quick to point out flaws in Fed policy for a couple of reasons. First, is simply due to the enormous effect that Fed policy actions and words have on the markets. Second, many in the media seem to regurgitate the Fed’s actions and words without providing much context or critique of them. The combination of the Fed’s power over the market coupled with poor media analysis of their words and actions might expose investors to improper conclusions and therefore sub-optimal investment decision-making.

With that, we review various parts of the 60 Minutes interview and offer links to prior articles to help provide alternative views and insight as well as a more thorough context of Chairman Powell’s answers.  

Click the following links for the interview TRANSCRIPT and VIDEO.

Can the Fed Chairman be fired?

PELLEY: Do you listen to the president?

POWELL: I don’t comment on the president or any elected official.

PELLEY: Can the president fire you?

POWELL: Well, the law is clear that I have a four-year term. And I fully intend to serve it.

PELLEY: So no, in your view?

POWELL: No.

Our Take: Yes, the Federal Reserve Act which governs the Fed makes it clear that he can be fired “for cause.”- Chairman Powell You’re Fired

Does the Fed play a role in driving the growing income and wealth inequality gaps?

PELLEY: According to federal statistics, the upper half of the American people take home 90% of income, leaving about 10% for the lower half of Americans. Where are we headed in this country in terms of income disparity?

POWELL: Well, the Fed doesn’t have direct responsibility for these issues. But nonetheless, they’re important.

Our Take:  Inflation hurts the poor and benefits of the wealthy. The Fed has an inflation target and therefore takes direct policy action that fuels the wealth divide. – Two Percent for the One Percent

Will Chairman Powell know when a recession is upon us?

PELLEY: This is the longest expansion in American history. How long can it last?

POWELL: It will be the longest in a few months if it continues. I would just say there’s no reason why it can’t continue.

PELLEY: For years?

Our Take: In January of 2008 Chairman Bernanke said a recession was not in the cards. It turns out the official recession started a month earlier.– Recession Risks Are Likely Higher Than You Think

How healthy is the labor market?

POWELL: So, the U.S. economy right now is in a pretty good place. Unemployment is at a 50-year low.

Our Take: We continually hear about the strength of the labor market. While that may seem to be the case, wages and the labor participation rate paint a different picture. – Quick Take: Unemployment Anomaly (RIA Pro – Unlocked)

Do record high stock valuations represent healthy financial conditions?

PELLEY: We have seen big swings in the stock markets in the United States. And I wonder, do you think the markets today are overvalued?

POWELL: We don’t comment on the valuation of the stock market particularly. And we do though, we monitor financial conditions carefully. Our interest rate policy works through financial conditions. So we look at a very broad range of financial conditions. That includes interest rates, the level of the dollar, the availability of credit and also the stock market. So we look at a range of things. And I think we feel that conditions are generally healthy today.

Our Take: We beg to differ with over 100 years of history on our side. – Allocating on Blind Faith (RIA Pro – Unlocked)

Is the Fed Chairman aware of the burden of debt and its economic consequences?

PELLEY: But the overarching question is are we headed to a recession?

POWELL: The outlook for our economy, in my view, is a favorable one. It’s a positive one. I think growth this year will be slower than last year. Last year was the highest growth that we’ve experienced since the financial crisis, really in more than ten years. This year, I expect that growth will continue to be positive and continue to be at a healthy rate.

Our Take: The record amount of debt on an absolute basis and relative to economic activity is a burden on the economy. Expectations should be greatly tempered. – The Economic Consequences of Debt and Economic Theories – Debt Driven Realities

Does Chairman Powell bow at the altar of the President and Congress?

On December 17 & 18 of 2019 President Trump tweeted the following: 

“It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!”

I hope the people over at the Fed will read today’s Wall Street Journal Editorial before they make yet another mistake. Also, don’t let the market become any more illiquid than it already is. Stop with the 50 B’s. Feel the market, don’t just go by meaningless numbers. Good luck!”

PELLEY: Your Fed is apolitical?

POWELL: Strictly non-political.

Considering the Fed made an abrupt U-Turn of policy following the Tweets above, a sharp market decline and very little change in the data to justify it, we think otherwise. – The Fed Doesn’t Target The Market

Summary

The Fed has a long history of talking out of both sides of their mouths. They make a habit of avoiding candor about policy uncertainties in what appears to be an effort to retain credibility and give an appearance of confidence. The Fed’s defense of their extraordinary actions over the past ten years and reluctance to normalize policy is awkward, to say the least and certainly not confidence inspiring. As evidenced by his responses to Scott Pelley on 60 Minutes, Jerome Powell is picking up where Bernanke and Yellen left off.

This article aims to contrast the inconsistencies of the most current words of the Fed Chairman with truths and reality. Thinking for oneself and taking nothing for granted remains the most powerful way to protect and compound wealth and avoid large losses.

My title comes from Jeremy Grantham’s recent CNBC interview. This remark occurs in a discussion about likely returns from the U.S. stock market. Everyone at Grantham’s firm, Grantham, Mayo, van Otterloo (GMO), agrees that over the next two decades stocks will deliver around 2% after-inflation or “real” returns, says Grantham himself. Traditionally, the market has delivered 6%-7% annualized real returns, but trying to achieve that now will be like trying to draw blood out of a stone. Investors hoping for the historical 6%-7% are bound to be disappointed.

The reason for Grantham’s pessimism is simple — P/E ratios are high. Grantham uses the Shiller PE (current price of the S&P 500 Index relative to the underlying constituents’ past 10-year average real earnings). The long term average of that metric is around 16, but over the past quarter century is has been over 20. But Grantham doesn’t think the average will return to 16 soon or in a way that value investors want. It will likely take around two decades instead of a more typical 7-year cycle. And, in a way, that’s more painful than having a market crash. A crash amounts to a valuation re-set; prices get cheap, and the opportunity to invest presents itself to those with courage. But a slow movement from a Shiller PE of 30 (where it sits now) to 16 is a real problem for long term investors who won’t get a good opportunity for returns for a generation.

Besides expensive valuations, the economic cycle will not be in investors’ favor. Grantham thinks recent growth numbers reflect a one-time bump of sidelined workers getting back into the labor market from the time of the financial crisis. That increase has produced an aritificial percentage point of growth in recent years, Grantham estimates, which means the U.S. isn’t growing at, say, 2.5%. Instead it’s growing at more like 1.5%. That will be apparent, in Grantham’s opinion, as the last workers who were frightened out the labor market after the crisis re-enter. Perhaps that game of re-entry can persist for a few more years, Grantham speculates, but it’s not a permanent feature of the economy. When it ceases, growth will suffer.

