Last week Frank Chaparro penned an interesting note:

“It looks like this bull market just won’t quit. Friday marked the 2,003rd trading day since the stock market rally began back in 2009, making it even longer than the bull market that preceded the 1929 crash.

And since President Donald Trump’s surprise victory in November, stocks have been on a seemingly unstoppable upswing with the S&P 500 rallying nearly 10%. 

The S&P 500, Dow Jones industrial average, and the Nasdaq all recently hit all-time highs at the same time for five straight days, making for the longest such streak in 25 years.

On top of that, stocks have not witnessed a 1% decrease since October 11. That is the longest streak since 2006.

He’s right, this really seems to be a “can’t lose” market.

Let’s evaluate a few of the reasons given as to why you should “buy” this bull market.

Investor Confidence Is Soaring

There is little doubt that since the election both investor and consumer confidence has soared. In fact, confidence (soft data) has become extremely detached from the actual activity (hard data) within the economy. 

Historically, this deviation has not lasted long, and it has always been “hope” giving up ground to the underlying “reality.” But nonetheless, it is “hope,” which is more commonly known as “animal spirits,” which drives markets higher in late stage market advances. Which suggests this is as good of a time as any to remind you of the following chart of investor psychology.

So, if you want to “buy” this bull market currently, you just need to figure out where in the current cycle you are.

Maybe this will help. Barclay’s just “goal sought” an entire analysis to justify 20x earnings as a “fair valuation” in the market. Does “New Paradigm” stage seem fitting?

“And that, ladies and gentlemen is how sell side analysts use ‘animal spirits’ to explain that a market which is valued 33% higher than historical average, is really ‘fairly valued.'”

Central Banks Continue Their Support

The economic recovery has been weak. In fact, we are currently running the slowest average annual growth rate in the history of the U.S. But, given a weak gross domestic product (GDP), the lowest rate of home ownership since the 70’s and a large segment of the workforce no longer counted, the S&P should not have moved from its recent its low of just over 600 to its current record levels. Right? 

Of course, it is widely understood by now the reason the market has risen well in excess of the underlying economic activity is summed up with just two words:  Quantitative Easing.

Of course, it isn’t just the Fed engaged in injecting liquidity into the financial markets, but every major global Central Bank as well.

Without the interventions by the Central Banks, it is not only very likely that the current market would be much lower in price, but it is extremely likely that the U.S. would have already experienced a secondary recession. As long as Central Banks continue to expand their balance sheets, the bull market has an ongoing support particularly as countries, like Japan, are directly engaged in buying more of the equity market directly.

This could very well inflate markets even further. I can’t argue that point.

However, there is a finite limit to the ability of Central Banks to absorb the debt and equity markets. Where that limit is; who knows. But there is a cold reality that when the limit is eventually reached the unwinding of the Central Bank liquidity bubble will likely not be kind.

Trumponomics Is The Cure For What Ills

Just recently Barbara Kollmeyer penned a piece for MarketWatch on how the “Trump Rally” could reignite for stocks. To wit:

“…analysts at Danske Bank have already started mapping out how the rally inspired by the election of President Donald Trump last autumn might be reignited…with signs that Trump and his administration seem ready to push forward with an agenda of economic reforms.

This analysis, of course, is all based on the assumption of the passage of fiscal policy by the Trump administration with NO OFFSETS. In other words, the entire premise is based upon the optimal outcome each policy enacted such as:

  • Tax reductions WITHOUT a border tax
  • Healthcare repeal without an offsetting unintended consequence
  • Zero impact from the tightening of monetary policy by the Fed
  • No offset from the continued strength of the US dollar
  • No offset from increasing levels of debt and an expanding deficit
  • No expectation of political infighting from a highly divisive Congress and Senate.
  • Etc. 

As my partner Michael Lebowitz recently penned:

“Many investors are suddenly comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem this bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today. Consider the following table:”

1982-today

The bottom line is that one should respect the narrative and its ability to propel the market higher. However, think for yourself and truly understand the pros and cons of Trumps proposals as well as the daunting odds of enacting them. Your investing success is dependent on determining whether the narrative is the truth or simply a rationalization to provide comfort and control when desperately needed.”

The reality is there are a lot of things that can go wrong along the way from both fiscal and monetary policy mistakes. Assuming, a “no risk” fiscal policy platform under the Trump administration will likely prove dangerous to investors in the not so distant future.

This Is No Alternative (T.I.N.A.)

Bond yields are low. Cash yields are even lower. Therefore, the only place for investors to get a return on their “cash” is in equities. In fact, because of Central Banks, as noted above, investing in equities is now just as “safe” as money markets because they will never let the markets crash. 

Seems completely logical.  Particularly when you are investing your “hard earned money” into the highest risk investments presently available.

What could possibly go wrong?

The Market Is Cheap Based On Forward Earnings Estimates

This is a strong argument. Wall Street analysts currently have earnings estimates surging over the next couple of years in particular due to the potential tax cuts as discussed above. As earnings recover, it is hoped the markets will move from a “valuation based expansion” to an “earnings based expansion.” 

There are three problems that investors should consider in respect to this analysis:

    1. Estimates are generally overstated by as much as 33% historically. (shown in the chart below.)
    2. There are no considerations given to the impact of offsets from other policies such as border taxes, costs, regulatory requirements, fiscal or other monetary policies which could negate some of the positive impacts of lower tax rates.
    3. The current ramp up in estimates are based on the assumption that corporates rates will fall from 35% to 15-20%. There is no consideration given to effective tax rates currently averaging 12%.

Forward earnings, as stated above, is an extremely poor indicator of future performance. However, the fact the forward earnings forecasts have continued to fall, so that companies can “beat” their respective earnings estimates, shows the fault in using “guesses” about future profitability in trying to justify owning overvalued assets in the first place. 

But furthermore, even based on forward estimates for 2018, the markets remain expensive.

There Is No Recession In Sight

“There will eventually be a recession, there is just not one anywhere on the horizon currently.”

Saying that there will not be a recession is just naive and very short sighted. Recessions are part of the economic cycle and are inevitable. Considering that we are already more than 8-years into the current economic recovery, and in the 3rd longest economic expansion in history, we are likely closer to the next recession than not.

Of course, the real problem is that the media, Wall Street and the majority of the blogosphere never sees the recession until after the fact for one simple reason, the data they are working off of is subject to massive negative revisions in the future. This is why even the National Bureau of Economic Research, the agency responsible for dating recessions, is always late to the call.

As far as the stock market goes – the average drawdown during a recession has been in excess of 30%. Ignoring this reality is perilous to your long-term returns.

Conclusion – The Hope For A “Greater Fool”

The “Greater Fool Theory” surmises there is always a “greater fool” than you in the market to sell to.

For Wall Street, that greater fool is you. Haven’t you ever wondered why Wall Street never tells you to “sell and raise some cash?”

Of course, this leads to the belief there will always be someone to “sell to” when things get ugly. While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price.” 

Then there is the issue, as discussed last week, about the flaws of our own psychology. You may believe that you will sell out in time to avoid major financial disaster, history suggests you won’t. 

Here is the reality, the market will eventually mean revert because it always does. This is the most powerful argument for a huge correction. No matter how powerful a rally, the market will not go up forever. While that observation is obvious, it does not prevent it from being any less true.

The eventual reversion is part of the market cycle. This is why managing portfolio risk is so critically important and why if you don’t sell high, you cannot buy low. 

“Being bullish on the market in the short term is fine – you should be. The expansion of Central Banks balance sheets and the hopes of a fiscal policy tsunami should continue to support stocks as long as no other crisis presents itself. However, the problem is that a crisis, which is ALWAYS unexpected, inevitably will trigger a reversion back to the fundamentals.”

With margin debt at historically high levels, it is when the “herd” begins to turn that is the problem. It will not be a slow and methodical process but rather a stampede with little regard to valuation or fundamental measures. As prices decline it will trigger margin calls which will induce more indiscriminate selling. The vicious cycle will repeat until margin levels are cleared and selling is exhausted.

The reality is that the stock market is extremely vulnerable to a sharp correction. Currently, with complacency and optimism near record levels, no one sees a severe market retracement as a possibility. The common belief is there is “no bubble” in assets and the Federal Reserve has everything under control.

Take a moment to compare what you have heard, and read, with the questions presented here. Draw your own conclusions and invest appropriately.

As discussed yesterday, the exuberance in the markets, as witnessed by the net positioning of large speculators, has reached records on both ends of the spectrum. Those extremes, combined with spiking levels of “hope” in both the financial and economic data is all too reminiscent of the past.

I personally don’t like chart comparisons. Over the last couple of weeks, there have been numerous comparisons between the current market and that of the 1920’s, the 1980’s and just about everything else in between. The problem with similarities in market price patterns is that it fails to take into account the underlying factors such as employment, inflation, interest rates, and economic growth.

When looking at those variables along with some technical indicators, we find similarities to past bull market peaks.

“But Lance, all the economic data is improving. So the bull market still has room to go.”

Let’s take a look at the chart below.

In both previous bull market peaks we find, as measured as a percentage change from the previous bottom to current level, the following:

  • CORE INFLATION rose 11.7% and 7.1% just prior to the recession. Currently, Core CPI is up 11.1%
  • GDP GROWTH picked up by 7.5% and 5.1% just prior to the recession. Currently, GDP is up 6.8%
  • EMPLOYMENT was up from lows by 9.1% and 8.6%. Currently, Employment is up 19.0%
  • INTEREST RATES rose 50.8% and 51% from lows. Currently, Rates are up 87.9%

As we saw just prior to the beginning of the previous two recessions, such a bump is not uncommon as the impact of rising inflation and interest rates trip of the economy. Given the extreme speculative positioning in oil longs, short bonds, and short VIX, as discussed yesterday, it won’t take much to send market participants scrambling for the exits.

While I am NOT suggesting that we are about to have the next great market crash tomorrow, the current sensation of “Deja Vu” might just be worth paying attention to.

In the meantime, here is what I am reading this weekend.


Fed/Economy


Markets


Research / Interesting Reads


“Better to be out of a bull market than fully invested in a bear market” – Bill Henry

Questions, comments, suggestions – please email me.

 

#FakeNews In Investing

I regularly push back on the “buy and hold” investing meme because while it works in “theory,” reality has a far different outcome. This is not my opinion, it is the reality of human emotion and psychology as it impacts portfolio management over time. The annual Dalbar Investor survey shows the massive performance lag of individuals not only in the short-term but in the long-term as well. To wit:

  • In 2015, the 20-year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%.

Dalbar-2016-Performance-060616

Here is a visual of the lag between expectations and reality.

Dalbar-2016-ReturnComparision-060616

Importantly, THERE IS NO evidence linking investment recommendations to average investor underperformance. Analysis of the underperformance shows that investor behavior is the number one cause, with fees being the second leading cause.

There are THREE reasons why “buy and hold” investment strategies DO NOT WORK according to the Dalbar study:

Dalbar-2016-Psychology-060616

So, why am I bringing this up?

After recently pinging on the fallacy of “passive investing,” because you are not passive, I invariably receive push back from advisors who cling to the hope that markets will continue to rise indefinitely. Such as this one:

“Just caught up with your latest effort in the fake news category. The thrust of your argument seems to be, wrongly as usual, that active outperforms passive in bear markets.”  – Brent

Actually, no, that is not my argument.

My consistent argument is individuals, like Brent, mislead themselves, or their clients, by suggesting they will get average rates of return over time. They won’t and they don’t.

Markets do NOT compound returns, you do not get average returns, and you do not have 100-plus years to reach your goal.

Investing without a discipline or skill set is easy when the “bull market” is running. It is when the next “bear market” growls where individuals will be decimated as the mean reverting event takes its toll. As history proves, everyone has a threshold of pain – and bear markets always exert the pain required to force investors out near the bottom. 

This is just reality and why protecting capital during market declines is much more critical that chasing returns during market advances.

Furthermore, there is substantial evidence that a good manager with the right skill set can outperform over time. It took me about 5-minutes with a screener to find mutual funds that have outperformed the Vanguard S&P Index fund over the last 20-years.

Take the best performing fund over the last 20-years out of our group above. Sequoia has had a rough couple of years and is severely underperforming the market in the short-term. According to the current mentality, you should sell that fund and buy a passive index ETF. Why pay a fee for an underperforming fund. Right?

That decision would have cost you dearly coming out of the financial crisis.

As is always the case, a ramping bull market hides investor mistakes – it is the bear market that reveals them. However, it is psychology and fees that are the leading causes of underperformance during a bull market advance.

Investors need to be cognizant of, and understand why, the chorus of arguments in favor of short-sighted and flawed strategies are so prevalent. The meteoric rise in passive investing is one such “strategy” sending an important and timely warning.

Just remember, everyone is “passive” until the selling begins.

Net Positioning

Prior to 1991, the Commodity Futures Trading Commission (CFTC) compiled the Commitments of Traders Report (COT Report) once a month. This data reflected the three major trading groups positions as of the last trading day of the month and was released to the public 3-5 days later electronically and 10-15 days later by printed report. Then, from 1/91 to 10/92, the CFTC compiled the COT Report twice a month reflecting the holdings on the 15th of the month and the last trading day of the month. Again, the data was released days later to the public.

Beginning on 10/16/92 to the present, the CFTC compiles the data weekly reflecting the holdings as of the close of each Tuesday.  This data is released electronically to the public every Friday at 3:30 P.M and covers the holdings as of the previous Tuesday.

COT data is exceptionally important data as it is the sole source of the actual holdings of the three key commodity-trading groups, namely:

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

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

Therefore, as shown in the series of charts below, we can take a look at their current net positioning (long contracts minus short contracts) to gauge excessive bullishness or bearishness on the S&P 500, VIX, Crude Oil, US Dollar and 10-Year Treasury Bonds. With the exception of the 10-Year Treasury which I have compared to interest rates, the others have been compared to the S&P 500.

With the exception of the S&P 500, which is currently building a net short position which has usually denoted short-term market tops, the speculative positioning in the other major categories are extremely “crowded trades” currently. Historically, when the herd is eventually flushed in the opposite direction, the selling becomes a “stampede” to reverse positioning. 

The only question is “what” will be the trigger.

Buying Panic

The market has been surging higher since the beginning of the month based on the “hopes” of a “terrific” tax reform package from the Trump administration. As investors “rush to get in,” the issue of “risk” has now become an antiquated notion.

With the market currently trading almost 8% above the 200-dma, the risk of a “reversion” to the mean is obviously nothing to worry about, right?

Maybe not so fast. The chart below shows the very similar technical setup of the market going into the peak of the market in 2007.

I don’t need to remind you what happened next.

Even if tax cuts come through, they won’t impact the market until 2018. And according to Credit Suisse, there is still a problem:

“Investors have been asking how valuations look on 2018 EPS, when it is becoming more likely … that stock market friendly policy changes in Washington could materialize. On current 2018 expectations, US stocks still look highly overvalued.”

The charts below trace forward-looking price-to-earnings ratios all the way back to the mid-1980s:

Given that Wall Street has given up the difficult work of picking stocks and making models, of calling experts and building theories, and are now just trading on “Trump Tweets,” what could possibly go wrong?

Just some things I am thinking about.

Danielle DiMartino Booth, a former Dallas Federal Reserve official, released a new book this week entitled Fed Up. The book, a first-person account of the inner-workings of the Federal Reserve (Fed), provides readers with unique insight into the operations, leadership, and mentality of what is unquestionably the world’s most powerful financial force.  What it reveals about the Fed is neither flattering nor confidence-inspiring. By pulling back the curtain to reveal the Fed’s modern-day machinations, DiMartino Booth provides an assessment of the highest levels of economic thinking and how it is afflicting our economy.