Moreover, population growth in the U.S. is declining. We need a 2.1 fertility rate to keep growing, and the U.S. has a 1.76 fertility rate. Also, the fertility rate is below that in every other developed country. The population growth rate in the developed world “has gone to hell,” says Grantham. Only emerging markets countries present the prospect of stronger population growth. Besides a growing population in emerging markets, Grantham is also impressed with China’s emphasis on engineering and science education. China is beginning to dominate Artificial Intelligence and green energy, for example. India isn’t far behind, and, when pressed to single out a country that might be the single best investment in the emerging markets space, Grantham singled out India. Even if Grantham is uncomfortable making a specific country call, all of this means he thinks emerging markets are the future for equity investors. It’s a given, however, that emerging markets investors will have to endure volatility.

Grantham is less keen on Europe. Population growth is worse there than in the U.S., and the recent problems with immigration will only worsen, stressing the EU considerably. And a weakened EU grants more opportunity to China and Russia to misbehave. It also increases uncertainty. Brexit looks like it might be delayed, and when it’s delayed it looks like the odds of overturning it might increase somewhat. Still, Grantham provides no guarantees regarding the country of his birth.

While population growth — or lack thereof — present problems for the economy, at least it’s beneficial for the planet. Grantham has devoted time and resources to combat global warming and harm to the environment. Grantham proudly drives a Tesla, but noted that, as a value investor, he wasn’t interested in the company’s stock. He did allow that the stock could be successful, as Amazon’s has been.

The message investors should take from Grantham’s remarks is that stock returns in the developed world will be low for the next decade and possibly longer. That means you must increase your savings rate to meet your retirement and other goals. The market probably won’t do the heavy lifting that it’s done in the past.

With the current economic expansion already extremely long, even by historical standards, there is a rising risk that record low unemployment most likely won’t stay that way forever. 

Could your job be at risk when the next recession comes?

Severance packages are popular when companies seek to reduce workforce, especially older workers. According to Lee Hecht Harrison and Compensation Resources Inc. in their 2017-2018 Severance & Separation Benefits Benchmark Study of over 350 senior HR leaders at U.S. companies, 88% of companies pay severance.

Seeking to accept a severance package is more than a financial decision, there’s an emotional process about to arise. It’s one thing to prepare for retirement; to be placed suddenly in a situation where retirement or a possible dramatic shift in employment is thrust upon you, is quite another.

However, emotions need to be placed on the backburner until a financial decision is made. In most cases, you’ll have at least 21 days to do your homework. You’ll need the time to thoroughly understand the severance agreement especially if it includes a non-compete clause if planning to return to the workforce in a similar role.

For those who have accepted a severance package, what’s next?

The process can feel intimidating.

Don’t worry.

We’re here to help you make sense of it.

There are several points to consider:

Severance pay tax timing.

Depending on how severance pay is administered, it could be best to have it paid out over several years to avoid a big tax hit. A lump sum may push you into a higher tax bracket and perhaps trigger greater capital gain liability and   the Medicare surtax. Best to consult your tax advisor and then your employer’s HR department to determine whether this is a viable alternative. Naturally, working through your budget to make sure this strategy makes sense, is important.

Maximize your Health Savings Account contribution.

If you have a high-deductible medical plan and don’t require the cash for living expenses, consider maximizing your contributions to your company health savings account before your severance date. A HSA payroll deduction is pre-tax, grows tax deferred and for qualified expenses can be withdrawn free of tax. The family contribution limit for 2019 is $7,000. The maximum contribution limit for individuals is $3,500. Those over 55 are allowed an additional $1,000 catch-up contribution.

Lump sum or pension annuity: the decision is a personal one.

Don’t be pressured. Depending on the viability of the pension, current age, health, the direction of interest rates, family longevity, the intention to leave a legacy to family and the current state of your finances, an objective Certified Financial Planner can head you in the right direction. There are several ways to rebuild or re-create a pension for living expenses in retirement. However, sometimes taking the pension annuity is the most appropriate choice.

 

Retirement plan rollover or not.

Most likely the wisest decision is to roll over your retirement plan proceeds into a self-directed individual retirement account held with a full-service financial firm or registered investment advisor. You’ll command a greater selection of investment choices and hopefully lower costs. If younger than 59 ½ (at least 55 years old), and require distributions from your employer retirement account, then it’s best to leave the plan with the company and avoid the 10% early-distribution penalty. This withdrawal provision is NOT available for IRA accounts. A fiduciary or a professional who places your interests first can help you assess the best option.

Stock option exercise strategy considered.

A strategy to exercise company stock options should consider taxes, expiration dates and total net worth invested in the stock of your employer. We recommend no greater than 10% of your liquid net worth tied up in the company stock. Also, you must be sensitive to post-termination stock option rules, especially for vested options. Companies are known to strictly uphold termination deadlines. Exercise them within the stated window or leave money on the table.

What is this process called NUA. Is it right for me?

Have you accumulated company stock in a company retirement plan? You may have the option to complete an in-kind distribution of the shares into a non-retirement account. A ‘net unrealized appreciation’ tax strategy can be especially desirable if the company stock has appreciated significantly.         Through this process, the stock is distributed and taxed as ordinary income at its original value or cost basis. From there, the shares are held in a brokerage account and not taxed until sold. At that time, you’ll pay long-term capital gain rates on additional appreciation.  A qualified tax professional or financial planner can crunch the numbers and help you best understand the pros, cons and the mechanics of this process.

Healthcare coverage including COBRA.

A common mistake for those who are eligible for Medicare is to sign up for COBRA coverage (which extends group health coverage insurance with higher costs) and postpone taking Part B Medicare insurance. Keep in mind, COBRA is not considered qualified group health insurance coverage for Medicare purposes. If you do not sign up during the Part B 7-month initial enrollment period, you will be charged a late enrollment penalty of 10% of the Part B premium for every 12 months you go without coverage. This penalty is assessed for as long as you have Part B (the rest of your life!).

Don’t forget unemployment benefits.

Yes, if your severance is due to workforce reduction you may be eligible to collect unemployment benefits. Most states prohibit individuals from receiving unemployment benefits while receiving severance pay. Chapter 207 of the Texas Labor Code disqualifies unemployment benefits while receiving most forms of severance pay. However, it’s worth it to apply for benefits with the Texas Workforce Commission to make the determination.

For a severance kit assessment and expanded information about the points outlined here, please contact us at RIA Advisors to discuss your personal situation.

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

AAPL – Apple, Inc.

• After a brutal sell off last year, Wall Street has gotten very negative on the companies prospects. This sets up a reasonable opportunity for an upside surprise during earnings season.
• We added 1/2 of a position this past week and we will look to flesh it out on a pullback that holds support at the 50-dma.
• Stop-loss set at $160

BA – Boeing Co.

• BA had broken out recently to all-time highs following earnings and literally went “soaring” off.
• However, that gross extension set the stage for a sharp pullback which happened this week on news of the second 737 crash in 5-months.
• The sell-off held support at previous highs and will likely begin a basing period here for sometime as news works its way through the system. Fundamentals remain strong and this event will pass.
• We took on a 1/2 position and will add to the position on any weakness that doesn’t violate more critical levels of support.
• We are going to give BA some intial leeway and then will tighten up stops as the stock finds its footing.
• Stop is currently $340
  • Holding 1/2 position currently
  • Looking for opportunity to increase exposure opportunistically.

CHCT – Community Healthcare Trust

• CHCT recently broke out to new highs along with the rest of REIT complex following the pullback in interest rates.
• We noted previously that we were looking for a pullback which works off some of the overbought condition. That process is in the works now.
• Looking to add to the position during this pullback to $32, would like to see a bit more consolidation first.
• Stop is at $30

COST – Costco Wholesale

• I almost gave up on COST despite its fundamentals as the trade just didn’t seem like it was going to work out. Fortunately, the stock has come roaring back.
• While COST is not overbought as of yet, we are looking for a pullback to support between $220-225 to add to our position.
• Also, this will give COST time to register a buy signal which should help buoy the stock in the near term.
• Stop has been moved up to $210

FDX -Federal Express

• FDX has struggled since we added it to the portfolio. As with COST we like the fundamentals but performance during the recent market rally has been disappointing.
• FDX remains oversold and is close to a buy signal.
• Nonetheless, we are keeping a tight stop on the position and may look to swap for a better performing company if we don’t start seeing improvement heading into earnings.
• Stop-loss is moved up to $170

MMM – 3M Company

• We initially bought MMM on the idea of a trade war resolution.
• The recent rally has triggered a “buy” signal, but MMM is extremely overbought.
• We initially bought 1/2 postion in MMM and are looking for an opportunity to increase exposure. A break above $210 will likely be that entry point.
• However, the recent failure at resistance is concerning due to multiple tops at $210. A resolution to the “trade war” will likely be the boost needed to move MMM above resistance.
• However, we are tightening up stops to protect our profits.
• Stop is at $200

HCA – HCA Healthcare

• HCA, along with UNH, sold off over the previous week on concerns of “Medicare For All.”
• We are using this sell off as an opportunity to add to both positions as the sell off is over something that is highly unlikely to happen in the near term.
• We added to our position yesterday bringing the whole position up to target weights
• Stop-loss moved up to $120

IAU – IShares Gold Trust

• We recently added a position in gold to our portfolio after having been out of the metal since 2013.
• The recent pullback to support gave us the right opportunity to add the second position bringing IAU to target portfolio weight.
• Stop-loss is tight at $12.20 currently.

JPM – JP Morgan Chase

• Outside of Visa (V) we have no financial exposure to speak of in our portfolio. JPM has rallied recently above its 50-dma and has been consolidating.
• With JPM very close to a buy signal, we added 1/2 position to the portfolio for now.
• If JPM can break out above its 200-dma we will add the second 1/.2 of the position.
• However,we will carry a fairly tight stop for now at $100.

PPL – PPL Corp.

• We recently added 1/2 position of PPL to our portfolio.
• Fundamentally the company is fairly inexpensive and had been lagging much of the utility companies in our portfolio like DUK and AEP.
• However, the recent breakout above resistance is bullish so we added 1/2 position of PPL to the portfolio for now.
• We are looking for a pullback to support to add the second 1/2 of the position.
• Stop-loss is currently $29.50

In this past weekend’s newsletter we stated:

“This short-term oversold condition, and holding of minor support, does set the market up for a bounce next week which could get the market back above the 200-dma. The challenge, at least in the short-term remains the resistance level building at 2800.”

That bounce occurred on Monday which allowed us to add some trading positions to our portfolios. We update all of portfolios regularly at RIA PRO (Try now for FREE for 30-days with Code: PRO30)

Our job as portfolio managers is simple:

1. Protect investment capital, and; (Long-term view)
2. Take advantage of opportunity when it presents itself. (Short-term view)

The blending of the short and long-term views is the difficult part for readers to understand.

“If you have a long-term bearish view on future market returns, how can you be increasing equity exposure?”

Because, as rule #2 states, our job is to make money when we can while avoiding the long-term risk of capital destruction. As such, we must marry the long-term views with short-term opportunities which don’t necessarily always align.

For example, the media was full of commentary over the weekend discussing the market’s 10th anniversary.

“The U.S. bull market turned 10-years old Saturday, underscoring the resilience of a rally that has persisted despite tepid global growth, anxieties about central bank policies, and mounting trade tensions.” – WSJ

Yes, March 9th marked the 10-year mark of a bull market that started on that same day in 2009. Although there have been a few bumps along the way, the long-term bullish trend has remained intact.

“So, why can’t it just continue for another 10-years?”

It’s a important question and investors should review the catalysts of the last decade.

In 2009, valuations had reverted to the long-term average, asset prices got extremely oversold, and investor sentiment was extremely negative. These are all the ingredients necessary for a cyclical bull market which David Rosenberg detailed on Monday:

“Yes, this was indeed the third strong run-up in the S&P 500 on record with a total return increase of 400%. But in inflation-adjusted dollars, the $30 trillion expansion was a record, taking out the $25 trillion surge in real terms from December 1987 to March 2000.

As David details, the supports for the ensuing rally were abnormal in many aspects.

The government bailed out insolvent banks.