Throughout the book, it is clear her purpose is equal parts entertainment and education with a dash of sermon to underline the gravity of the situation.  Fed Up is compelling, well-written and its objectives are clear; expose the hubris at the Fed which results in poor decision-making and generate much-needed debate to bring about change in how the Fed functions. As you read this review, and hopefully the book as well, we remind you the Fed is sworn to serve the American public and should be held accountable to this obligation.

We thank Danielle for giving us the privilege of reading an advance copy of her book so that we can provide this timely review to you. Neither 720Global, LLC nor its owners have received any form of direct or indirect compensation in exchange for the review of this book.

Confluence of Events

Skill, talent, temperament and career path often have a funny way of converging at just the right time to produce something that is needed at a particular moment to change the course of events. Danielle DiMartino Booth’s Wall Street experience and tenure as a journalist converge with her personal traits of curiosity, healthy skepticism and integrity to expose the powerful forces of the Fed and the means by which they use their influence.

DiMartino Booth spent enough time on Wall Street to become “enlightened” as to the ways of high finance and then went on to pursue a career in journalism at the Dallas Morning News.  Her insight and warnings in the years preceding the Great Financial Crisis of 2008 are well-documented and stand in stark contrast to the mindset of the Fed and then-chairman Ben Bernanke who “found little evidence to support the existence of a national home price bubble.” Fortunately, the President of the Dallas Federal Reserve Bank, Richard Fisher, was a rare exception within the Fed and took notice of DiMartino Booth’s articles. In the fall of 2006, Fisher convinced her to join the Dallas Research Department.

Theory Versus Practice and a Dose of Hubris

From her early days at the Dallas Fed, DiMartino Booth recognized that the Federal Reserve is run by Ph.Ds. from the premier economic schools of the nation. Referring to them as the “MIT mafia,” she notes that the large concentration of academicians at the Fed is a recent trend. Traditionally, Fed governors hailed from the banking sector where they came equipped with a deeper understanding of the workings of the main street economy and a real-world perspective of the benefits and consequences that accompany monetary policy. In years’ past, the practical experience of leadership naturally guided academically-oriented researchers and analysts on staff. According to DiMartino Booth, Richard Fisher was a Fed President of this mold. Unfortunately, the influx of Ph.Ds. over the last 15 to 20 years with virtually no practical experience changed the Fed’s thinking. In her words,

The overwhelming dominance of academics goes a long way toward explaining why the financial crisis of 2008 blindsided the Fed”.

Prominently throughout the book, DiMartino Booth highlights the arrogance and hubris that these academics-turned-central bankers possessed and the control they garnered. They believed that their textbooks, unproven theories, and complex research papers provided new sophistication and certainty with which to manage the domestic and, indeed, the global economy. They shelved simple models, and all but ignored real-time market data and the word on the street. In their pursuit of certainty, they forgot that human behavior could not be replicated in a petri dish.

This myopic academic perspective affected the staff economists and spread to the upper echelons of the Federal Reserve.  As DiMartino Booth writes:

Not that Bernanke wasn’t listening, but over time, he fixated on academic theories. Real life reports by Fisher and other District Bank presidents counted for little.” 

She added that current Fed Chairwoman Janet Yellen, who at the time ran the San Francisco Fed, was more married to her models than Greenspan and Bernanke combined.

Despite warnings from DiMartino Booth and Fisher, the Fed failed to see that Malignant stars were aligning for a once-in-a-century global economic meltdown. Though precious few inside the Fed saw the crisis coming, it is patently false to suggest insiders hadn’t been fairly warned”.

As concerning as the Fed’s myopia was, she found their hubris equally troubling. From the Fed Governors and district presidents down to the staff Ph.Ds.’ the air of royalty and elitism permeated the atmosphere. Many of these economists lived in vacuums, where assumptions about human behavior and intricate modeling replaced real world experience and observation. It should be no surprise therefore that DiMartino Booth and Fisher, lacking Ph.Ds.’ were generally ignored despite their repeated expression of concern and warning.

Driving Animal Spirits

In giving us the proper perspective on the events of the financial crisis and the Fed response, DiMartino Booth effectively lays the ground work for historical events that influenced future course.  She describes the sequence of events beginning ten years earlier that would formally establish the ultimate term describing financial moral hazard, “the Greenspan Put.”

The once-mighty hedge fund, Long-Term Capital Management (LTCM), run by the so-called best and brightest Ph.Ds. (a theme that should start to sound familiar by now), including two Nobel Prize winning board members, thought they had developed a means by which they could guarantee profits from derivative trading. When their theories and models didn’t align with reality, massive losses ensued, and Wall Street was holding the risk. Fed Chairman Alan Greenspan, along with Treasury Secretary Robert Rubin and Treasury official Lawrence Summers, orchestrated a government-sponsored bailout of the hedge fund.

The LTCM bailout – to be clear, the American taxpayer bailout of a hedge fund and in turn Wall Street – sent a very clear “risk-on” signal to major financial institutions and investors which elevated Greenspan and company to a status akin to deity. Per DiMartino Booth:

They were hailed as geniuses. I imagined my fellow Wall Streeters going to the cathedral in my neighborhood and lighting candles. Thanks be to God and Greenspan.

Fast forward to the aftermath of the 2008 crisis, and through many different forms of extraordinary and highly questionable monetary policy, DiMartino Booth makes a case that the Fed remains overly concerned with spurring animal spirits. In other words, they believe that continually boosting investor confidence and driving financial asset prices higher is a necessity. In DiMartino Booth’s words:

“…and yet here was the Fed, with Yellen as its biggest cheerleader, once again trying to build an economic recovery on the back of frenetic animal spirits.”

In the Fed’s mind, Bear Stearns, Lehman, Fannie Mae and other institutions lay testimony to what happens when the free markets are left to their own devices. Left out of their discussion, however, was the role the Fed might have played in creating the problems through ill-advised policy.

DiMartino Booth makes clear that Fed officials have both the free hand and the lack of humility to disregard the potential negative implications for the average citizen while at the same time emphasizing the needs of their primary constituent – Wall Street.  The Fed’s tactics are not just about investor confidence but backed by a faulty theory called the wealth effect. They erroneously associate financial asset inflation to wealth generation and wealth generation to prosperity for all. In retrospect, they either failed to recognize that artificially manipulating markets higher would predominately benefit the wealthy or they knew this but elected not to disclose it. In DiMartino Booth’s words:

“The problem was the bulk of these trillions was in the hands of a few. Those who were most insulated from the needs to earn a living were driving the rally. Any middle-class recovery was an illusion.”

“Who will pay when this credit bubble bursts? The poor and the middle-class, not the elites. If those injured most by Fed policy could understand, they would be marching at Yellen’s door with protest signs, screaming show us the wealth effect!

Transparency

Touted increasingly by the Bernanke and Yellen regimes, emphasis on improving Fed transparency appears to be nothing more than a self-serving ruse designed to deflect congressional efforts to regulate the Fed. DiMartino Booth explains that, although intended to highlight the substance of Federal Open Market Committee (FOMC) meeting discussions, published FOMC minutes are altered well after the meeting to mollify Wall Street’s and the markets’ interpretation of the original statement.  She also discloses that Bernanke and Yellen brazenly “leak” information to the press to suit various purposes. Such purposes may include efforts to “correct” markets when desired or even as a bully tactic aimed at Fed members that may have stepped out of line with the Chairman’s preferences.

Fixing the Fed

DiMartino Booth is not supportive of the extreme call by some to “end the Fed”, but she firmly believes there needs to be dramatic reform. The various recommendations she offers include specific suggestions involving the way monetary policy is formed and implemented as well as the objectives of such policy.  Many of the economic woes facing the nation are either a direct or indirect result of an over-imposing and ham-handed monetary policy approach based on intellectual arrogance. She makes a compelling plea for change, listing numerous reasonable actions that should be undertaken to improve the Fed’s influence over the economy to the benefit of all Americans, not just the wealthy.

Summary

Wealth inequality, wage stagnation, massive debt loads, feeble economic growth and weak productivity growth are but a few of the economic and social problems that are the legacy of poor monetary policy.  Less than a decade after the Financial Crisis, we are again confronted with asset prices perched well above fundamentals, an unfettered shadow banking system and an even larger concentration of too-big-to-fail banks. Additionally, unprecedented interest rate policy is complicit in allowing lawmakers and the U.S. Treasury to shirk their fiscal responsibilities and recklessly expand the national debt.  It is unbecoming and irresponsible for Fed officials to continually neglect to accept any role in the prior two economic bubbles and the one now festering.

What DiMartino Booth describes in Fed Up is the manifestation of years of central bank evolution. To the academics who occupy the chairs in the Marriner Eccles Building today, it is the blooming flower of the seeds planted by John Maynard Keynes and nurtured by Alan Greenspan, Ben Bernanke, and Janet Yellen. The reality, as so well described by DiMartino Booth, is that of an intellectual contagion. The role the Federal Reserve has assumed today better resembles that of a global virus. By way of multiple global financial crises over the past 30 years, their influence and power have adapted and spread to cover all of the developed world.

By pulling back the curtain on this reality, DiMartino Booth accomplishes what may be the first meaningful step toward properly diagnosing an important source of present day economic illness. Fed Up provides a post-crisis update of how the Federal Reserve runs the country with substantial evidence of the short-cuts and manipulations employed as a means to their ends. The recommendations offered in the book are reasonable and actionable but will certainly be viewed as a threat to Fed independence. It is that independence which has served as the enabler of a powerful, un-elected governing body which bears no accountability or burden of proof for its actions. The time to reign in and redefine how the Fed operates is past due and Fed Up offers not only the rationale but a potent and lucid blueprint for doing so.


If you would like to order Fed Up by Danielle DiMartino Booth click here – LINK


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In this past weekend’s newsletter, I discussed my remembrances of the Riddler in the original Batman series and how he would pose riddles to the dynamic duo as they faced the certain demise. In that vein, I posed the following question:

“IF investment success is achieved by ‘buying when others are fearful and selling when others are greedy,’ then what should you be doing now?”

This is the most difficult question for investors who are caught up in the “Greed/Fear Cycle.” As I noted yesterday, this is a key point made by the legendary Howard Marks:

“It’s the swings of psychology that get people into the biggest trouble, especially since investors’ emotions invariably swing in the wrong direction at the wrong time. When things are going well people become greedy and enthusiastic, and when times are troubled, people become fearful and reticent. That’s just the wrong thing to do. It’s important to control fear and greed.

We need to remember to buy more when attitudes toward the market are cool and less when they’re heated. Too little skepticism and too much eagerness in an up-market – just like too much resistance and pessimism in a down-market – can be very bad for investment results.

Warren Buffett once said,

‘The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.’

The fundamental building block of investment theory is the assumption that investors are risk averse. But, in reality, they are sometimes very risk averse and miss a lot of buying opportunities, and sometimes very risk tolerant and buy when they shouldn’t. Risk aversion isn’t constant or dependable. That’s what Buffett means when he says that when other people apply less, you should apply more.”

This is the subject of today’s chart review, but first a quick bit of history.

In 2013, I posted an article discussing the ability of the market to be driven higher (to 2300) by Bernanke/Yellen’s continued injections of liquidity through QE programs. To wit:

“That’s right, despite all of the recent ‘bubble talk,’ it is entirely possible that stocks could rise 30% higher from here.  However, it is not because valuations are cheap because as I discussed in my recent analysis of Q3 earnings stocks are trading near 19x trailing earnings.

The use of forward, operating estimates, is only beneficial to Wall Street analysts who need to create a ‘valuation’ story when none really exists. Overly optimistic assumptions about the future spurs faulty analysis in the present as sliding earnings leads to sharp valuation increases.

Then last year, I penned “2400 or Bust!” stating:

“The reality is that a breakout and advance to 2400 is actually quite possible given the confluence of Central Bank actions, increased leverage, and the embedded belief ‘There Is No Alternative (TINA).’  It would be quite naive to suggest otherwise.

Given the technical dynamics of the market going back to the 1920’s, it would be equally naive to suggest that ‘This Time Is Different (TTID)’ and this bull market has entered a new ‘bull phase.’” 

While the Fed has stopped expanding its balance sheet, investor sentiment has finally kicked into drive asset prices higher. This is what the famed Richard Russell described as the “mania phase:”

‘The third or speculative phase of a bull market is characterized by a wild and wooly and ever-increasing entrance by the retail public. This phase is characterized by hot tips, hype, and pure greed.’“

I point out this previous remarks because I am often considered to be a “perma-bear” simply because I point out the risks posed to investor capital versus the “hope” that prices continue to rise. This point was made clear in a Twitter discussion this weekend:


Whether it is Howard Marks, Richard Russell, or even Warren Buffett, the time to invest in the markets is when others are fearful. The time to sell is when everyone else is greedy.

I have accumulated the following series of charts to let you decide your own personal level of skepticism and eagerness as markets hit all-time highs.


Fundamental Views

With markets hitting all-time highs, it is not surprising that valuations are pushing the second highest level in history as well.

Not surprisingly, when valuations are above 20x earnings, forward 10-year returns have declined.

This is also shown in the record levels of Enterprise Value / Gross Value Added (GVA).

On an inflation-adjusted basis, the market capitalization rate of the S&P 500 as a percentage of GDP is now at the second highest level on record.

Which, not surprisingly, given the record amount of financial engineering being used to boost bottom line earnings, is weighing on corporate return on equity.

However, given the complete disregard for fundamentals, which has been typical near major bull market peaks, let’s take a look at some of the technical views.

Then there is Ed Yardeni’s “Boom Bust” indicator as discussed this past weekend:

The Boom-Bust Barometer (made famous by Dr. Ed Yardeni) is a simple, but effective, way of avoiding large drawdowns in the stock market. As you can see in the charts below, the indicator is currently making all-time highs.”

Technical Views

The 6-year rate of change in the inflation-adjusted S&P 500 index is now falling back towards zero. It is the decline in the rate of return of the index that has preceded major market reversions. (The reversions are where the negative ROC occurs.)

As I have discussed previously, market prices are like a rubber-band that can only be stretched so far before they ultimately “snap back.” At 3-standard deviations (roughly 99% of historical price movement), which is a very rare occurrence, the price of the market has risen to levels that have historically denoted peaks rather than beginnings.

One of the big concerns as of late is the extremely high level of “complacency” in the market currently. An extremely complacent market, combined with extreme overbought conditions, should elicit some concern about excessive market risk currently.

The ratio of the CBOE Skew / VIX index also suggests that investors should have a higher level of caution than normal. Look for the indicator to turn down and begin to deteriorate as an early warning indicator of a market correction. 

Of course, the extremely low level of “fear” in the market currently has led to a maddening chase for “junk bonds” in the market. As shown below, the S&P 500/High Yield Bond ratio is pushing its highest level on record. This will end badly for those who unwittingly undertake the risk believing “high yield bonds” are a “safe alternative” to stocks. They aren’t.

Lastly, the deviation of the market from its 3-year moving average, combined with a 3-standard deviation push above the 3-year average and a concurrent “sell signal,” should be some type of warning.

On a very short-term basis, the current uptrend is tightening into a very tight wedge. A break to the downside of this wedge, the most likely probability, should lead to an initial retest of 2200ish.  A break below that level will likely lead to a retest of 2075.

Answering The Riddle

Some time ago I wrote a discussion on “Asymmetrical Bubbles” and George Soros’ theory of reflexivity.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

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

There is currently much debate about the health of financial markets. Have we indeed found the “Goldilocks economy?” Can prices can remain detached from the fundamental underpinnings long enough for an economy/earnings slowdown to catch back up with investor expectations?

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

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

In the long term, it will ultimately be the fundamentals that drive the markets. It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: “Stocks have now reached a permanently high plateau.” The clamoring of voices proclaiming the bull market still has plenty of room to run is telling much the same story.  History is replete with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.

It is critically important to remain as theoretically sound as possible. The problem for most investors is their portfolios are based on a foundation of false ideologies which is only discovered when reality collides with them.

So, Batman, if our job is to “Sell High” so we can “Buy Low” then what are you doing now?

Riddle me that.

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One of my favorite investing legends is Oaktree Management’s, Howard Marks. His investing wisdom have been a major source of education over the years and his deep knowledge and understanding of investor psychology and market dynamics is truly unparalleled.

This past weekend, I was digging through some old research and ran across an interview between Goldman Sach’s Hugo-Scott Gall and Howard Marks on everything from investment decisions to behavioral dynamics.

This interview was originally done back in 2013, and interestingly enough it is just as relevant today as it was then. I hope you find this as informative and educational as I did.


Hugo Scott-Gall: How can we understand investor psychology and use it to make investment decisions?

Howard Marks: It’s the swings of psychology that get people into the biggest trouble, especially since investors’ emotions invariably swing in the wrong direction at the wrong time. When things are going well people become greedy and enthusiastic, and when times are troubled, people become fearful and reticent. That’s just the wrong thing to do. It’s important to control fear and greed.

Another mistake that people often make is that they compare themselves with others who are making more money than they are and conclude that they should emulate the others’ actions … after they’ve worked. This is the source of the herd behavior that so often gets them into trouble. We’re all human and so we’re subject to these influences, but we mustn’t succumb. This is why the best investors are quite cold-blooded in their professional activities.

We can infer psychology from investor behavior, and that allows us to get an understanding of how risky the market is, even though the direction in which it will head can never be known for certain. By understanding what’s going on, we can infer the “temperature” of the market. In my book, I give a list of characteristics that can give you an idea whether the market is hot or cold, and by using them we can control our buying patterns. They include capital availability, the eagerness of lenders and investors, the ease of entry for new funds, and the width of credit spreads, among others.

We need to remember to buy more when attitudes toward the market are cool and less when they’re heated. For example, the ability to do inherently unsafe deals in quantity suggests a dearth of skepticism on the part of investors. Likewise, when every new fund is oversubscribed, you know there’s eagerness. Too little skepticism and too much eagerness in an up-market – just like too much resistance and pessimism in a down-market – can be very bad for investment results.

Warren Buffett once said,

“The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.”

I agree thoroughly, and in order to understand how much prudence others are applying, we need to observe investor behavior and the kinds of deals that are getting done. In 2006 and 2007, just before the onset of the financial crisis, many deals got done that left me scratching my head. That indicated low levels of risk aversion and prudence. We can’t measure prudence through a quantitative process, and so we have to infer it by observing the behavior of market participants.

The fundamental building block of investment theory is the assumption that investors are risk averse. But, in reality, they are sometimes very risk averse and miss a lot of buying opportunities, and sometimes very risk tolerant and buy when they shouldn’t. Risk aversion isn’t constant or dependable. That’s what Buffett means when he says that when other people apply less, you should apply more.


Hugo Scott-Gall: Why do behavior patterns and mistakes recur despite the plethora of information available now? Are we doomed to repeat our mistakes?

Howard Marks: Information and knowledge are two different things. We can have a lot of information without much knowledge, and we can have a lot of knowledge without much wisdom. In fact, sometimes too much data keeps us from seeing the big picture; we can “miss the forest for the trees.”

It’s extremely important to know history, but the trouble is that the big events in financial history occur only once every few generations. The latest global financial crisis began in 2008 and the one before that in 1929. That’s a gap of 79 years. So, while memory has the potential to restrain action and induce prudence by reminding us of tough periods, over time as memory fades the lessons fade as well.

In the investment environment, memory and the resultant prudence regularly do battle with greed, and greed tends to win out. Prudence is particularly dismissed when risky investments have paid off for a span of years. John Kenneth Galbraith wrote that the outstanding characteristics of financial markets are shortness of memory and ignorance of history.

In hot times, the few who do remember the past are dismissed as relics of the old, lacking the ability to imagine the new. But it invariably turns out that there’s nothing new in terms of investor behavior. Mark Twain said that “history does not repeat itself but it does rhyme,” and what rhymes are the important themes.

The bottom line is that even though knowing financial history is important, requiring people to study it won’t make a big difference, because they’ll ignore its lessons. There’s a very strong tendency for people to believe in things which, if true, would make them rich. Demosthenes said,

“For that a man wishes, he generally believes to be true”

Just like in the movies, where they show a person in a dilemma to have an angel on one side and a devil on the other, in the case of investing, investors have prudence and memory on one shoulder and greed on the other. Most of the time greed wins. As long as human nature is part of the investment environment, which it always will be, we’ll experience bubbles and crashes.


Hugo Scott-Gall: What things in your skill set have served you well?

Howard Marks: While knowing financial analysis and accounting is essential, almost any smart person can acquire those skills and get a rough idea of the merits of a company. Superior investors are those who understand both fundamentals and markets and have a better sense for what a given set of merits is worth today and what it will be worth in the future. I don’t think I became less able to do financial analysis over time, but I engaged much more in understanding and sensing markets and values: the “big picture”. A lot of my contribution comes from understanding history and investor behavior, from inferring what’s going on around me, and from controlling my emotions.


Hugo Scott-Gall: Success in our industry often leads to overconfidence. How do good investors avoid that?

Howard Marks: Mark Twain once said,

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

And I totally agree with that. One of the chapters in my book is about the importance of knowing what you don’t know. People who are smart often overestimate what they know, and this tendency can grow, particularly if they are financially successful. And eventually, you get to the master of the universe problem that Tom Wolfe identified in “The Bonfires of the Vanities.”

I believe there’s a lot we don’t know, and it’s important to acknowledge that. I’m sure I know almost nothing about what the future holds, but a lot of people claim to know exactly what’s going to happen. I consider it very dangerous to listen to them. As John Kenneth Galbraith said,

“There are two kinds of forecasters. Those who don’t know, and those who don’t know they don’t know.”

I’m proud to say I’m a member of the first group. Amos Tversky, who was a great behaviorist at Stanford University, said that,

“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on”.

That is particularly true for investing. I’d much rather have my money run by somebody who acknowledges what he doesn’t know than somebody who’s overconfident. As Henry Kaufman, the noted economist pointed out,

“We have two kinds of people who lose a lot of money; those who know nothing and those who know everything.”


Hugo Scott-Gall: Have you always been this way, or did you learn to be self-aware and emotionally disciplined?

Howard Marks: I’m inherently unemotional, and I’ve also observed for 45 years that emotions swing in the wrong direction and learned that it’s extremely important to control it. In the market swoon of 1998, I had an employee tell me he was afraid the financial system was going to melt down. I heard him out and then told him to carry on with his work. I don’t compare myself or my colleagues to them, but battlefield heroes aren’t people who are unafraid; they’re people who are afraid and do it anyway. And so we must keep investing; in fact, we should invest even more when it is scary, because that’s when prices are low.

Walter Cronkite once said:

“If you’re not confused you don’t understand what’s going on”.

In the fourth quarter of 2008, I paraphrased that to say, “If you’re not afraid you don’t understand what’s going on.” Those were scary times. But even if you’re afraid, you have to push on. In the depths of the crisis in October ’08 I wrote a memo that I’m particularly proud of, called ‘The Limits to Negativism.’ It touched on the importance of skepticism in an investor. In good times skepticism means recognizing the things that are too good to be true; that’s something everyone knows. But in bad times, it requires sensing when things are too bad to be true. People have a hard time doing that.

The things that terrify other people will probably terrify you too, but to be successful an investor has to be stalwart. After all, most of the time the world doesn’t end, and if you invest when everyone else thinks it will, you’re apt to get some bargains.


Hugo Scott-Gall: Do you calculate estimates of fair value in advance for the things you want to buy, and do you wait to buy until those are reached in a market downdraft?

Howard Marks: We can try to do analysis in advance, but opportunities often arise unexpectedly. For example, if everyone gets scared due to some sudden bad news about a company, that can give us an opportunity to respond spontaneously and buy its debt cheap. So we can’t plan everything and follow a neat pattern, as a lot of what we do is very opportunistic. We can have estimates of value for some companies, but we can’t know which companies will show up on the troubled list on a given day, or what bonds are going to come up for sale. Most of the inquiries are incoming to us rather than outgoing, meaning we try to buy the things that they want to sell. We have to be generally ready but also be responsive to opportunities to be self-aware and emotionally disciplined?


Hugo Scott-Gall: How do you think about the current very low interest rate regime?

Howard Marks: Yes. The point is that today you can’t make a decent return safely. Six or seven years back, you could buy three to five-year Treasurys and get a return of 6% or so. So you could have both safety and income. But today, investors have to make a difficult choice: safety or income. If investors want complete safety, they can’t get much income, and if they aim for high income, they can’t completely avoid risk. It’s much more challenging today with rates being suppressed by governments.

This is one of the negative consequences of centrally administered economic decisions. People talk about the wisdom of the free market – of the invisible hand – but there’s no free market in money today. Interest rates are not natural. They are where they are because the governments have set them at that level. Free markets optimize the allocation of resources in the long run, and administered markets distort the allocation of resources. This is not a good thing… although it was absolutely necessary four years ago in order to avoid a complete crash and restart the capital markets.


Hugo Scott-Gall: If it’s human nature that causes the bubbles and crashes, do you think asset management should be done with more machines and fewer people?

Howard Marks: No, I disagree strenuously. People who doubt the existence of inefficient markets and the ability to profit from them may disagree with me. But if you think you’re operating in an inefficient market like I try to do, a lot can be accomplished by getting great people, developing an effective investment approach, hunting for misvaluations, keeping psychology under control, and understanding where you are in the cycle. I am not saying that everyone should try this. In fact, an algorithm or an index fund may work best for a lot of people. But at Oaktree, we don’t make heavy use of machines. We are fundamentalists and ours is a “non-quant shop.” As long as there are people on the other side making mistakes – failing to fully understand assets, acting emotionally, selling too low and buying too high – we’ll continue to find opportunities to produce superior risk-adjusted returns. This is something I’m very sure of.


Hugo Scott-Gall: Where would you want to be if you were starting your career as a contrarian today?

Howard Marks: A market being interesting in the long term and being cheap at the moment are two different things. Credit and debt investing is still very, very attractive and interesting to spend time in, even though it may not be especially rife with great bargains today


The more things change, the more they remain the same.

As discussed yesterday, the markets have been quiet. Too quiet. That makes me worry as generally when volatility resurfaces it has not been kind to investors in the short-term.

But despite the lack of volatility in the market, the S&P eclipsed 2300 yesterday breaking through the psychological barrier on its continued quest towards 2400.

While the market continues to trade on the back of Trump announcements of potential tax reform and support for airlines, the economic backdrop continues to show signs of age.

The important point to note here is the historical deviation between exuberance and economic realities has generally NOT been resolved by reality catching up with fantasy. It has always been the other way around.

This brings me to my interview with Danielle DiMartino-Booth this past week. She and I dig into the economy, the Fed’s missteps, and the realities that currently prevail in the market and the economy. I am sure you will enjoy the interview.

 

(Note: If you order a copy of Fed Up and bring it to the 2017 Economic & Investment Summit on April 1st in Houston, Texas you can have Danielle personally autograph for you. Also presenting Greg Morris, Michael Lebowitz, and Dave Collum.)

In them meantime, here is what I am reading this weekend as I put my “S&P 2300” hat on…for now.


Trump/Economy


Markets/Fed


Favorite / Interesting Reads


“The only thing standing between you and your goal is the Bulls*** story you keep telling yourself as to why you can’t achieve it.” -The Wolf Of Wall Street

Questions, comments, suggestions – please email me.

A Better Way To Use P/E’s

There has been an ongoing debate about market valuations and the current state of the financial markets. On one hand, the “bulls” use forward price-earnings ratios to justify current valuation levels while the the “bears” cite trailing valuations based on reported earnings per share. The problem with both measures is that valuations, at any specific point in time, are horrible portfolio management tools.

[Note: One of the most egregious fabrications used by Wall Street to try and sell individuals investment products is using forward P/E ratios based operating earnings (earnings before reality) as compared to historical trailing P/E ratios based on reported earnings]

One of the primary problems with fundamental measures, such as P/E ratios, is the “duration mismatch.”

What is truly ironic is that when it comes to buying ‘crap’ we don’t really need, people will spend hours researching brands, specifications, and pricing. However, when it comes to investing our ‘hard earned savings,’ we tend to spend less time researching the underlying investment and more time fantasizing about our future wealth.”

This “mentality” leads to what I call a “duration mismatch” in investing. While valuations give us a fairly good assessment about future returns, such analysis is based on time frames of five years or longer. However, for individuals, average holding periods for investments has fallen from eight years in the 1960’s to just six months currently.

The point to be made here is simple. The time frame required for fundamental valuation measures to be effective in portfolio management are nullified by short-term investment horizons.

It is critical to understand that the current LEVEL of valuations are only useful in determining what the long-term return will be. This is something I have discussed many times previously as it relates to your financial planning specifically. 

More importantly, every bull market in history has ultimately crumbled under the weight of fundamental realities. Despite the many hopes to the contrary, this time will be no different. But rather than arguing absolute valuation levels and future expected returns; P/E ratios can also be used to tell us much about the current trend of the markets as well as major turning points.

The chart below shows the monthly P/E ratio (using Dr. Robert Shiller’s data) going back to 1881.

There is something about P/E ratios that is rarely discussed by the financial media which is whether valuation levels are “expanding” or “contracting.” I have noted the major periods of multiple expansions and contractions. (The green shaded area is the deviation of current multiples from the long-term median.)

I have smoothed the data in the chart above with a 12-month average to better identify the “trend” of valuations as compared to the S&P 500 as shown in the chart below.

Not surprisingly, we find that periods where multiples are “expanding” are correlated to rising asset prices and vice-versa. Therefore, viewing changes in the direction (or trend) of valuations can provide some clue as to changes in market cycles. This is due to the fact that changes in price (“P”) has a much greater near-term impact on valuations than earnings (“E”). While I am NOT suggesting that earnings are unimportant, changes to earnings move at a much slower pace than price and, therefore, has a muted effect on the directional changes to the overall P/E ratio.

Since 2010, almost 2/3rds of the increase in the P/E Ratio has come from price rather than earnings growth. The same is true during declining markets when dramatic changes in price have a much bigger impact on valuation changes.

Importantly, I am NOT suggesting that P/E’s could or should be used as a “market timing” tool. However, it is quite clear that over shorter-term time frames the directional trend of valuations, rather than the absolute level, is much more telling.

Currently, the ongoing multiple expansion remains supportive to overall stock prices. This is one primary reason why my portfolio allocation model remains fully invested. However, this does not mean that you should go “diving” headfirst into the pool either. The low-hanging fruit has already been harvested and, as noted above, future returns on investments made today are likely to be disappointing.

Bank Loans Issue Warning

At the heart of every major economic expansion in history is lending. Not surprisingly, as shown in the chart below, lending tends to lag changes in the overall economic growth rate. This is because, of course, businesses tend to want confirmation of improvement in the economy before taking on extra debt. Conversely, debt is then liquidated through debt reductions, forced payoffs or defaults during an economic decline. This correlation is shown below.

The downturn in commercial loans and leases, while early, should issue a sign of caution to investors about applying too much hope to the current administration to spark an economic rebound in the near term. While tax cuts, repatriations, and tax reform may indeed provide a boost to bottom line earnings, as I have stated previously, there is likely going to be little throughput into the economy unless there is a significant ramp up in consumer demand. But therein lies the problem:

“Here is another problem. While economists, media, and analysts wish to blame those ‘stingy consumers’ for not buying more stuff, the reality is the majority of American consumers have likely reached the limits of their ability to consume. This decline in economic growth over the past 30 years has kept the average American struggling to maintain their standard of living.”