• There were two massive fiscal stimulus programs separated by 8-years.
• The Fed funds rate was ZERO for eight years, and repeated intervention into the marketplace boosted the Fed’s assets six-fold. How could asset values not be influenced by the central bank taking $4.5 trillion of ‘safe’ securities out of the public market?
• Because there were no investable opportunities, cloud computing and AI aside, there was no capital deepening cycle. Cash flows (from tax relief too) were diverted to stock buybacks and dividend payments. The share count of the S&P 500 hit two-decade lows alongside two crazes – buybacks and M&A.
• The Fed’s policies ignited the mother of all leverage cycles in the corporate sector. And it’s not all just about BBB-rated bonds. It’s about private equity, which experienced a massive credit bubble this cycle as well.
• The WSJ mentions ‘anxieties’ about central banks even though they have been the best friend to the investing class than they have ever been in modern history.
• The article also posited that the 10-year bull run confronted “mounting trade tensions.” Well, in truth, by the time these tensions began, in early 2018, over 90% of the bull markets was behind us.
• What sort of market has but 4-companies accounting for 9% of the total return of this 10-year cycle; and 20 of the S&P 500 representing 30% of the total return gain? Answer- a highly concentrated one.

Importantly, this is what happened.

The challenge for investors will be what happens next.

Currently, there is an overwhelming “hope” that what happened over the last 10-years will continue over the next ten. This is a psychological tendency known as “recency bias,” and is one of the biggest behavioral mistakes investors make when it comes to investing.

However, history suggests that the opposite is true more often than not. As I wrote previously:

“’Record levels’ of anything are ‘records for a reason.’

It should be remembered that when records are broken, that was the point where previous limits were reached.  Also, just as in horse racing, sprinting or car races, the difference between an old record and a new one are often measured in fractions of a second.

Therefore, when a ‘record level’ is reached it is NOT THE BEGINNING, but rather an indication of the PEAK of a cycle. Records, while they are often broken, are often only breached by a small amount, rather than a great stretch. While the media has focused on record low unemployment, record stock market levels, and record confidence as signs of an ongoing economic recovery, history suggests caution. For investors, everything is always at its best at the end of a cycle rather than the beginning.”

It isn’t just the stock market hitting record levels in terms of time, but also the economy. According to WSJ’s Alan Blinder:

“Only two economic expansions since 1854 have lasted longer than 100 months, and none have lasted more than 120 months. If the current expansion lasts into July, it will be the longest in history.”

While the old Wall Street axiom is that “bull markets don’t die of old age,” old age usually brings most things closer to the end. As I showed previously in “Is The Market Predicting A Recession?” stocks usually peak, and trough, ahead of the economy.

As John Murphy noted last week for StockCharts:

• The bull market that ended in March 2000 preceded an economic downturn by a year.
• The October 2007 stock market peak preceded the December economic peak by two months.
• The March 2009 stock upturn led the June economic upturn by three months.
• Historically, stocks usually peak from six to nine months ahead of the economy. Which is why we look for possible stock market peaks to alert us to potential peaks in the economy that usually follow. And we may be looking at one.

The weekly chart below shows the S&P 500 hitting an all-time high last September before falling nearly 20% into the end of 2018. While the first two months of 2019 has seen an impressive surge back to its November highs, the market is starting to build a pattern of lower highs, and lower bottoms. More importantly, both relative strength and the MACD indicators are trending lower and negatively diverging from the markets price action.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes. (See an unlocked version here. We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and long-short ideas. You can try RIA PRO free for 30-days with code PRO30)

John continues by looking at the monthly chart of the S&P 500 going back 10-years to the start of the bull market.

“The uptrend is still intact. The sharp selloff that took place during the fourth quarter of 2018 stayed above the rising trendline drawn under its 2009, 2011, 2016 lows. That’s the good news. What may not be so good are signs that long-term momentum indicators are starting to weaken. The two lines in the upper box plot the monthly Percent Price Oscillator (PPO). [The PPO is a variation of MACD and measures percentage changes between two moving averages].

The PPO lines turned negative during the second half of last year when the faster red line fell below the slower blue line. And they remain negative. [The red histogram bars plotting the difference between the two PPO lines also remain in negative territory below their zero lines (red circle)]. Secondly, and maybe more importantly, the 2018 peak in PPO is lower than the earlier peak formed at the end of 2014. That’s the first time that’s happened since the bull market began. In technical terms, that creates a potential ‘negative divergence’ between the PPO lines and the S&P 500 which hit a new high last September.

This raises the possibility that the ten-year bull market may have peaked in the fourth quarter and is now going through a major topping process. If the bull market in stocks is nearing an end, that could start the clock ticking on the nearly ten-year expansion in the U.S. economy. That might not prevent it from setting a new record for longevity this July, but it might diminish its chances for celebrating the eleventh anniversary in the summer of 2020.”

These same negative divergences can be seen in the monthly chart below going back to 1995. Whenever the long-term bull trend lines have been broken from a topping process, with negative divergences, and monthly sell signals, it has been coincident with more major market topping processes.

Sure, this time could be different for a whole variety of reasons, but those generally fall into the category of “hope” rather than a systematic and disciplined approach to investing.

Even after the recent correction, long-term extensions and deviations remain at historically high levels which, historically speaking, have not been extremely kind to investors. But valuations, despite the recent correction, are still pushing 30x earnings as well.

As Brett Arends recently noted:

“From the viewpoint of long-term investment, major risks remain according to some long-term strategists. Yes, conventional wisdom on Wall Street tells you that stocks are likely to gain an average of around 9% a year. And yes, that’s based on the historical average going back at least to the 1920s. But, say some financial historians, that’s a misreading of the past. Stocks, they say, typically produced ‘average’ returns if you bought them at roughly ‘average’ valuations in relation to things like net assets and net income. And U.S. stock valuations today, they warn, are anything but average. According to price-to-earnings or ‘PE’ data tracked by Yale University finance professor and Nobel Prize winner Robert Shiller, the S&P 500 is about 75% above its historic average valuation. ‘

But it isn’t just the technical backdrop of the market that is completely reversed but also the fundamental and economic one. As I showed in “QE – Then, Now & Why It May Not Work:”

With the fundamental and technical backdrop no longer as supportive, valuations still near the most expensive 10% of starting valuations, and interest rates higher, the returns over the next decade will likely be disappointing.

However, that’s the long-term view and valuations are a “horrible” timing device. This is why we use a specific set of price indications over varied time frames to determine short-term risk versus reward.

Currently, the markets are rallying, so we need to participate.

As investors, we have to make money when “the cards are hot.” But just as important is knowing when it is time to “fold and step away from the table.”

I know it seems completely implausible today, but over the next decade there will be many who will have wished they had sold today.