Without the end demand from consumers to push companies to expand production, increase employment and raise prices, there is little impetus for companies to expend capital. The chart below shows the relationship between the extensions of loans and leases as it relates to private fixed investment. Despite hopes that companies would deploy borrowed capital into fixed investment to expand production leading to more job creation, this has not been the case. The ongoing decline in fixed investment continues to suggest an ongoing caution by business owners in deploying capital in productive manners but rather through leverage capital to increase productivity and financial engineering.

The lack of deployment borrowed capital can be clearly seen in the relationship between loans and leases and monetary velocity. While bank loans have increased since 2010, as financial engineering to boost earnings per share to offset weak revenue growth surged, the movement of money through the economic system has continued to plunge. Hence, this is why, despite soaring earnings and stock market prices, the economy has continued to stumble along at 2% annual growth rates as the economy remains starved of monetary flows.

Again, this indicator is very early in its suggestion of weakening demand for credit. However, given the very late stage of economic expansion, this could well be an early warning sign worth paying attention to.

It’s Been Quiet – What Happens Next?

As I was catching up on my reading this morning, this comment from the WSJ caught my attention:

“The S&P 500 hasn’t experienced a daily trading range of 1% or greater for 34 consecutive trading sessions, the longest streak since 1995, according to the Journal’s Market Data Group.

Should the market stay stuck in the doldrums on Monday, it would be the longest streak dating back to at least 1974, according to Thomson Reuters data. And guess what? The S&P 500 has inched down 0.2% in recent trading, putting the record in reach.

The average daily range between a session’s intraday high and low over that stretch, dating back to Dec. 14, is just 0.54%, according to FactSet. That compares to the S&P 500′s average daily trading range in 2016 was 0.96%.”

The reason this was interesting is because of something I was discussing last year during the month of September:

“The bulls and the bears have met at the crossroad. However, neither is ready to commit capital towards their inherent convictions. So, for 43-days, and counting, we remain range bound waiting for what is going to happen next.”

sp500-marketupdate-090816-1

Let me remind you how that ended.

So, here we are once again. Since December the 15th, there has been little volatility in the market. This has lured investors into the same false sense of security seen last year before the rout heading into the November election.

Of course, the problem is we simply don’t know for sure which way this “historically tight trading range” will resolve itself, or when. What is for certain, is that it eventually will. The problem for investors is the “bet wrong” syndrome that occurs in times like this.

I know. It’s boring. We all want to “DO SOMETHING.”  But that is simply your emotions at work.

In investing, sometimes the best thing “TO DO” is to “DO NOTHING.”  This is where having the patience to wait for the “fat pitch” becomes much more difficult, but more often than not, provides the best results.

While we remain in the seasonally strong time of the year, a short-term correction remains likely as I detailed previously in “Buy The Dip?” 

Importantly, I have noted with vertical dashed red lines the buy and sell indications relative to the markets subsequent direction. In each case, a registered sell signal at the top of the chart, and confirmed by a reversal of the bottom indicator, have led to short and intermediate-term corrections in the market. These two signals should not be ignored.”

“In this analysis, the correction could be as small as 2.7% or potentially as large at 13.2%. This is quite a dispersion of outcomes and one we will only know with certainty after the fact. However, recent history has suggested that similar setups have seen deeper corrections so such risk should not be readily dismissed.”

Given the overall optimism of the markets, currently based solely on “hopes” of fiscal policy forcing fundamentals to catch up with price, the most likely outcome is the market finding support between the 4.9% and 6.6% correction levels. This should not be any surprise since the markets have suffered 5% corrections, or more, with regularity over the past couple of years.

Just some things I am thinking about.

The Lowest Common Denominator: Debt

At a recent investment conference, hedge fund billionaire Stanley Druckenmiller predicted that interest rates would continue rising. Specifically, he suggested that, consistent with the prospects for economic growth, the 10-year U.S. Treasury yield could reach 6.00% over the next couple of years. Druckenmiller’s track record lends credence to his economic perspectives.  While we would very much like to share his optimism, we find it difficult given the record levels of public and private debt.

Druckenmiller’s comments appear to be based largely on enthusiasm for the new administration’s proposals for increased infrastructure and military spending along with tax cuts and deregulation. This is consistent with the outlook of most investors today.  Although proposals of this nature have stimulated economic growth in the past, today’s economic environment is dramatically different from prior periods. Investors and the market as a whole are failing to consider the importance of the confluence of the highest debt levels (outright and as a % of GDP) and the lowest interest rates (real and nominal) in the nation’s history.  Because of the magnitude and extreme nature of these two factors, the economic sensitivity to interest rates is greater and more asymmetric now than it has ever been.  Additionally, due the manner in which debt and interest rates have evolved over time, the amount of interest rate risk held by fixed income and equity investors poses unparalleled risks and remains, for the moment, grossly under-appreciated.

Proper assessment of future investment and economic conditions must carefully consider changes in the debt load and the interest rates at which new and existing debt will be serviced.

A 45-year Trend

For more than a generation, there has been a dramatic change in the landscape of interest rates as illustrated in the graph below.  Despite the recent rise in yields (red arrow), interest rates in the United States are still near record-low levels.

Data Courtesy: Bloomberg

Declining interest rates have been a dominant factor driving the U.S. economy since 1981. Since that time, there have been brief periods of higher interest rates, as we see today, but the predictable trend has been one of progressively lower highs and lower lows.

Since the Great Financial Crisis in 2008, interest rates have been further nudged lower in part by the Federal Reserve’s (Fed) engagement in a zero-interest rate policy, quantitative easing and other schemes.  Their over-arching objective has been three-fold:

  • Lower interest rates to encourage more borrowing and thus more consumption (“How do you make poor people feel wealthy? You give them cheap loans.” –The Big Short)
  • Lower interest rates to allow borrowers to reduce payments on existing debt thus making their balance sheet more manageable and freeing up capacity for even more borrowing
  • Maintain a prolonged period of low interest rates “forcing” investors out of safe-haven assets like Treasuries and money market funds and into riskier asset classes like junk bonds and stocks with the aim of manufacturing a durable wealth effect that might eventually lift all boats

In hindsight, lower interest rates were successful in accomplishing some of these objectives and failed on others. What is getting lost in this experiment, however, is that the marginal benefits of decreasing interest rates are significantly contracting while the marginal consequences are growing rapidly.

Interest Rates and Duration

What are the implications of historically low interest rates for a prolonged period of time?  What is “seen” and touted by policy makers are the marginal benefits of declining interest rates on housing, auto lending, commercial real estate and corporate funding to name just a few beneficiaries. What is “unseen” are the layers of accumulating risks that are embedded in a system which discourages savings and therefore eschews productivity growth. Companies that should be forced into bankruptcy or reorganization remain viable, and thus drain valuable economic resources from other productive uses of capital.

In other words, capital is being misallocated on a vast scale and Ponzi finance is flourishing.

In an eerie parallel to the years leading up to the crisis of 2008, hundreds of billions of dollars of investors’ capital is being jack-hammered into high-risk, fixed-income bonds and dividend-paying stocks in a desperate search for additional yield. The prices paid for these investments are at unprecedented valuations and razor thin yields, resulting in a tiny margin of safety. The combination of high valuations and low coupon payments leave investors highly vulnerable. Because of the many layers of risk across global asset markets that depend upon the valuations observed in the U.S. Treasury markets, deeper analysis is certainly a worthy cause.

At the most basic level, it is important to appreciate how bond prices change as interest rates rise and fall.  The technical term for this is duration. Since that price/interest rate relationship is the primary determinant of a bond’s profit and loss, this analysis will begin to reveal the potential risk bond investors face. Duration is defined as the sensitivity of a bond’s price to changes in interest rates. For example, a 10-year U.S. Treasury note priced at par with a 6.50% coupon (the long term average coupon on U.S. Treasury 10-year notes) has a duration of 7.50. In other words, if interest rates rise by 1.00%, the price of that bond would decline approximately 7.50%.  An investor who purchased $100,000 of that bond at par and subsequently saw rates rise from 6.50% to 7.50%, would own a bond worth approximately $92,500.

By comparison, the 10-year Treasury note auctioned in August 2016 has a coupon of 1.50% and a duration of 9.30. Due to the lower semi-annual coupon payments compared to the 6.50% Treasury note, its duration, which also is a measure of the timing of a bonds cash flows, is higher. Consequently, a 1.00% rise in interest rates would cause the price of that bond to drop by approximately 9.30%. The investor who bought $100,000 of this bond at par would lose $9,300 as the bond would now have a price of $90.70 and a value of $90,700.

A second matter of importance is that the coupon payments, to varying degrees, mitigate the losses described above. In the first example, the annual coupon payments of $6,500 (6.50% times the $100,000 investment) soften the blow of the $7,500 loss covering 86% of the drop in price. In the second example, the annual coupon payments of $1,500 are a much smaller fraction (16%) of the $9,300 price change caused by the same 1.00% rise in rates and therefore provide much less cushion against price declines.

In the following graph, the changing sensitivity of price to interest rate (duration- blue) is highlighted and compared to the amount of coupon cushion (red), or the amount that yield can change over the course of a year before a bondholder incurs a loss.

The coupon on the 10-year U.S. Treasury note used in our example only allows for a 16 basis point (0.16%) increase in interest rates, over the course of a year, before the bondholder posts a total return loss. In 1981, the bondholder could withstand a 287 basis point (2.87%) increase in interest rates before a loss was incurred.

Debt Outstanding

While the increasing interest rate risk and price sensitivity coupled with a decreasing margin of safety (lower coupon payments) of outstanding debt is alarming, the story is incomplete. To fully appreciate the magnitude of this issue, one must overlay those risks with the amount of debt outstanding.

Since 1982, the duration (price risk) of nominal U.S. Treasury securities has risen 70% while the average coupon, or margin of safety, has dropped 85%. Meanwhile, the total amount of U.S. public federal debt has exploded higher by 1,600% and total U.S. credit market debt, as last reported by the Federal Reserve in 2015, has increased over 1,000% standing at $63.4 trillion. When contrasted with nominal GDP ($18.6 trillion) as graphed below, one begins to gain a sense for how radically out of balance the accumulation of debt has been relative to the size of the economy required to support and service that debt.  In other words, were it not for the steady long-term decline in interest rates, this arrangement likely would have collapsed under its own weight long ago.

Data Courtesy: St. Louis Federal Reserve (FRED)

To provide a slightly different perspective, consider the three tables below, which highlight the magnitude of government and personal debt burdens on an absolute basis as well as per household and as a percentage of median household income.

Data Courtesy St. Louis Federal Reserve (FRED) and USdebtclock.org

If every U.S. household allocated 100% of their income to paying off the nation’s total personal and governmental debt burden, it would take approximately six years to accomplish the feat (this calculation uses aggregated median household incomes). Keep in mind, this assumes no expenditures on income taxes, rent, mortgages, food, or other necessities. Equally concerning, the trajectory of the growth rate of this debt is parabolic.

As the tables above reflect, for over a generation, households, and the U.S. government have become increasingly dependent upon falling interest rates to fuel consumption, refinance existing debt and pay for expanded social and military obligations. The muscle memory of a growing addiction to debt is powerful, and it has created a false reality that it can go on indefinitely. Although no rational individual, CEO or policy-maker would admit to such a false reality, their behavior argues otherwise.

Investors Take Note

This article was written largely for investors who own securities with embedded interest rate risks such as those described above. Although we use U.S. Treasury Notes to illustrate, duration is a component of all bonds. The heightened sensitivities of price changes coupled with historically low offsetting coupons, in almost all cases, leaves investors in a more precarious position today than at any other time in U.S. history. In other words, investors, whether knowingly or unknowingly, have been encouraged by Fed policies to take these and other risks and are now subject to larger losses than at any time in the past.

This situation was beautifully illustrated by BlackRock’s CIO Rick Rieder in a presentation he gave this fall. In it he compared the asset allocation required for a portfolio to achieve a 7.50% target return in the years 1995, 2005 and 2015. He further contrasts those specific asset allocations against the volatility (risk) that had to be incurred given that allocation in each respective year. His takeaway was that investors must take on four times the risk today to achieve a return similar to that of 1995.

Summary

We generally agree with Stanley Druckenmiller. If enacted correctly, there are economic benefits to deregulation, tax reform and fiscal stimulus policies. However, we struggle to understand how higher interest rates for an economy so dependent upon ever-increasing amounts of leverage is not a major impediment to growth under any scenario. Also, consider that we have not mentioned additional structural forces such as demographics and stagnating productivity that will provide an increasingly brisk headwind to economic growth. Basing an investment thesis on campaign rhetoric without consideration for these structural obstacles is fraught with risk.

The size of the debt overhang and dependency of economic growth on low interest rates means that policy will not work going forward as it has in the past. Although it has been revealed to otherwise intelligent human beings on many historical occasions, we retain a false belief that the future will be like the past. If the Great Recession and post-financial crisis era taught us nothing else, it should be that the cost of too much debt is far higher than we believe.  More debt and less discipline is not the solution to a pre-existing condition characterized by the same. The price tag for failing to acknowledge and address that reality rises exponentially over time.

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Financial planning gets a bum rap.

Or no rap at all.

After all, the process lacks excitement.

There are none of the day-to-day highs and lows of the stock market.

No sizzle.

Financial planning doesn’t make headlines or capture the attention of media talking heads.

It flies under the radar.

And to that I say:

Thank goodness.

As a saver and investor, financial planning should be at the top of your list of tasks to accomplish.

Consider financial planning a mundane sentinel which forms the foundation of money awareness. When plans are attached to goals or life benchmarks as I call them, they take on a life of their own as progress markers along the path to a successful financial life.

A plan is a complete diagnostic of money chemistry. And the numbers don’t lie.

At times, it’s is validation, other times, an awakening.

On occasion, a warning.

See? Perhaps planning is exciting (we’ll keep that between us. Our own little secret).

Now that I have your attention and you’re ready to go, I’ll share seven huge mistakes I’ve encountered with the planning process over the last two decades.

You depend on the wrong tools to get the job done.

Online publicly-available financial planning calculators are the junk food of finance posing as nutritious choices. I guess it’s better than nothing, however just because a planning calculator is available from a reputable firm like Vanguard or Charles Schwab surprisingly doesn’t make it worthy of consideration.

As a matter of fact, per a recent study, the efficacy of publicly-available retirement planning tools from 36 popular financial websites was challenged and results were extremely misleading.

These quick (worthless) financial empty-calories don’t provide enough input variables to provide a level of accuracy. Most egregious is the dramatic over-estimation of returns and plan success.

If you trust an online calculator to adequately plan for retirement or any other long-term financial life benchmark, and feel confident in the output (most likely because it provided a positive outcome,) then you’re ostensibly setting yourself for dangerous surprises.

Avoid them. They’re not worth it. Best not to do any planning at all if it’s this route.

You haven’t undertaken a comprehensive financial diagnostic

According to the 2013 Household Financial Planning Survey & Index prepared for the Certified Financial Planning Board of Standards, only 19 percent of 1,000 household financial decision-makers had gone beyond a simple household budget when it came to planning.

A properly designed financial plan will cover important elements like retirement savings, insurance analysis and estate review; a qualified planner will target and outline specific areas of strength and weakness along with flexible, realistic routes to each financial goal.

If you’re stressing over the process, how long it takes to get a plan together: don’t. Yes, there’s a financial self-discovery period on your part and that will take effort and homework. However, a plan can be modular based on your most important concern first, then built on over time.

You employ a broker to handle planning responsibility.

You’re best to seek out a fiduciary, a professional or an organization that places the clients’ interest first.