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

Basic Materials

• Previous support from February lows has been broken and is now resistance.
• XLB has triggered a “buy” signal but is wrestling with resistance at the 200-dma.
• XLB is still very overbought (top panel) and the failure at resistance is troubling given materials and industrials both stand to benefit from a “trade deal.”
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 position.
  • This Week: Hold
  • Stop-loss remains at $53
• Long-Term Positioning: Bearish

Communications

• XLC has broken above resistance and is holding that support.
• As expected the “sell” signal reversed to a “buy” this past week.
• Sector back to extreme overbought.
• Short-Term Positioning: Neutral
  • Last Week: Recommended to “hold” 1/2 position
  • This Week: Hold 1/2 position
  • Stop-loss moved up to $45
• Long-Term Positioning: Bearish

Energy

• XLE broke above the 200-dma and has retested that support and held.
• Sell-signal (bottom panel) should reverse this week.
• Currently, XLE is correcting the overbought condition and the backdrop is turning more bullish.
• Short-Term Positioning: Neutral
  • Last week: Recommend “hold” 1/2 position
  • This week: We added 1/2 position to portfolios yesterday.
  • Stop-loss moved up to $63
• Long-Term Positioning: Bearish

Financials

• XLF finally broke above downtrend resistance but lots of resistance from 2018 remains.
• A “buy” signal has been triggered (bottom panel)
• XLF is correcting the extreme overbought condition short-term. Look for a reversal which doesn’t violate support to add exposure.
• Short-Term Positioning: Neutral
  • Last week: Recommended “hold” 1/2 position
  • This week: Hold 1/2 position
  • Stop-loss moved up to $25.50
• Long-Term Positioning: Bearish

Industrials

• XLI has rallied sharply on hopes of a resolution on trade. However, whatever deal is struck, it has likely already been priced in.
• Buy signal in lower panel is very extended.
• The extreme overbought condition is being corrected short-term, after taking profits in current holdings continue to be patient for a pullback to support to add exposure.
• Previous all-time highs remain a likely target.
• Short-Term Positioning: Bullish
  • Last week: Recommended “hold” 1/2 position
  • This week: Rebalance holdings. Hold 1/2 position, add on pullback to $72
  • Stop-loss moved up to $70
• Long-Term Positioning: Neutral

Technology

• A “Buy” signal (bottom panel) has been triggered.
• Given the current extreme overbought conditions short-term, look for a pullback to add exposure to portfolios.
• Pushed above downtrend resistance and is looking to test old highs.
• Short-Term Positioning: Bullish
  • Last week: Recommended “hold” 1/2 position
  • This week: Hold 1/2 position, Add on pullback to $65-66
  • Stop-loss moved up to $64.00
• Long-Term Positioning: Neutral

Staples

• After breaking above the 400-dma, XLP broke above resistance and is approaching previous highs.
• XLP has triggered a “buy” signal (lower panel)
• Currently still overbought, however the pullback to $53.50 hit our target to add exposure.
• Short-Term Positioning: Bullish
  • Last week: Recommended “hold” 1/2 position
  • This week: Add 1/2 position with pullback to $53.5.
  • Stop-loss remains at $52.50
• Long-Term Positioning: Bullish

Real Estate

• Long-term trend line is currently holding.
• After breaking out to all-time highs, it has just kept going. There has not been a decent risk/reward opportunity to increase exposure.
• Buy signal reaching more extreme levels (bottom panel)
• Remains at more extreme overbought condition short-term. (top panel)
• Short-Term Positioning: Bullish
  • Last week: Recommended “hold” 1/2 position
  • This week: Hold 1/2 position
  • Add on any weakness that works off over-bought condition or holds support at $33
  • Stop-loss adjusted to $32.50
• Long-Term Positioning: Bullish

Utilities

• Long-term trend line remains intact.
• Previous support continues to hold.
• Buy signal has been registered.. (bottom panel)
• Back to extreme overbought conditions.
• Broke above resistance and moved to all-time highs.
• Short-Term Positioning: Bullish
  • Last week: Wait for a pullback to $56 to add exposure.
  • This week: Rebalance holdings and continue to hold
  • Stop-loss moved up to $54 with a target of $60
• Long-Term Positioning: Bullish

Health Care

• Sell-signal (bottom panel) is being reversed.
• The current overbought condition is being worked off and XLV is holding support currently at the long-term uptrend line.
• Short-Term Positioning: Neutral
  • Last week: Recommended “hold” 1/2 position
  • This week: Added a position to portfolios yesterday.
  • Stop-loss moved up to $89
• Long-Term Positioning: Neutral

Discretionary

• Long-term trend line has been broken.
• Previous support was successfully tested in recent sell off.
• Downtrend resistance has been broken but overhead resistance remains short-term.
• A “buy” signal has been registered (lower panel)
• Extreme overbought conditions are being corrected short-term.
• The recent correction to $108 hit our target to add exposure.
• Short-Term Positioning: Neutral
  • Last week: Recommended “hold” 1/2 position
  • This week: Add 1/2 position if needed.
  • Stop-loss moved up to $106.00
• Long-Term Positioning: Neutral

Transportation

• Previous support failed in recent sell-off. Rally on Monday also failed to reclaim that level.
• Buy signal. (bottom panel) has been triggered..
• Overbought condition is being relieved on a short-term basis.
• The recommendation to add exposure at $60 with a tight stop at $58 remains.
• Short-Term Positioning: Neutral
  • Last week: Recommended “hold” 1/2 position
  • This week: Hold 1/2 of position or add exposure at $60.
  • Stop-loss adjusted to $58
• Long-Term Positioning: Bearish

For the first time since the Global Financial Crisis, Turkey has officially entered a recession after GDP fell 2.4% in the fourth quarter of 2018 and 1.6% in the third quarter. Turkey’s economic contraction is the result of the sharp decline of the lira currency, aggressive interest rate hikes, and a credit bust that is just getting started. Turkey’s nascent recession and credit bust are symptoms of the bursting of an economic bubble that I’ve been warning about for the past several years.

To summarize my warnings, a credit bubble formed in Turkey starting in the early-2000s, which led to an artificial economic boom. Private sector credit grew from roughly 15% of GDP in 2003 to 70% of GDP in 2016. Loans to the private sector sextupled from 2010 to 2018. This credit bubble was the result of record low interest rates, which made it much cheaper to borrow.

The chart below shows how interest rates remained at record low levels from 2009 to 2018. The decline of Turkey’s currency necessitated raising interest rates to shore up the currency. Unfortunately, as I explained in Forbes, high interest rates cause credit bubbles to burst, which then results in an economic contraction.

Since August, Turkey has been experiencing a credit bust:

Turkey’s recession and credit bust are only in their infancy, I’m afraid. Turkey has had a tremendous debt-fueled economic boom over the past fifteen years and is about to experience the hangover.