Planning isn’t a big attention-getter, especially at brokerage firms. It isn’t a profitable venture as it directs attention and resources away from activities that generate revenues, like selling products. If anything, it’s a loss leader. An afterthought.

To maintain an image of care or come across as ‘consultative,’ financial plans are offered but they’re not a focus. They’re employed as a method to discover where assets are and where opportunities lie to generate sales.

This is not what planning is supposed to be. The process minimizes the importance of building, maintaining and monitoring a holistic financial plan. A plan must be taken seriously and not considered an afterthought.

Recently, Antoinette Koerner, a professor of entrepreneurial finance and chair of the finance department at the MIT Sloan School of Management, along with two co-authors, set out to analyze the quality of financial advice provided to clients in the greater Boston area.

They employed “mystery shoppers” to impersonate customers looking for advice on how to invest their retirement savings. Unfortunately, it didn’t work out too well.

Advisors interviewed tended to sell expensive and high-fee products and favored actively-managed funds over inexpensive index fund alternatives. Less than 8% of the advisors encouraged an index fund approach.

The researchers found it disconcerting how advisor incentives were designed to motivate clients away from existing investment strategies regardless of their merit. They found that a majority of the professionals interviewed were willing to place clients in worse positions to secure personal, financial gain.

So, let me ask: Would you rather have a comprehensive plan completed by a professional who adheres to a fiduciary standard where your financial health and plan are paramount, or a broker tied to an incentive to sell product?

Brokerage firms are willing to offer financial plans at no cost. However, the price you’ll ultimately pay for products and lack of objectivity, is not worth a ‘free’ plan. It’s in your best interest to find a financial partner who works on an hourly-fee basis or is paid to do the work, not investments sold.

Your portfolio revolves around the plan & not vice versa.

Let’s face it, and I’ve mentioned it previously: Planning is boring, investments are exciting. There are investors who believe that if they can consistently achieve greater than market returns, then the rest of the plan will follow suit.

Not really.

A “returns first” perspective will place a plan in jeopardy as taking on additional risk will likely not lead to commensurate returns, especially if not backed by an aggressive savings and debt management strategy to provide a cushion against market losses.

The genesis of an effective financial plan begins with the prioritization of personal goals broken down by needs and wants along with the rates of return required to meet them. The rates of return should be considered a blend of market performance, your personal savings rate and a willingness to increase savings during times of below average or poor market performance.

So, let your plan drive required returns and work with an objective pro who can mesh return expectations with current market reality.

You believe plan results are written in stone.

I need you to believe your plan is formed of mud and clay. A financial plan represents a human life with a path far from perfect. A plan is supposed to be molded, changed, pushed, pulled and on occasion, downright messy.

Even if you’re disappointed by the outcome (your financial resources won’t go as far as required, or there’s compromise on certain wants), a financial plan should always be based on optimism and a strategy to improve thus the push/pull. You push habits that require improvement, pull from expectations to create results you can live with.

If planning starts early, say, 5-10 years from the goal, you can rein in weaknesses and switch gears, make positive changes that will have a formidable impact. The plan should be a revelation; a level of financial alertness that goes a long way to expose flaws, identify strengths and generate ongoing dialogue about current and future lifestyle decisions.

You discount luck in the process.

It’s the spin of a roulette wheel. Where the results of your goals and market returns intersect is pure luck. Will you experience a great tailwind of investment returns that enhance your outcome?  Or is a headwind on the horizon which requires an increased savings discipline or more focus on a return of your human capital (income potential).

For example, based on current stock valuations, there’s an above average probability that e a retiree will face a prolonged, low-return headwind which will require ongoing monitoring of expenses and portfolio withdrawals at the least, every three years.

Bad luck in the form of a poor sequence of returns or above average inflation can lead to premature portfolio depletion. In other words, you may outlive your money!

The alignment of investment returns to the accomplishment of a financial goal within a specific time frame is a random and occasionally frustrating event. Never discount how “being in the right market cycle at the right time,” makes a tremendous contribution to your success.

It’s best to understand this concept of luck before planning begins. It’ll keep you grounded and aware of your savings, investment and debt habits post-plan improvement/monitoring stage.

Your plan investment return estimates are too optimistic.

To a broker, flat or bear market cycles don’t exist. He or she has been trained by an employer to believe stocks perpetually go up. It’s the greatest wide-spread alternate-reality “fact.”

You’ve heard and read how markets have reached new highs (17 years), and it’ll be shoved in your face that markets always move higher (17 years). Did I mention it took 17 years? What’s 17 years? To you? To me? An eternity. To the market? A blip.  We’re advised how it’s one big bull market party and it goes on forever.

How dare you miss the fun? 

Realistically, the dogma is false narrative. If you fall for it, you may wind up spending an investment life making up for losses or breaking even.

Most financial planning software generates outcomes based on something called “Monte Carlo” simulation. It’s as close as planners get to represent the variability of market returns over time.

Monte Carlo generates randomness to a portfolio and simulates, perhaps thousands of times, around an average rate of return. Unfortunately, asset-class returns most Monte Carlo tools incorporate tend to be optimistic.

In addition, even though Monte Carlo simulates volatility of returns, it does a very poor job representing sequence of returns which I think of as a tethered rope of successive poor or rich returns.

Per friend and mentor Jim Otar, a financial planner, speaker and writer in Canada:

Markets are random in the short term, cyclical in the medium term, and trending in the long term. They are neither random, nor average, nor trending in all time frames. Secular trends can last as long as 20 years (up down or sideways). The randomness of the markets are piggybacked onto these secular trends. Assuming an average growth and adding randomness to it does not provide a good model for the market behavior over the long term and it makes the model to “forget” the black swan events. 

It’s why at Clarity, as a backstop, we employ various planning methodologies which incorporate how market cycles operate and where your goals may fall within them.

Look for an upcoming interview on Real Investment Advice with Jim.

Consider financial planning as the ultimate uneventful main event.

Granted, a comprehensive plan experience won’t be the talk of your next cocktail party. However, it just may allow you the freedom and peace of mind to enjoy the benchmarks you work hard every day to reach.

And that’s worth more than money to you and your family.

This past weekend I was at a “Super Bowl” party in my neighborhood. As a money manager, I like parties as they are a rather insightful indicator of the current psychology of the “average investor.” The great thing is that I do not have to do much other than stand in the middle of the room, have a drink in my hand, and wait. Generally, it doesn’t take long to find out where we are within the current investment cycle as one of three things will happen;

1. No one wants to talk about their investments;
2. A comment about investing might arise, or
3. They tell you everything about their latest investment success.

The chart below explains the concept.

The party this weekend was an example of the third stage. Wives were walking around with freshly injected lips and botoxed faces. Men were brandishing new Rolex watches while bragging about their latest acquisitions. I now know more about their personal stock portfolios than I do about their children’s latest successes.

As I discussed yesterday, there is a suspended disbelief that currently exists in the markets. Yet as I stated:

There is one important truth that is indisputable, irrefutable, and absolutely undeniable: ‘mean reversions’ are the only constant in the financial markets over time. The problem is the next ‘mean reverting’ event will remove most, if not all, of the gains investors have made over the last five years.”

By the time, the sentiment of both individuals and professionals have become universally “bullish,” the markets have generally been near at least a short-term peak, if not worse. The only issue is the ability to know, with certainty, whether a particular peak will lead to a correction within an uptrend; or potentially something far more dangerous.

While I am not suggesting the market is about to crash; it does suggest investors are “all in” at this point with no real concern of the inherent risk. I can confirm that statement by the number of individuals that asked my opinion about every “high flier” stock in the market with a P/E with greater than 100x or worse, had no P/E because there were no earnings.

Of course, when I made the fundamental argument about the foolishness of investing that way, the conversation quickly ended with “yes, but I am making so much money.”

I have a sneaking suspicion I will probably not be invited to any more parties any time soon. However, it is apparent investor “greed” is back.

With that said, let’s take a look at the current bull and bear cases for the market.

THE BULL CASE

1) Participation Improving

Following the election, the scramble to close out short-positions and chase the markets sent the number of stocks on bullish buy signals soaring higher. From a bullish perspective, the rising number of stocks on bullish buy signals remains supportive currently.

This same applies to the number of stocks hitting new highs versus new lows on the NYSE. The improvement in the number of stocks hitting new highs also supports the bullish short-term view. However, the negative divergence longer-term still remains problematic.

In both cases above, when these indicators turn down, it has normally been a good warning about a short-term consolidation or correction in the market.

2) Stocks Made Successful Retest Of Support

As I discussed in last weekend’s newsletter, while there are certainly plenty of reasons to be cautious, there is still a case being made for a further advance in the markets. The market made a solid retest of the tops made in late 2015, and early 2016, leading up to the election. That retest of support, and subsequent breakout to new highs, confirmed the continuation of the “bull market” that began in 2009. 

Furthermore, the price momentum of the market is rising from low levels set in early 2016 and remains positively entrenched. Again, this is supportive of the underlying bullish advance and keeps portfolios currently allocated towards equity risk. 

It is worth noting the markets remain extremely overbought and the surge in the markets has likely priced in a lot of the fundamental benefits of any policy changes currently expected from the new Administration. The current extension of the markets above its moving averages certainly does not rule out the possibility of a correction in the short-term. A break of support and the current trend, which would currently be around 2100, will change the dialog significantly.

3) It’s The Carry Trade Stupid

Since 2009, as Central Banks swung into action liquefying the markets and removing investment risk by providing a proverbial “put” to market participants, the “yen carry trade” has been the cornerstone of the market’s advance.

As noted below, the use of the carry trade, (chart courtesy of David Larew), has continued to provide the support behind the bullish advance. While the markets are currently having a bit of weakness, given the strength of the underly “carry trade,” this will likely be another “buy the dip” opportunity for market participants.

Such a rise in participation suggests the momentum behind stocks is supportive enough to push stocks to higher levels and should not be dismissed lightly.

WARNING:

Let me be VERY CLEAR – this is VERY SHORT-TERM analysis. From a TRADING perspective, there remains a trading opportunity on “dips.” This DOES NOT mean the markets are about to begin the next great secular bull market. Caution is highly advised if you are the type of person who doesn’t pay close attention to your portfolio or have an inherent disposition to “hoping things will get back to even” if things go wrong rather than selling.


THE BEAR CASE

1) Short-Term: Market Rally On Declining Volume

The recent market rally, while strong, occurred amidst declining volume suggesting more of a short-covering rally rather than a conviction to a “bull market” meme.

The market is currently registering two short-term sell signals. With prices extremely deviated from the long-term moving averages, the risk of a correction in the short-term remains elevated

2) Longer-Term Dynamics Still Bearish

If we step back and look at the market from a longer-term perspective, where true price trends are revealed, we see a very different picture emerge. As shown below, the current dynamics of the market are extremely similar to those of the previous two bull market peaks. Given the deterioration in revenues, bottom-line earnings, and weak economics, the backdrop between today and the end of previous bull markets is consistent. 

The market remains on a long-term “sell signal” and is pushing a 3-standard deviation extreme, which has only occurred at the peaks of previous bull market cycles. 

Since this a very slow moving chart, the time-frame for the “end game” to eventually play out could be several more quarters into the future.

3) Bonds Ain’t “Buyin’ It”

Lastly, if a “bull market” were truly taking place we should see a flight from “safety” back into “risk.” That is currently not the case. 

As shown below, previous peaks in the stock-bond-ratio has been coincident with both short and long-term market corrections.

Currently, we are not seeing “risk taking” being a predominate factor at the moment. Could this change? Absolutely.

But for now, it is worth watching this indicator. When it reverses, it has generally been a good indicator for reducing risk capital in portfolios. 


What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case currently to warrant retaining equity risk in portfolios on a short-term basis. 

However, the longer-term dynamics are clearly bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the “risk” of having excessive exposure to the markets greatly outweighs the potential “reward. “

Could the markets rocket up to 2400 as I have discussed previously? I think, given the “irrational exuberance” that currently exists, it is quite possible.

While the markets could reward you with another 100 points of upside, there remains a substantial risk of 200-400 points of downside. 

Those are odds that Las Vegas would just love to give you.

There is little doubt currently that complacency reigns in the financial markets. Nowhere is that complacency more evident than in the Market Greed/Fear Index which combines the 4-measures of investor sentiment (AAII, INVI, MarketVane, & NAAIM) with the inverse Volatility Index.

The reason I revisit the index above is due to last Thursday’s “3-Things” post in which I presented two arguments concerning the potential for a 50-70% decline in the markets. John Hussman’s view was simply a valuation argument stating:

“To offer some idea of the precipice the market has reached, the median price/revenue ratio of individual S&P 500 component stocks now stands just over 2.45, easily the highest level in history. The longer-term norm for the S&P 500 price/revenue ratio is less than 1.0. Even a retreat to 1.3, which we’ve observed at many points even in recent cycles, would take the stock market to nearly half of present levels.”

The second argument was from Harry Dent based on demographic trends within the economy as the mass wave of “baby boomers” become net-distributors from the financial markets (most importantly draining underfunded pension funds) in the future. To wit:

At heart, I’m a cycle guy. Demographics just happens to be the most important cycle in this modern era since the middle class only formed recently — its only been since World War 2 that the everyday person mattered so much; because now they have $50,000-$60,000 in income and can buy homes over 30 years and borrow a lot of money. This was not the case before the Great Depression and World War 2.

And based on demographics, we predicted that the U.S. Baby Boom wouldn’t peak until 2007, and then our economy will weaken — as both did in 2008. We’ve lived off of QE every since.”

Not surprisingly, those two comments drew a lot of fire from readers such as this one:

Or this one…

Hmmm….where have I heard this before.

“Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as they have predicted. I expect to see the stock market a good deal higher within a few months.”

– Dr. Irving Fisher, Economist at Yale University 1929

This Utopian belief of now infinite stability within the financial markets due to ongoing Central Bank interventions is a most dangerous concept.  This is particularly the case given the structural and economic shifts in the economy due to the rise in debt which has derailed the efficient allocation of capital. As shown below the economy is currently mired at the lowest average annual growth rate since 1790. (Data courtesy of Measuring Worth)

Furthermore, a quick analysis of past history suggests the regularity of corrections which have run the gamut of devastating blows to investor capital. (Monthly data courtesy of Dr. Robert Shiller)

If you look at the chart above you will notice the longest economic expansions in history have also been followed by declines of 30% or more. With the current economic expansion now the 3rd longest in history at 92-months, a subsequent correction of 30% or more should not be surprising.

Of course, what fuels corrections is not just a change in investor sentiment, but an ignition of the leverage that exists through the extension of debt. Currently, leverage is near the highest levels on record which is the equivalent of a tank of gasoline waiting on a match.

And…corporate leverage. The chart below shows the total liabilities and equity of non-financial businesses in the U.S. divided by the Gross Value Added. I have overlaid the S&P 500 for relevance.

As can be clearly seen, leverage fuels both halves of the full market cycle. On the way up, increases in leverage provide the capital necessary for accelerated share buybacks and increased speculation in the markets. Leverage, like gasoline, is inert until a catalyst is applied. It is the unwinding of that leverage that accelerates the liquidation of assets in the markets causes prices to plunge faster and further than most can possibly imagine.

It has only happened twice already since the turn of the century. Yet, less than a decade from the last crash, investors have once again fallen prey to excessive exuberance and the belief that somehow this time will most assuredly be different. 

Measuring The Size Of The Next Correction

As a portfolio strategist, there is little question the markets are still confined to a bullish uptrend. Currently, portfolio allocation models remain near fully invested. Therefore, what concerns me most is NOT what could cause the markets rise, as I am already invested, but what could lead to a sharp decline that would negatively impact investment capital.

[Important Note: It is worth remembering that winning the long-term investment game has more to do with avoidance of losses than the capturing of gains. It is a function of math.]