Please follow me on LinkedIn and Twitter to keep up with my updates.

Please click here to sign up for our free weekly newsletter to learn how to navigate the investment world in these risky times.

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

• Recent rally pushed into the January peak and failed at very overbought conditions.
• As noted last week, the market tested and failed the 2800 psychological resistance level.
• Longer-term “buy signal” is in place which is bullish
• Short-term market is remains overbought and the pullback violated the 200-dma, so no entry just yet for trading positions.
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 position
  • This Week: Hold 1/2 of position, look for reversal of overbought condition to add.
  • Stop-loss remains $270
• Long-Term Positioning: Neutral

Dow Jones Industrial Average

• Recent rally failed at the January highs and remains very overbought.
• DIA remains well above its 200-dma but that will be critical support.
• A “buy signal” is in place
• Market is back to extreme overbought, look for retracement to support (200-dma) before additional advancement.
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss remains at $250
• Long-Term Positioning: Neutral

Nasdaq Composite

• Recent rally failed at the January highs and market remains overbought.
• QQQ is wrestling with important support at the 200-dma.
• A buy signal was triggered last week.
• Market remains very overbought. Support needs to hold at the 200-dma while it works off the overbought condition.
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss remains at $165
• Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

• Recent rally failed at the 200-dma and is now testing important support at the Oct-Nov lows.
• A “buy” signal was triggered last week.
• Small-caps have reversed about half of its overbought condition so there is still downside risk currently.
• Short-Term Positioning: Neutral
  • Last Week: Hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss remains at $66 – could break next week.
• Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

• Like it’s small-cap brethren, the recent rally failed to hold the 200-dma.
• Currently, Mid-caps are testing support at the Oct-Nov highs
• Mid-caps have recently flipped back onto a buy signal. However, the recent correction has not reduced the overbought condition we noted last week.
• Short-Term Positioning: Neutral
  • Last Week: After taking profits previously, hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss is adjusted to $332.50
• Long-Term Positioning: Neutral

Emerging Markets

• EEM is currently testing its 200-dma.
• The extreme overbought condition is being worked off currently, so it will be important for EEM to maintain support over the next week.
• After adding a 1/2 position to portfolios we suggested a short-term corrective action was likely. If the position holds support and turns up we will add to our holdings.
• Short-Term Positioning: Bullish
  • Last Week: Added to holdings.
  • This Week: Hold current position.
  • Stop-loss moved to $41
• Long-Term Positioning: Bearish

International Markets

• Recent rally failed at the 200-dma and turned lower.
• The downtrend from all-time highs is converging with 200-dma (green dashed line) which is providing additional downward resistance.
• While a “buy signal” has been triggered, EFA reamins very overbought in the short-term.
• Short-Term Positioning: Neutral
  • Last Week: After taking profits, hold 1/2 of position
  • This Week: Hold 1/2 of position
  • Stop-loss moved up to $62
• Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

• Oil showed some muscle by breaking above the 3-year trend channel and above the 38.2% Fibonacci retracement.
• $60 is the next major resistance level at the 50% retracement which will coincide with the downward trending 200-dma.
• Oil is very close to triggering a “buy” signal which will allow us to add exposure if some of the short-term overbought condition can be worked off.
• Short-Term Positioning: Neutral
  • Last Week: After taking profits, hold 1/2 position
  • This Week: Hold 1/2 position
  • Stop-loss adjusted to $54
• Long-Term Positioning: Bearish

Gold

• As we noted last week, the recent rally was pushing into resistance at 3-year highs and was extremely over-bought.
• The sell-off tested support at the 61.8% retracement of the decline and is now back to oversold.
• Gold turned up last week and remains on a “buy” signal.
• Currently on “buy” signal (bottom panel) so positions can be added.
• Short-Term Positioning: Bullish
  • Market pulled back to support at $122 last week
  • Added 1/2 position
  • Adding 1/2 position this week.
  • Stop-loss for whole position set at $119
• Long-Term Positioning: Improving From Bearish To Bullish

Bonds (Inverse Of Interest Rates)

• Long-term support continues to hold at $111.
• Currently on a buy-signal (bottom panel)
• Entry point was triggered at $120 with reversal of overbought condition.
• Resistance remains at $124.50
• Strong support at the 720-dma (2-years) (green dashed line) which is currently $118.
• Short-Term Positioning: Bullish
  • Last Week: Hold positions.
  • This Week: Add to holdings after successful test of support at $119.
  • Stop-loss adjusted to $118
• Long-Term Positioning: Bullish

One of the most highly debated topics over the past few months has been the rise of Modern Monetary Theory (MMT). The economic theory has been around for quite some time but was shoved into prominence recently by Congressional Representative Alexandria Ocasio-Cortez’s “New Green Deal” which is heavily dependent on massive levels of Government funding.

There is much debate on both sides of the argument but, as is the case with all economic theories, supporters tend to latch onto the ideas they like, ignore the parts they don’t, and aggressively attack those who disagree with them. However, what we should all want is a robust set of fiscal and monetary policies which drive long-term economic prosperity for all.

Here is the problem with all economic theories – they sound great in theory, but in practice, it has been a vastly different outcome. For example, when it comes to deficits, John Maynard Keynes contended that:

“A general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”

In other words, when there is a lack of demand from consumers due to high unemployment, then the contraction in demand would force producers to take defensive actions to reduce output. Such a confluence of actions would lead to a recession.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Unfortunately, as shown below, economists, politicians, and the Federal Reserve have simply ignored the other part of the theory which states that when economic activity returns to normal, the Government should return to a surplus. Instead, the general thesis has been:

“If a little deficit is good, a bigger one should be better.”

As shown, politicians have given up be concerned with deficit reduction in exchange for the ability to spend without constraint.

However, as shown below, the theory of continued deficit spending has failed to produce a rising trend of economic growth.

When it comes to MMT, once again we see supporters grasping onto the aspects of the theory they like and ignoring the rest. The part they “like” sounds a whole lot like a “Turbotax” commercial:

The part they don’t like is:

“The only constraint on MMT is inflation.”

That constraint would come as, the theory purports, full employment causes inflationary pressures to rise. Obviously, at that point, the government could/would reduce its support as the economy would theoretically be self-sustaining.

However, as we questioned previously, the biggest issue is HOW EXACTLY do we measure inflation?

This is important because IF inflation is the ONLY constraint on debt issuance and deficits, then an accurate measure of inflation, by extension, is THE MOST critical requirement of the theory.

In other words:

“Where is the point where the policy must be reversed BEFORE you cause serious, and potentially irreversible, negative economic consequences?”

This is the part supporters dislike as it imposes a “limit” on spending whereas the idea of unconstrained debt issuance is far more attractive.

Again, there is no evidence that increasing debts or deficits, inflation or not, leads to stronger economic growth.

However, there is plenty of evidence which shows that rising debts and deficits lead to price inflation. (The chart below uses the consumer price index (CPI) which has been repeatedly manipulated and adjusted since the late 90’s to suppress the real rate of inflationary pressures in the economy. The actual rate of inflation adjusted for a basket of goods on an annual basis is significantly higher.) 

Of course, given the Government has already been running a “quasi-MMT” program for the last 30-years, the real impact has been a continued shift of dependency on the Government anyway. Currently, one-in-four households in the U.S. have some dependency on government subsidies with social benefits as a percentage of real disposable income at record highs.

If $22 trillion in debt, and a deficit approaching $1 trillion, can cause a 20% dependency on government support, just imagine the dependency that could be created at $40 trillion?

If the goal of economic policy is to create stronger rates of economic growth, then any policy which uses debt to solve a debt problem is most likely NOT the right answer.

This is why proponents of Austrian economics suggest trying something different – less debt. Austrian economics suggests that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit. This expansion of credit then creates an expansion of the supply of money.

Therefore, as one would ultimately expect, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities. Finally, the credit-sourced boom results in widespread malinvestments. When the exponential credit creation can no longer be sustained a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear” which causes resources to be reallocated back towards more efficient uses.

Time To Wake Up

For the last 30 years, each Administration, along with the Federal Reserve, have continued to operate under Keynesian monetary and fiscal policies believing the model worked. The reality, however, has been most of the aggregate growth in the economy has been financed by deficit spending, credit expansion and a reduction in savings. In turn, the reduction of productive investment into the economy has led to slowing output. As the economy slowed and wages fell the consumer was forced to take on more leverage which also decreased savings. As a result of the increased leverage, more of their income was needed to service the debt.

Secondly, most of the government spending programs redistribute income from workers to the unemployed. This, Keynesians argue, increases the welfare of many hurt by the recession. What their models ignore, however, is the reduced productivity that follows a shift of resources toward redistribution and away from productive investment.

In its essential framework, MMT suggests correctly that debts and deficits don’t matter as long as the money being borrowed and spent is used for productive purposes. Such means that the investments being made create a return greater than the carrying cost of the debt used to finance the projects.

Again, this is where MMT supporters go astray. Free healthcare, education, childcare, living wages, etc., are NOT a productive investments which have a return greater than the carrying cost of the debt. In actuality, history suggests these welfare supports have a negative multiplier effect in the economy.

What is most telling is the inability for the current economists, who maintain our monetary and fiscal policies, to realize the problem of trying to “cure a debt problem with more debt.”

This is why the policies that have been enacted previously have all failed, be it “cash for clunkers” to “Quantitative Easing”, because each intervention either dragged future consumption forward or stimulated asset markets. Dragging future consumption forward leaves a “void” in the future which must be continually filled, This is why creating an artificial wealth effect decreases savings which could, and should have been, used for productive investment.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the end result, has been clearly wrong. It hasn’t happened in 30 years.

MMT supporters have the same view that if the government hands out money it will create stronger economic growth. There is not evidence which supports such is actually the case.

It’s time for those driving both monetary and fiscal policy to wake up. The current path we are is unsustainable. The remedies being applied today is akin to using aspirin to treat cancer. Sure, it may make you feel better for the moment, but it isn’t curing the problem.

Unfortunately, the actions being taken today have been repeated throughout history as those elected into office are more concerned about “satiating the mob with bread and games” rather than suffering the short-term pain for the long-term survivability of the empire. In the end, every empire throughout history fell to its knees under the weight of debt and the debasement of their currency.

It’s time we wake up and realize that we too are on the same path.

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• What Do Central Banks Know?
• Sector & Market Analysis
• 401k Plan Manager

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In last week’s missive, we discussed a critical point concerning the bull run so far.

“Despite the underlying economic and fundamental data, the markets have surged back to extremely overbought, extended, and deviated levels. The chart table below is published weekly for our RIA PRO subscribers (use code PRO30 for a 30-day free trial)

You will note that with the exception of bond prices, every market and sector is more than 5% above its 50-day moving average and year-to-date performance is pushing more historic extremes both in price and in extreme overbought conditions. 

On virtually every measure, markets are suggesting the fuel for an additional leg higher in assets prices is extremely limited.”

The chart below compares last weeks analysis to this week. You can see the sharp difference between the two periods as much of the overextension last week has now been reversed. 

The chart below also shows the short-term reversal of the market as well as the test of minor support at the initial October lows. 

This short-term oversold condition, and holding of minor support, does set the market up for a bounce next week which could get the market back above the 200-dma. The challenge, at least in the short-term remains the resistance level building at 2800.

However, the next two charts suggest there is a decent probability any bounce will fail in the short-term and should be used for rebalancing risk.

1. The market has not reversed to levels which normally signals short-term bottoms. The red lines in the bottom four panels denote periods where taking profits, and reducing risk, has been ideal. The green lines have been prime opportunities to increase exposure. As you will note, these indicators tend to swing from extremes and once a correction process has started it is usually not completed until the lower bound is reached. 

Important Note: This does not mean the market will decline sharply in price. The current overbought conditions can also be resolved by continued consolidation within a range as we have seen over the last two weeks. 

2) There is historically a very high correlation between what happens in the transportation sector (a view on the economy) and the market as a whole. Watch for a rally in the transportation sector to signal an all-clear for the markets. 

The current set up suggests that the correction that started last week is not yet complete and any bounce will likely be a good opportunity to reposition portfolios in the short-term until a better entry point to increase exposure is achieved. 

The problem with statements like these is that those of the “permanently bullish” mindset tend to extrapolate the analysis into the onset of the next major “bear market.”  Such is certainly not the intent, nor is it a suggestion to sell everything and hide in cash. 

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What should be readily apparent is that paying attention to price can help alleviate our natural tendency to “buy high” and “sell low.”  Managing a portfolio of investments is simply measuring risk and reward and placing bets when reward outweighs the potential risk. Tweaking exposure to “risk” overtime can pay big dividends over the long-term which is our goal of investing to begin with. 