What causes the next correction of magnitude is unknown. It always is until after the fact. There are many factors that can, and will, contribute to the eventual correction which will “feed” on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The chart below shows the deviation from the long-term trend line. I have calculated an advance to 2400 for the S&P 500 which, as I published in “2400 or Bust”, is a reasonable target for the current “melt-up” phase of the market.

As stated above, the bull market trend which began in 2009 remains currently intact (dashed blue line). A correction from 2400 back to that bullish uptrend line, which occurred in both 2011 and 2012, would entail a decline to 2100.  That would be a 14.2% decline and while not technically a “bear” market, for many investors it will certainly “feel” like one.

But what if a simple correction accelerates? To analyze how a market accelerates to a 50% correction, we can use a “Fibonacci Retracement” analysis as shown in the chart below. As defined by Investopedia:

“The Fibonacci retracement is the potential retracement of a financial asset’s original move in price. Fibonacci retracements use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction. These levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.”

So, a 50% retracement from the 2400 level would push the markets back towards 1547. As identified in the chart, a 23.6% retracement from the 2009 lows would violate the bullish trend line. Such a violation would set up a change in trend, from bullish to bearish, thereby bringing more selling into the market.

If the next wave of selling starts to trigger “margin calls,” the next three levels of retracement become much more viable. The market would initially seek out support at the 38.2% retracement level of 1748 which would be a decline of 27.16% and would push the markets into an “official” bear market. As margin calls accelerate, so does the forced liquidation which then bleeds over into psychological panic selling as investors reach the point of capitulation.

This is where “buy and hold” quickly becomes “get me the $*@# out.”

That can’t happen you say? As shown in the chart below, corrections of 50% to 61.8% of the previous advance are common with corrections even eclipsing 100% as well.

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession. But considering we are already 91-months into the current cycle and extremely levered, there is a rising level of risk that should not be ignored.

By the way, a 50% retracement would register a 35.5% decline in investor portfolios. A 61.8% retracement would destroy 43.9% of investor capital.

And that is how you get a 50% decline.  

However, while I show that the greater levels of a potential correction will likely be coincident with a recession, as they have historically been, it does NOT mean that a recession is required. A sharp rise in interest rates or inflation, a downturn in economic growth, deflationary pressures from the Eurozone, or a credit related issue in the “junk bond” market could all do the trick.

No one will know, until in hindsight, what the catalyst will be that ignites a “panic” in the market. This is why we do analysis to understand the potential risks in the market as compared to expected reward. What is abundantly clear is that the potential “upside” in the market is currently outweighed by the “downside” risk. It is important to remember that our job as investors is to “sell high” and “buy low.”

Unfortunately, for most, they are already doing exactly the opposite.

There is one important truth that is indisputable, irrefutable, and absolutely undeniable: “mean reversions” are the only constant in the financial markets over time. The problem is that the next “mean reverting” event will remove most, if not all, of the gains investors have made over the last five years.

Don’t think it can happen?

You might want to reconsider.

As we conclude week two of the new Presidential cycle, it certainly has not been dull.

The markets have started struggling with an Administration which is hanging up on heads of state, threatening to send troops to Mexico, discussing border taxes and thinking about doubling the required wages for HB-1 visas. Of course, those issues are still currently offset by hopes for a sea of infrastructure spending, tax cuts and reform and an increase in jobs and wages.

The “hope” is most clearly seen in the sentiment surveys, but remains elusive in the “hard data.” As noted recently by Charlie McElligott via RBC:

“The US data has been running at such a clip, as a matter of fact, it’s an increasingly (and massively rhetorical) popular question asked by clients: when do analyst / strategist expectations begin to overshoot?

Tied-into this, the Bloomberg ‘econ surprise’ series gives an interesting breakout of the drivers of the directional data surprises, and it crystalizes one ‘area’ that Mark Orlsey and I have been paying a lot of attention to with regards to where the largest ‘beats’ are coming from.

The economic surveys and ‘animal spirits’ indicators have been ‘en fuego’ (see Friday’s U Mich Confidence printing highs since 2003!), and the chart below captures just how much of the ‘surprise index’ upside that surveys have been dictating – it’s visually stunning, and reiterates that ‘rubber needs to meet road’ in coming months.

We can see this more real time by looking at the Chicago Fed National Activity Index (CFNAI) which is arguably one of the more important economic indicators. The index is a composite made up of 85 subcomponents which give a broad overview of overall economic activity in the U.S. However, unlike backward-looking statistics like GDP, the CFNAI is a forward-looking metric that gives some indication of how the economy is likely to look in the coming months.  Importantly, understanding the message the index is designed to deliver is critical.  From the Chicago Fed website:

“The Chicago Fed National Activity Index (CFNAI) is a monthly index designed to gauge overall economic activity and related inflationary pressure.  A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth, and positive values indicate above-average growth.

The overall index is broken down into four major sub-categories which cover:

  • Production & Income
  • Employment, Unemployment & Hours
  • Personal Consumption & Housing
  • Sales, Orders & Inventories

Here is my point. While “exuberance” in terms of “attitudes” is surging, actual activity remains quite subdued. The first chart compares my combined consumer confidence composite to the CFNAI.

The next chart is the dispersion of the components of the CFNAI also compared to consumer “confidence.”

In both instances there is a wide deviation between “attitude” and “activity.” More importantly, “attitudes” have typically reverted back to “activity” rather than the other way around. 

This potentially leaves the market set up for disappointment in the months ahead. Be careful.

In them meantime, here is what I am reading this weekend as I put my “Dow 20,000” hat back in the drawer for now.


Trump/Economy


Markets/Fed


Favorite / Interesting Reads


“Bubbles Are Invisible To Those Inside The Bubble.” -€ Jim Dines

Questions, comments, suggestions – please email me.

February Bumps

With January now behind us, and as the luster of the election begins to fade, the question becomes what will the month of February bring. While it is impossible to predict outcomes with absolute certainly, we can look at historical precedents to discern the risk that we undertake as investors.

If we look at the month of February going back to 1960 we find that there is a slight bias to February ending positively 57% of the time.

Unfortunately, the declines in losing months have wiped out the gains in the positive months leaving the average return for February almost a draw (+.01%)

A look at daily price movements during the month, on average, reveal the 4th trading day of February through the 12th day provide the best opportunity to rebalance portfolio allocations and reduce overall portfolio risk.

Currently, bullish exuberance is once again pushing extremely high levels. As noted yesterday:

Historically, the combination of excessive exuberance, complacency and extensions have not worked out well for investors in the short-term.

Furthermore, Blake Morrow at Forex Analytix made an interesting point as well:

“We have been making higher highs and higher lows (the definition of an uptrend). However, the rate that the higher highs are happening is lower than that of the higher lows. From this, it follows that we may be developing an ascending wedge. Also, the apex is not as tight in price that I typically like for a reversal pattern.

 

“Never ever lose sight of long term relationships” – Paul Krake – View from the Peak

Throughout 2016 we highlighted that various measures of equity valuations are at historically high levels and present an unfavorable risk/reward profile.

Comparing valuation metrics to their respective longer term averages is a good way to gauge richness or cheapness, but it does not necessarily paint a complete valuation picture. For instance, Amazon’s stock trades at an astronomical price to earnings ratio (P/E) of 172 or about seven times that of the S&P 500. Despite the seemingly high ratio, one cannot single-handedly declare that Amazon is expensive. If Amazon’s sales continue to grow at a torrid pace, a ratio of 172 may not be out of line.

The objective of this article is to form a complete valuation picture of the S&P 500. Although the work behind valuations and rich/cheap analysis is never complete, this exercise will help you understand the earnings growth priced into current valuation levels. It also provides a framework to evaluate the upside and downside of various combinations of earnings projections and price multiples. From there, you can make your own judgment about whether current valuations make sense.

P/E

The graph below plots the Cyclically Adjusted Price to Earnings ratio (CAPE) since 1883, its average and plus/minus one standard deviation levels from the average. The current ratio of 28.14 is approximately 1.75 standard deviations higher than average and stands perched above almost every prior observation in the last 130 years except those of the late 1920’s and the late 1990’s.

Data Courtesy Robert Shiller – http://www.econ.yale.edu/~shiller/data.htm

Calculating P/E ratios may be done using CAPE, earnings for the trailing twelve months (TTM) or numerous other methods. While market practitioners tend to favor TTM, CAPE is used here for the same reasons Ben Graham and Robert Shiller preferred it – ten years of earnings data helps eliminate short-term noise that frequently distorts quarterly and annual earnings. CAPE takes an additional step and adjusts for inflation, thus normalizing the ratio for different inflation environments. While some may claim that these two approaches yield wildly different results, we found only a minor variance. TTM P/E for the S&P 500 is currently 1.50 standard deviations above its 130-year average, only slightly below that calculated using CAPE (1.75).

The bar chart below shows the distribution of CAPE values or the percentage of time the ratio was in each respective P/E band on the x-axis.

Data Courtesy Robert Shiller – http://www.econ.yale.edu/~shiller/data.htm

While not a perfect bell curve, the chart above does have a similar shape, albeit with a long right tail. Over 80% of the data lies between a ratio of 8 and 20. The current ratio of 28.14 has only been eclipsed by 3% of the observations. Put more bluntly; the S&P 500 is in no man’s land by this measure.

Earnings

To gauge the expected earnings growth that is currently priced into the market, we could take the all too popular consensus forecasts published by Wall Street at face value. While that might be a fast approach, history, as discussed in “Earnings Magic Exposed”, has proven misleading.

Instead, we prefer to solve for the expected earnings growth rate using the CAPE ratio. If one believes in mean reversion, then it is likely CAPE will regress to its historical average ratio (16.7) within the next five years. If we further assume the price of the S&P 500 does not change, we can easily solve for expected earnings growth. Given those assumptions, the required annualized earnings growth for the next five years is nearly 11% at current valuations. In other words, the S&P 500 price would be unchanged over the next five years if corporate earnings grow 11% annually and CAPE regresses to its long-term average. However, if we assume investors expect the S&P 500 price to grow 5% a year as it has averaged this century, then earnings must increase 16.50% annually to offset the reversion to the mean of CAPE. If we take a more conservative stance and assume that CAPE will remain at one standard deviation above average at 23.35 and the S&P 500 price will grow 5% annually, earnings must grow at an annualized rate of 4.50%.

A scenario in which earnings grow annually at 4.50% may seem reasonable, but it is relatively optimistic when put in context with previous growth trends and economic impediments. Consider that over the last three, five and ten years, S&P 500 earnings have grown at annualized rates of -0.48%, 2.34%, and 1.80%, respectively. It is worth noting that the three- and five-year periods do not include a recession. Expecting that streak to continue five more years fails to incorporate reasonable recession probabilities into the analysis.

To put additional perspective on expected earnings growth, we analyze the nation’s economic growth rate. Since 1947, real GDP and corporate earnings have grown at nearly identical long-term rates. The graph below charts the cumulative growth of earnings and GDP over this period. Note that, while the growth rates vary wildly, they have been well-correlated over the longer-term as witnessed by comparing the less volatile earnings polynomial trend line (blue dotted line) with GDP (green line).

Data Courtesy: St. Louis Federal Reserve (FRED) and Bloomberg

The graph below aids in forecasting earnings growth by highlighting the secular trend of GDP growth since 1950.

Data Courtesy: St. Louis Federal Reserve (FRED)

The trend was confirmed by Janet Yellen, who on January 18, 2017, stated that the long-run GDP growth rate is expected to fall under 2%. Based on the GDP trend line and the correlation of earnings to GDP expectations, one should assume earnings growth will follow GDP and be 3% or less.

The future growth rate assumption mentioned above is not solely a function of extrapolation from previous trends. It is truly arrived at with a thorough understanding of the economy’s structural impediments – debt, demographics, and productivity as we have noted in numerous prior articles.

Scenario Analysis

At this point, we have presented you with historical earnings trends and a way to estimate future earnings growth. Additionally, we provided a long history of the price to earnings ratio and the statistically significant distribution it has followed. With this data in mind, we present the table below which allows you to forecast stock price changes based on future P/E ratios and earnings growth estimates. Note the three colored boxes reflect what we consider to be optimistic, fair and pessimistic estimates. Here are the simple steps to evaluate forward returns:

  1. Select the CAPE ratio you expect to see in 2022. At the top of the table are six options ranging from 10.1 to 28.1 (current level). The range is based on standard deviations as shown above each P/E level.
  2. Select the expected annualized earnings growth for the next 5
  3. Find the intersection of your CAPE and earnings growth estimates. The number at the intersection is the expected annualized price return for the S&P 500 for the next five years. As a quick example, a projected CAPE of 20.0 and 3% earnings growth will result in an expected annual return of -2.57% for each of the next five years.

As illustrated in the table, the risk/reward profile is very unbecoming unless you believe CAPE will stay grossly elevated and earnings will grow significantly more than they have over the past ten years.  A relatively riskless strategy, whereby one buys and holds to maturity a five-year U.S. Treasury bond yielding 1.98%, beats all but the most optimistic scenarios highlighted above.

Summary

Many investors believe that the initiatives of the new administration will provide an economic spark generating economic growth and increasing corporate earnings. Although confidence is a cheap form of stimulus, reality is that the structural headwinds the economy faces are brisk. Given the historically high valuations and poor risk/reward ratio, we prefer to let the market prove us wrong.

One final note for consideration; since January 1, 2012, the S&P 500 has increased 75%, while earnings have increased 2%. In other words, for all intents and purposes, the entire rally from 2012 is a function of multiple expansion and is in no way supported by fundamentals. For investors who hold mean reversion as an important guiding principle, it is not unrealistic to expect the CAPE multiple to regress back towards its historical average. Indeed, it is entirely expected.

We leave you with the article’s opening quote as it is such an important concept to grasp.

“Never ever lose sight of long term relationships”.

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In this past weekend’s newsletter, I reviewed every S&P sector and several major markets to analyze the risk/reward opportunities that currently exist. In a nutshell, there really weren’t many. To wit:

“We can also witness the rather extreme extension of prices above the 200-dma. Such extensions, which are always combined with extreme overbought conditions, have typically not lasted long and have been a good indication to take profits in the short-term. This provides some opportunity to invest capital following a correction to some level of support.”

On Monday, the market reversed much of the advance from last week as a spike in volatility pressured stocks lower. Importantly, one of the bigger concerns, from a short-term risk assessment view, has been the negative divergence of the MACD (moving average convergence divergence) with the potential of a short-term sell signal. The combination of these suggests a larger corrective action may be in store. 

BUY THE DIP?

Which brings us today’s questions. How big of a correction might we expect and should it be bought?

For the answer to the first question, we can review recent support levels and make some educated guesses. The first chart below shows the standard Fibonacci retracement levels for the S&P 500 from the previous lows. Initially, the market should find support at the retest of the bullish trend line from the February 2016 lows. A failure there will be a retracement of 38.2% of the recent advance to roughly 2300.

Importantly, I have noted with vertical dashed red lines the buy and sell indications relative to the markets subsequent direction. In each case, a registered sell signal at the top of the chart, and confirmed by a reversal of the bottom indicator, have led to short and intermediate-term corrections in the market. These two signals should not be ignored.

The next chart attempts to quantify several potential correction levels from the recent highs.

In this analysis, the correction could be as small as 2.7% or potentially as large at 13.2%. This is quite a dispersion of outcomes and one we will only know with certainty after the fact. However, recent history has suggested that similar setups have seen deeper corrections so such risk should not be readily dismissed. 

Given the overall optimism of the markets, currently based solely on “hopes” of fiscal policy forcing fundamentals to catch up with price, the most likely outcome is the market finding support between the 4.9% and 6.6% correction levels. This should not be any surprise since the markets have suffered 5% corrections, or more, with regularity over the past couple of years.

Secondly, should you “buy this dip?” Probably. As I quoted in this weekend’s missive:

“So that keeps telling me that the highest probability outcome remains for lower-highs and lower-lows in VIX.

And that keeps happening in a US Equity market that is often called ‘expensive’ (it is), but doesn’t get cheaper. Maybe someone from the orthodoxy of macro ‘valuation’ experts can chime in on why this is happening.

I think it’s because consensus continues to position for a correction that would be deemed “rational”, as opposed to buying all dips in an irrationally profitable position that’s been complimented by prevailing growth and inflation conditions.

Can the U.S. stock market get more expensive? Absolutely.”

I don’t disagree with the point. There are TWO very important lessons that should not be forgotten at this late stage of the market’s advance.

“The market can remain irrational, longer than you can remain solvent.” – J. M. Keynes

“In a bull market, you can only be long or neutral.” – D. Gartman

Currently, there is little indication any correction in the short-term will lead to the beginning of a full-blown bear market reversion to the mean. 

But, more importantly, there never is.

Last Leg?

There continues to be several warning signs which continue to persist despite ongoing hopes that “Trumponomics” will create the backdrop for a fiscal policy driven continuation of the “bull market” advance.

The first is the ongoing negative divergence of stocks above the 50 and 200-day exponential moving average. As shown below, the last time this occurred was heading into the peak of the market in 2007. Look for a sharp decline in both indicators towards the 20-level to confirm a top is most likely in.

On a long-term scale, the market is now pushing 3-standard deviations of its 3-Year moving average (12-quarters) This is a historical rarity and as always denoted the end, rather than the beginning, of an advance. However, given this is a quarterly indicator, it is extremely slow to move which means the market can get even more extreme first. 

Also, as shown below, historically when both the RSI and Ultimate Oscillator have simultaneously reached such high levels on a quarterly basis was also at more important market peaks. Again, this is a very slow-moving indicator but is noteworthy nonetheless.

It is also worth noting that sharp rises in interest rates, particularly when combined with an overbought, overbullish and extended market have generally had short to intermediate-term problems.

As David Rosenberg pointed out over the weekend:

This time around, not only are valuations at 15-year highs but we’re entering it into the eighth year of the expansion of the bull market. You have to respect where were you are in the market cycle in the business expansion and we’re much more mature now than we were in that early stage of Reagan or you can argue the early stage of Bill Clinton or Barrack Obama. I mean the benefit of being elected at the bottom of the cycle, then you can just ride it up and just take credit for it. I think that the challenge for Donald Trump with all deference to the animal spirit rally they were seeing right now is that the multiples are really stretched and that maybe if were not even in the ninth inning of the game here, we’re certainly somewhere in or around the seventh inning stretch. So, the answer is no. It’s not like Ronald Reagan at all in that regard 

So basically, I’m supposed to take it at face value because the markets are telling me that this is their view today, and their view today might not be the market’s view 3, 6, 12 months from now or 5 years from now. But the market’s telling me that one man, President Trump is gonna be able to, with fiscal policy, will be able to do what Bernanke and Yellen and Draghi and Trichet and Koroda and Carney, who actually run the printing presses, what they couldn’t do in the past 8 years a president’s gonna be willing to do, or be able to do, on inflation? And the answer is no. That’s just not gonna happen.

What did inflation do during this supply side Reagan era? Went from 12 percent to down below 5 percent over his 8-year term? Why anybody thinks that Trump’s policies themselves are gonna create inflation, I can’t build an inflation view out of that.”

What if he’s right? An maybe that is exactly what the Economic Policy Uncertainty Index is telling us.

Hedging Risk

What I am fairly certain of is that we are unlikely to exit this year without a fairly sharp reversion at some point along the way. What I don’t know is the timing or catalyst of a more meaningful bear market.

Therefore, there are a few actions to take in order to hedge risks in portfolios currently. There is nothing fancy about hedging risk, it is just about taking action to do so.

Keep it simple.

There are many ways to get very complex hedging risk from utilizing options, shorting, etc. The problem is that you are transferring the risk of being wrong, and losing capital, from one side of the balance sheet to the other. As noted above in a “bull market,” which we are clearly in currently, only be “neutral” or “long.” In a “bear market,” when the trend has become negative, then you can be “neutral or short.”

Therefore, hedging risk currently is about taking steps to reduce risk and become more neutral until a better risk/reward opportunity is presented for being long. 

Clean Up Your Portfolio – Bull Markets Make Us Lazy

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have been big winners
  3. Sell laggards and losers
  4. Rebalance portfolios to target weightings
  5. Raise cash and reduce overall equity risk exposure to more conservative levels.
  6. Look to increase fixed income exposure as part of a “risk off” trade.

The election has injected a huge amount of undue and misplaced optimism in the market. Such periods of exuberance have previously ended badly for investors.

While I am still currently long the market, I remain aware of the risks.

If I am wrong, and the market does indeed somehow manage to launch into a full-fledged, viable bull market, then I will adjust risk exposure higher in portfolios.

But what if I am right? How long will it take you to get back to even this time?

Congratulations! If you are reading this article it is probably because you have money invested somewhere in the financial markets.

That’s the good news.

The bad news is the majority of you reading this article have probably NOT saved enough for retirement. Such isn’t my assumption, it is what survey after survey tells us. To wit:

“While the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, the only real accomplishment has been a widening of the wealth gap between the top 10% of individuals that have dollars invested in the financial markets and everyone else. This was shown by the Fed’s most recent consumer survey.

“With the average American still living well beyond their means, the reality is economic growth will remain mired at lower levels as savings continue to be diverted from productive investment into debt service. This skew in wealth, between the top 10% and bottom 90%, has distorted much of the economic data which suggests savings rates and incomes are rising across the broad spectrum of the economy. The reality, as shown by repeated studies and surveys, is an inability for many individuals to meet even small emergencies, must less being anywhere close to having sufficient assets to support a healthy retirement. To wit:

“Take a look at that graphic carefully.

  • 33% of Americans have $0 saved for retirement.
  • 56% only have $0-$10,000
  • 66% have less than one-year of median income saved.
  • 74% have less than $100,000 saved for retirement.

With 3/4th’s of America dependent upon an already overburdened social security system in retirement, the “consumption function,” on which roughly 70% of the economy is dependent, is being grossly overestimated. “

In other words, 74% of American’s are “hoping” the financial markets will bail them out of their “under-saving.”

This is the same problem that faces every pension in America right now…and the pensioners depending on them.

As I discussed last week in the “Myth Of Passive Investing:”

“The idea of “passive” investing is ‘romantic’ in nature. It’s a world where everyone just invests some money, the markets rise 7% annually and everyone one’s a winner. 

Unfortunately, the markets simply don’t function that way.”

During strongly trending bull markets, investors tend to forget that devastating events happen. Major events such as the “Crash of 1929,” “The Great Depression,” the “1974 Bear Market,” the “Crash of ’87”, Long-Term Capital Managment, the “Dot.com” bust, the “Financial Crisis,” etc. These events are often written off as “once in a generation” or “1-in-100-year events,” however, it is worth noting these financial shocks have come along much more often than suggested. Importantly, all of these events had a significant negative impact on individual’s “plan for retirement.”

I bring this up because I received several emails as of late questioning me about current levels of savings and investments and whether there would be enough to make it through retirement. In almost every situation, there are significant flaws in the analysis due primarily to the use of “online financial planning” tools which are fraught with wrong assumptions.

Your Personal Returns Will Be Less Than An “Index”

One of the biggest mistakes that people make is assuming markets will grow at a consistent rate over the given time frame to retirement. There is a massive difference between compounded returns and real returns as shown above. Furthermore, the shortfall is compounded further when you begin to add in the impact of fees, taxes, and inflation over the given time frame.

The chart below shows what happens to a $1000 investment from 1871 to present including the effects of inflation, taxes, and fees. (Assumptions: I have used a 15% tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1% annual expense ratio. In reality, all of these assumptions are quite likely on the low side.)

As you can see, there is a dramatic difference in outcomes over the long-term.

Chasing an “index” is fraught with risk and problems:

  • The index contains no cash
  • An index has no life expectancy requirements – but you do.
  • It doesn’t have to compensate for distributions to meet living requirements – but you do.
  • It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
  • It has no taxes, costs or other expenses associated with it – but you do.
  • It has the ability to substitute at no penalty – but you don’t.
  • It benefits from share buybacks – but you don’t.

The reality is that you have nothing in common with a “benchmark index.”

Investing is not a “competition” and treating it as such has disastrous consequences over time. 

When You Start Makes All The Difference

Importantly, the return that investors receive from the financial markets is more dependent on “WHEN” you begin investing with respect to “valuations” and your personal “life-span”.

The single biggest mistake made in financial planning is NOT to include variable rates of return in your planning process. 

Furthermore, choosing rates of return for planning purposes that are outside historical norms is a critical mistake. Stocks tend to grow roughly at the rate of GDP plus dividends. Into today’s world GDP is expected to grow at roughly 2% in the future with dividends around 2% currently. The difference between 8% returns and 4% is quite substantial.

Also, to achieve 8% in a 4% return environment, you must increase your return over the market by 100%. The level of “risk” that must be taken on to outperform the markets by such a degree is enormous. While markets can have years of significant outperformance, it only takes one devastating year of losses to wipe out years of accumulation.

The chart below takes the average of all periods above (black line) and uses those returns to calculate the spend down of retiree’s in retirement assuming similar outcomes for the markets over the next 30-years. As above, I have calculated 4% annual withdrawal rate include the impact of inflation and taxation.

On the surface, it would appear the retiree would not have run out of money over the subsequent 30-year period. However, once the impact of inflation and taxes are included, the outcome becomes substantially worse.

What Your Financial Planning Should Consider

The analysis above reveals the important points individuals should consider in their financial planning process:

  • 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 accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 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.

Time To Get Real

You cannot INVEST your way to your retirement goal. As the last decade should have taught you by now, the stock market is not a “get wealthy for retirement” scheme. You cannot continue under-saveing for your retirement hoping the stock market will make up the difference. This is the same trap that pension funds all across this country have fallen into and are now paying the price for.

Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most 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 prepare properly for retirement.

Investing for retirement, no matter what age you are, should be done conservatively and cautiously with the goal of outpacing inflation over time. This doesn’t mean that you should never invest in the stock market, it just means that your portfolio should be constructed to deliver a rate of return sufficient to meet your long-term goals with as little risk as possible.

  1. Save More And Spend Less: This is the only way to ensure you will be adequately prepared for retirement. It ain’t sexy, or fun, but it will absolutely work.
  2. You Will Be WRONG. The markets go through cycles, just like the economy. Despite hopes for a never-ending bull market, the reality is “what goes up will eventually come down.”
  3. RISK does NOT equal return. The further the markets rise, the bigger the correction will be. RISK = How much you will lose when you are wrong, and you will be wrong more often than you think.
  4. Don’t Be House Rich. A paid off house is great, but if you are going into retirement house rich and cash poor you will be in trouble. You don’t pay off your house UNTIL your retirement savings are fully in place and secure.
  5. Have A Huge Wad. Going into retirement have a large cash cushion. You do not want to be forced to draw OUT of a pool of investments during years where the market is declining. This compounds the losses in the portfolio and destroys principal which cannot be replaced.
  6. Plan for the worst. You should want a happy and secure retirement – so plan for the worst. If you are banking solely on Social Security and a pension plans, what would happen if the pension was cut? Corporate bankruptcies happen all the time and to companies that most never expected. By planning for the worst, anything other outcome means you are in great shape.

Most likely what ever retirement planning you have done, is wrong. Change your assumptions, ask questions and plan for the worst. There is no one more concerned about YOUR money than you and if you don’t take an active interest in your money – why should anyone else?

Well, it finally happened.

After repeated attempts by investors to push the Dow above the psychological barrier of 20,000, it finally occurred during a flurry of executive orders and actions during the first week of the Trump Administration. Between orders for building a wall, orders to freeze regulations and plans being discussed for infrastructure projects, the basic material, technology and industrial sectors pulled all three major indices to historic highs as investors bet on increased spending and growth.

Of course, the push to all-time highs has also led to a further extension of the overbought and overly exuberant conditions of the market. As noted yesterday, the stock-bond ratio is at levels that have previously denoted trouble for the markets.

Furthermore, while interest rates turned up this week after their recent decline, the historic relationship between extremely suppressed volatility and the 10-year Treasury rate suggests a “flight to safety” is likely not too far into the future. 

I can only surmise how this eventually turns out. But whether it is extremely suppressed volatility, extreme long positions in small-cap stocks or historical short positions in bonds, the “rubber band” is stretched very tightly. 

Of course, while “Trump-xuberance” currently reigns, there seems to be nothing to worry about.

But then again, maybe that is exactly what we should be worrying about.

In them meantime, here is what I am reading this weekend as I wear my “Dow 20,000” hat.


Trump


Markets


Interesting Reads


“Gambling with cards or dice or stock is all one thing. It i€™s getting money without giving an equivalent for it.” -€ Henry Ward Beecher

Questions, comments, suggestions – please email me.

Another View On The Inflation Argument

There is little evidence that current levels of inflation are stable. As I wrote in “Inflation: The Good & The Bad”, outside of just two areas, rent and health care, there remains a broader deflationary trend currently.

Importantly, as I noted, there are two types of inflation:

“Inflationary pressures can be representative of expanding economic strength if it is reflected in the stronger pricing of both imports and exports. Such increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allowing for absorption of higher prices.

That would be the good.

The bad would be inflationary pressures in areas which are direct expenses to the household. Such increases curtail consumptive demand, which negatively impacts pricing pressure, by diverting consumer cash flows into non-productive goods or services.”

There is another way to view whether the “good” inflation is manifesting itself within the economy. The chart below shows the three major components that input into creating economically viable inflation – commodity prices (which reflects real economic activity,) wages (which allow for increases in spending and support for higher prices,) and the Velocity Of Money (which shows the demand for money through the economic system.) 

When we combined these three components into a composite inflation index, and compare it to CPI, we find an important outcome.

Currently, there are relatively few “real” inflationary pressures in the economy particularly as monetary velocity continues to plummet. It is also notable that both CPI and the inflation index remain below 2.5% even as interest rates push that level. Ultimately, either inflation will rear its head, or rates will drop back in line with the historic norms of real inflation levels and economic growth. 

There is little argument over the fact that the current economic growth rate has been “sluggish” at best. Growth in the financial markets has been primarily a function of the Federal Reserve’s ongoing balance sheet expansion as economic activity remains fairly subdued. With the Federal Reserve now increasing interest rates over concerns about rising inflationary pressures, the Fed may once again be making the same mistake as they did in 1999. To wit:

If this market rally seems eerily familiar, it’s because it is. If fact, the backdrop of the rally reminds me much of what was happening in 1999.

1999

  • Fed was hiking rates as worries about inflationary pressures were present.
  • Economic growth was improving 
  • Interest and inflation were rising
  • Earnings were rising through the use of “new metrics,” share buybacks and an M&A spree. (Who can forget the market greats of Enron, Worldcom & Global Crossing)
  • The stock market was beginning to go parabolic as exuberance exploded in a “can’t lose market.”

If you were around then, you will remember.

With Yellen, and the Fed, once again chasing an imaginary inflation ‘boogeyman’ (inflation is currently lower than any pre-recessionary period since the 1970’s) the tightening of monetary policy, with already weak economic growth, may once again prove problematic.”

The biggest fear of the Federal Reserve has been the deflationary pressures that have continued to depress the domestic economy. Despite the trillions of dollars of interventions by the Fed, the only real accomplishment has been keeping the economy from slipping back into an outright recession.