This is why every great investor throughout history has basic investing rules which all revolve around limiting losses to capital. Here are James Montier’s 7-Immutable Laws Of Investing:

1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don’t understand

If these rules sound logical to you, and you are nodding your head in agreement, then how does a pitch to “buy and hold” and “ride out the market” make any sense?

During a bull market cycle, buying and holding good investments which pay a dividend is absolutely the right thing to do. However, at the end of market cycle, not so much. 

What Do Central Banks Know That You Don’t

As we noted in Thursday’s missive on why QE may not work this time, Central Bankers globally have jumped back into the “emergency measure” pool.

• The Fed
  • Has announced it will be “patient” with future rate hikes.
  • The pace of QT, or balance sheet reduction, will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets.
  • It is expected the Fed will announce in March that QT will end and the balance sheet will stabilize at a much higher level, and;
  • QE is a tool that WILL BE employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.
• China has launched its version of “Quantitative Easing” to help prop up its economy which grew at the slowest pace in nearly 30-years.
  • China has taken fiscal and monetary policy measures such as fast-tracking infrastructure projects
  • Additional monetary support for the economy
  • A cut in taxes, and;
  • A Reduction  banks’ reserve requirements

• The ECB, after downgrading Eurozone growth, announced

  • They will not raise rates in 2019, and;

  • They will extended the TLTRO program, which is the Targeted Longer-Term Refinancing Operations scheme which gives cheap loans to struggling Eurozone banks, into 2021. (Currently, Italy, Spain, Greece, and Portugal all borrow more than they deposit and more tha $800 billion from the previous TLTRO is set to mature over the next two years. Without the extension of the program, defaults could rise sharply.)

But there is nothing to worry about, right?

Maybe, but if there is nothing to worry about, then why the sudden pivot by Central Banks? What are they seeing that you don’t?

As we discussed in our analysis, the macro-environment in the U.S. is markedly different than it was in 2009. The Fed’s starting point to battle the next recessionary environment is far weaker than it was then when the Fed funds rate was twice as high and the balance sheet four-times smaller.

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Here is the important point. We, as investors, have been trained over the last decade to “buy” whenever Central Banks are engaged in monetary interventions. So far it has worked in lifting asset prices higher. But therein lies the risk of complacency. 

In 2009, most of the risk in the financial and credit markets had been wrung out from the decline. Today, the markets are more exposed than ever to leverage and credit risk throughout the global ecosystem. 

My friend Doug Kass had a great note Friday related to this risk.

“Astonishingly I heard a ‘talking head’ on one of the business media platforms earlier this week who said that none of the excesses that existed in past recessionary periods are in place today. 

To say excesses, systemic issues, and possible instability, don’t exist is borderline irresponsible.

As I see it, there are several measurable excesses and associated risks that represent this cycle’s new challenges that may be summarized into these five categories:

• An untenable level of global (private and public sector) debt
• Structural instability and growth threats in the form of rising deficits and demographic trends (i.e., slowing population growth)
• Lack of (sovereign) cooperation
• Unparalleled political instability and rising policy risks
• A dangerous shift in market structure

Debt

Debt that is not self-funding is future consumption brought forward.

Through years of unprecedented monetary ease, we have enjoyed unsustainable consumption and growth which cannot continue at its current pace in the future. Debt, then, is a drag on future growth, and the amount of debt the world now has will be a monster drag on that growth.

The fact is that the global economies are over levered with debt in our private and public sectors that are excessive. As I chronicled in “Why Interest Rates Are the Bull Market’s Most Serious Threat,” in the fullness of time, the weight of debt will act as a governor to economic growth – it saps capital. To think otherwise is foolhardy.

Deficits and Demographic Threats

Under the weight of rising and uncontrolled deficits (supported by both parties) and slowing population growth, intermediate to longer-term economic and profit growth prospects are diminishing. Near term, domestic economic growth is already weakening (as supply side economics is being further discredited). At the same time Chinese growth is failing to stabilize and it appears that Europe is entering a deepening recession – underscoring the fragility of the global economic system that is still being propped up by low or negative interest rates.

China 

It is my core expectation that U.S. and China will fail to agree on trade. (My baseline expectation is that investors will view a likely, superficial agreement as no agreement at all). We will find out shortly whether my view is accurate and that there will be no big deliverables with regard to IP theft and/or technology exchange. The consequences for the global economy are obvious – China accounts for only about 14% of world GDP but accounts for about one third of the delta in global economic growth.

Earnings & Risk

Most importantly, for investors, the consensus expectations for corporate profits, and economic growth expectations, remain far too optimistic.”

I will steal his last line as I agree that risks currently remain to the downside which explains our cautious outlook for 2019-2020. 

If the message that Central Banks are sending comes to fruition, it will likely be a challenging backdrop for equities in the months ahead. 

Currently, it certainly seems these concerns are outlandish and far fetched but the data is all too present and real. After a scorching run in the first two months of the year, it is hard to see anything as being bearish, but therein lies the risk.

As an investor, our job should be an honest evaluation of our portfolio allocations and our investment strategy with relation to the relevant market risks. 

In other words, ask yourself this one simple question:

“What will happen to my money if something goes wrong?”

If that question raises no concerns for you, do nothing? But if you didn’t like the plunge last November and December, it may be time to re-evaluate things. 

See you next week. 

 

Following today’s release of the February employment report, we stumbled across an anomaly.

Common sense suggests that as the unemployment rate declines and the economy and labor markets strengthen, there should be fewer unemployed workers looking for a job and conversely, if unemployment is rising there should be more people looking for jobs. This is not complex econometric math. If true, then the duration of time that unemployed workers are unemployed before finding a new job should track the unemployment rate.

As shown below in blue, this was generally true from 1948 to 2010, and it has also been true for the last nine years as shown in orange. What’s very noticeable however is that the relationship has shifted to the right, meaning that since 2010, it takes an unemployed person about 10-15 weeks longer to find a job than it did in the prior 60 years. The important question: why?

The data above shines a light on a glaring inconsistency in the broadly accepted narrative that insists we are at full employment and the employment situation is at historically strong levels. Fed Chairman Jay Powell gushed about the strength of the labor market and wage growth in his testimony to Congress in late February. Is it true?

Along with the data presented above we have questioned how the unemployment rate and jobless claims can be near 50-year lows while the labor participation rate is at 35-year lows. Furthermore, although wage growth has been improving of late, why has it been so benign over the past 10-years despite what we are told is an insatiable demand for labor?

The state of the economy has changed since the financial crisis and the methods used to assess the employment situation appear to fail the “sniff” test. Yes, the labor data holds promise, but it is not nearly as good as advertised.