Despite many claims to the contrary, the global economy is far from healed which explains the need for ongoing global central bank interventions. However, even these interventions seem to be having a diminished rate of return in spurring real economic activity despite the inflation of asset prices.

What is being realized on a global basis is that injecting the system with liquidity that flows into asset prices, does not create organic economic demand. Both Japan and the Eurozone’s interventions have failed to spark inflationary pressures as the massive debt burden’s carried by these countries continues to sap the ability to stimulate real growth. The U.S. is facing the same pressures as continued stimulative measures have only succeeded in widening the wealth gap but failed to spark inflation or higher levels of economic prosperity for 90% of Americans.

With inflationary pressures impacting the areas that specifically target consumptive spending, there is a real risk of a monetary policy mistake as the Fed once again chases an “inflation boogeyman.” 

Stock/Bond Ratio Confirms Breakout

Following the October swoon, stocks have vaulted to all-time highs following the election of President Trump with the Dow recently breaking above the magical 20,000 level.

As I discussed previously in “Danger Lurks As Extremes Become The Norm” there have only been few occasions where investors have felt so “giddy” about the financial markets. Such periods of exuberance have never ended well for investors as they were deluded by near-term “greed” which blinded them to the building risks. 

Surprisingly, investors are currently more exuberant than just about at any other time on record.”

One of the things that I pay close attention to is the ratio of the S&P 500 compared to longer duration bonds. The theory is that when investors are willing to take on more risk, money flows out of “safe haven” like bonds to equities as portfolio allocations become more aggressively tilted. The opposite occurs as investors began to reduce “risk exposure” in portfolios and focus more on “safety.”

As you can see in the chart below, there is a very high level of correlation between the rise and fall of the stock/bond ratio and the very broad Wilshire 5000 index.

Since the Fed began extracting liquidity from the markets, beginning with the end of QE 3 and now the hiking of interest rates, the stock-bond ratio deviated from its normal correlation. However, post the election in November, that correlation has now rejoined the market as exuberance thrives and the ratio is pushing higher extremes. 

Of course, with seemingly everyone in the “bullish camp,” and a good degree of history forgotten, Bob Farrell’s rule #9 comes to mind:

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

With the markets hitting all-time highs, this is an event that has only occurred during very short periods of our long market history. Of course, this only makes sense that when considering that the market spends the majority of its time making up previous losses. As my father often told me:

“Breaking even is not an investment strategy.”

But for now – it’s “Party On, Garth.” 

Everyone’s A Genius

The last point brings me to something Michael Sincere’s once penned:

“At market tops, it is common to see what I call the ‘high-five effect’ — that is, investors giving high-fives to each other because they are making so much paper money. It is happening now. I am also suspicious when amateurs come out of the woodwork to insult other investors.”

Michael’s point is very apropos, particularly today. It is interesting that prior to the election the majority of analysts, media and investors were “certain” the market would crash if Trump was elected. Since the election, it’s “high-fives and pats on the back.” 

While nothing has changed, the confidence of individuals and investors has surged. Of course, as the markets continue their relentless rise, investors begin to feel “bullet proof” as investment success breeds over-confidence.

The reality is that strongly rising asset prices, particularly when driven by emotional exuberance, “hides” investment mistakes in the short term. Poor, or deteriorating, fundamentals, excessive valuations and/or rising credit risk is often ignored as prices increase. Unfortunately, it is only after the damage is done that the realization of those “risks” occurs.

As Michael stated:

“Most investors believe the Fed will protect their investments from any and all harm, but that cannot go on forever. When the Fed attempts to extricate itself from the market one day, that is when the music stops, and the blame game begins.”

In the end, it is crucially important to understand that markets run in full cycles (up and down). While the bullish “up” cycle last twice as long as the bearish “down” cycle, the damage to investors is not a result of lagging markets as they rise, but in capturing the inevitable reversion. This is something I discussed in “Bulls And Bears Are Both Broken Clocks:”

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’  The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.

The markets are indeed in a liquidity-driven up cycle currently. With margin debt near peaks, stock prices in a near vertical rise and “junk bond yields” near record lows, the bullish media continues to suggest there is no reason for concern.

The support of liquidity is being extracted by the Federal Reserve as they simultaneously tighten monetary policy by raising interest rates. Those combined actions, combined with excessive exuberance and risk taking, have NEVER been good for investors over the long term.

At market peaks – everyone’s a “Genius.”

Just some things I am thinking about.

It was an ongoing conversation between a mom and adult daughter and me (in the middle).  Moving slowly to what I call the “legacy awareness,” stage where we begin to explore mom’s legacy, a loving daughter’s inheritance expectations (or lack of) and possible living benefits (my carefully-chosen words for gifting valuables) for both.

The dialogue flowed innocent enough, until one simple, direct question left my lips:

 “Carol, if mom dies what would you do with the house?”

I do these things on purpose. It got real quiet. Then.

Carol: “Well, I don’t want that!”

Mom:  “It’s a great house; it was our house, mine and your father’s. You lived there too didn’t you like it?”

Carol: “Of course, but I have my own place, and all that ____,” I mean stuff.”

But the word had slipped out. The “J” word.

Junk? That’s Not Junk. It’s My Entire Life!!

Most likely that 3,000 square-foot albatross with shingles is not a cherished heirloom in the eyes of your kids. In fact, they would prefer you deal with the house and its contents as soon as possible – I mean while you’re alive and well enough to handle daunting tasks that come with downsizing into a more humble abode.

Want to see the kids reduce to the behavior of a two-year old, flailing arms and legs tantrum style? Die and leave them to deal with your dwelling and its dusty contents.

Deep attachment to a house is understandable – plenty of wonderful moments were created within those walls; most likely you’ve accumulated plenty of items through the decades and haven’t parted with much in a very long time.

Parents are still storing their parent’s stuff too. There’s multi-generational hoarding going on everywhere. And I don’t see many families doing anything about this affliction.

Frankly, many retirees would rather stay put; moving is stressful. I don’t care how old you are. It’s less trouble to remain in a place that’s outgrown you and choose to live in what I call “the house within the house,” which usually is reduced to two rooms and a bath.

To make it worse, it feels wrong to upset contents that have settled deep into memories. It feels right to leave everything as is – let the next generation handle it. But do they truly want to?

Your kids are busy with their kids, careers, and still coping with the financial distress that comes with a mediocre economic recovery. A majority of households are dealing with too much debt, skyrocketing college costs, underemployment, and now this? Do the kids want an inheritance? Sure. Do they want the house? No.

As we age, memories start to weigh a hell of a lot more than brass antiques or hardly used bedroom suites. An elderly widow was ashamed to tell me she hadn’t used her fireplace since 1987 – the year her husband passed away in a chair in front of it. The old lounger hadn’t been utilized either except recently by Tiger her new tabby cat.

In 1993, my father passed away in his home. Over two decades later, I still find myself using Google Maps to cyber-visit the location to see how it’s changed and praying nothing hadn’t. I was the kid who wanted desperately to hold on to the house. I was so afraid I’d forget or disrespect his memory if it didn’t stay in the family. It was a sacred place to me. A real-life example of how housing can get messy. Unlike other purchases, a house gets deeply imbedded in the threads of our emotions.

A close friend said holding on to the death house was “creepy,” and my thinking macabre. Why? After all, he was my dad. I found nothing weird about the situation. In fact, wasn’t it actually normal to feel this way? Eventually, I did drop the idea. When my head cleared, I realized it wasn’t bricks and stucco I was after. I longed for flesh and blood (dad) back.

Currently, retirees are ravaged by the Federal Reserve’s ongoing decision to transform safe money into dead money by cementing short-term interest rates at low hum.

And regardless of the Fed’s plan to raise short-term interest rates, banks won’t return the favor for savers. Your money markets, savings accounts, CDs? All dead money.

The result is a dismal level of income generated (after inflation/taxes many yields are negative) and little hope for a respectable income from high-quality bond investments. Those in the “golden years” are ravaged by austerity even though they will ostensibly live more years than their parents and should be more active doing it too. Oh the joy of longevity.

Since low (no) rates on money markets, certificates of deposit, savings accounts and corporate and government bonds will be around for a longer period than any of us originally anticipated, (thus the word cementing) retirees must think creatively about the utilization of additional resources available to them like the house.

Don’t Be Scared. Free The Cash! 

I know this may sound taboo, but desperate times call for some “out of the box,” thinking – Why not consider squeezing your greatest illiquid asset?  I’m referring to – you know: The albatross with the bay windows. If you play your cards right, the house your kids don’t want can be a boost to retirement cash flow. Would this be so wrong to consider if done responsibly?

When consulting with pre and current retirees about income planning, I notice how reluctant they are to consider the house as a future source of cash flow. I’m always the one who initiates the idea. And the faces I get when I do! The topic is horribly taboo. Why? My job is, at the right moment, to bring up sensitive topics. Part of what I do is to place myself in less-than-desirable circumstances as a first step to awareness.

Admittedly it’s an uncomfortable conversation in the beginning, however when you consider how tough (impossible) it is to earn interest on conservative investments and how challenging it is to save for retirement, strategically utilizing home equity may be the only choice available for those looking to eke out some sort of comfortable existence in retirement.

Those close to retirement are afraid of misusing home equity. We’ve all read about or knew homeowners who considered their houses as never-ending money fountains splashing cash for new televisions, cars or expensive vacations. Even seniors or retirees willing to investigate the option of utilizing home equity have been reluctant due to declining or stagnant house values and the unattractive fees associated with reverse mortgage products.

Retirees appear to be more receptive to home equity extraction later in life, especially for long-term care expenses, when instead they could mindfully draw from equity along with other income sources starting earlier and thereby enjoy a more fulfilling lifestyle.

Instead, many have resorted to re-entering the work force (if 55 or older, it appears you’re working more years than originally anticipated, too) and remaining vigilant about cutting household expenses. But how much cost cutting can you do before you need to hit the big stuff?

Code Red Moments

I call seriously considering the big stuff – “Code Red Moments.”

“And they ain’t fun,” as I’ve been told repeatedly.

Let me be clear: Code Red is and never will be “fun.” These moments are accompanied by the stark realization that drastic measures must be taken to survive financially.

At the least, thinking outside the box (or the house) a discussion with family, and a strategy session with a qualified financial professional on how to go about taking the right steps is warranted.

According to a September 2014 Center for Retirement Research at Boston College Report the median balance of a household with head (of household) age 55-64 in 401(k) & IRAs was $100,000 in 2013 for income ranges $61,000-$90,999.

Thank goodness for Social Security otherwise most of us would be sunk. A select few are still eligible for defined benefit (pension) plans; the number of workers lucky enough to know what pensions are continues to decrease markedly since the early 1980’s.

Don’t be afraid. Finally, the academics have embraced the concept of using home equity to meet retirement income needs.

How do you begin?

Spark A Dialogue.

Granted – sounds obvious enough. In practice though, not easy. Conversations about legacies, estate plans, inheritances are difficult. Don’t be afraid to enlist a “fire starter,” like your financial advisor if he or she is objective enough and possesses a semblance of EQ or emotional intelligence. Empathy and respect are important here.

At the least, kids should be willing to assist parents with the overwhelming tasks that go with the relocation process. Families just don’t talk enough (or at all), about inheritance matters until forced to or a life event triggers it. It’s time for this conversation to begin as soon as possible. If only so the parents are aware of your preferences.

Grandchildren are surprisingly effective at easing the pain of regret even if their intent is limited to the excitement of spending time in a different environment or rolling toy trucks over carpet in a new location.

Recently, a grandmother of three shared with me how she decided to sell her large home and move to a more modest apartment in a suburban retirement community. She was remorseful even though the children were very communicative and supportive of the move. When her grandson’s face lit up at the feel of new carpet and a balcony and shared how excited overall he was about the new place, her remorse turned to joy. She was instantly relieved and satisfied with her decision.

Outright Downsizing Is An Effective Method To Lower Living Costs

Why continue to remain in the smaller “house within the house,” situation especially if the children are willing to help?

On occasion, the death of a spouse or other life-changing episode can jump start actions.  It’s best to contemplate “going smaller”, before forced to hit the code-red button.

So, sell the big house. Let it go. Based on recent reports, it appears to be an opportune time. Use the cash to purchase a smaller place in full (no mortgage if possible). Release the shackles of the material goods you haven’t dusted in years and get them to a consignment shop. Better yet, open the door to gifting cherished items to the children while you’re still alive.

Think seriously about renting. Why not? Yes, rental rates have increased in several markets so you should examine the tradeoff between buying and selling on a case-by-case basis. First, you’ll need to gather information about the area you’re looking to reside. For example, gaining a handle on annual home price changes vs. annual percentage of rent increases or decreases would be important. From there, one of the best calculators on the internet is available for free from the New York Times at http://www.nytimes.com/interactive/business/buy-rent-calculator.html.

Keep the extra cash you would have used to purchase a residence (or at the least as a down payment) liquid in a low-cost, no-load mutual fund that invests in ultra-short bonds which will generate a small monthly addition to cash flow.  And think about splurging on a nice vacation.  After all, you’re liquid now.

Consider A Home Equity Conversion Mortgage Saver Now

I understand the concerns about the closing costs and fees that go along with reverse mortgages, but hear me out.

Data released by the National Reverse Mortgage Lenders Association (NRMLA) shows senior home equity increased by $152 billion in the third quarter of 2016. Seniors have $6.1 trillion in home equity available according to the most recent NRMLA/Risk Span Reverse Mortgage Market Index (RMMI) report. That’s unlocked potential you can’t ignore if tapped strategically. Remember, you must be 62 years old to consider any reverse mortgage option.

Although you’re limited by the amount you can borrow, the HECM Saver is more cost effective than a standard reverse mortgage option. For example, the HECM Saver has an upfront premium (cost) of .01 percent of your property’s value compared to two percent for a standard reverse mortgage. Also, those who utilize the HECM Saver are limited to borrow roughly 10 to 18 percent less than for the Standard reverse mortgage.

Instead of withdrawing in the form of a lump-sum cash payout, it’s best to retain a line of credit that can be utilized only when necessary. Work with a knowledgeable financial partner who can assist you with establishing clear rules to trigger and monitor credit line usage.

The decision should be based on a thorough examination of cash-flow needs, your overall portfolio mix and current market conditions.  The goal is to have a readily available source of funds to draw from as warranted.

The debt associated with a reverse mortgage (or HECM Saver) must be paid in full when the borrower dies, moves out permanently, or elects to pay it off voluntarily. Any equity remaining belongs to the borrower or the borrower’s estate. If the debt exceeds the property value, the FHA (Federal Housing Association) bears the loss, not the borrower or the borrower’s estate.

My favorite website designed to educate mortgage and reverse mortgage borrowers is The Mortgage Professor, www.mtgprofessor.com  operated by Jack M. Guttentag, Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. You can access, free of charge, a series of articles about reverse mortgages including Using a HECM to Strengthen Retirement Plans.

As I have a history of creating retirement income distribution strategies, I witness investment portfolio survival rates increase dramatically when a HECM Saver is tapped through times of high sequence of return risk (a series of poor return or negative performance years in distribution portfolios) and bear market cycles.

Now is an opportune time to apply for a HECM Saver as limits to borrow will be attractive (the principal loan factor at the time of loan origination, which is the percentage of home equity available), and Libor rates remain at historic lows.

However, we are witnessing a steady increase in rates which began in late 2015.

Unfortunately, as Libor rates gravitate higher, the PLF factor is reduced, or the amount available to borrow against your home, decreases. There is still adequate time however, borrowers should seek to avoid setting up HECM lines of credit when rates are high.

Use the positive news about housing to get the thought process rolling.

It’s ok parents, really – your children don’t seek your house.

Have faith that the memories within will always be worth a small fortune to them no matter what.

And that is exactly what the kids want.