Beginning in December of last year, following the announcement by OPEC of a cut in oil production, I have discussed the headwinds” that persist against a sustained rise in oil prices.

The supply/demand dynamics currently suggest that oil prices and energy-related investments could find a long-term bottom within the next year or so following the next recession. However, it does not mean those investments will repeat the run witnessed prior to 2008 or 2014. Such is the hope of many investors currently as their ‘recency bias’ tends to overshadow the potential of the underlying fundamental dynamics.”

After exiting the energy space in April 2014, there have been small tradeable opportunities within the energy sector but the trend remains sorely negative. The recent pounding of both oil prices, and the energy-related sector, continues to support the repeated warnings to remain clear of the space for now.

Energy continues to struggle after breaking its 50-dma and broke its 200-dma two weeks ago. While energy had a bit of a bounce last week, and tested resistance at the 50-dma, the bounce failed and the trend continues to materially weaken. Energy is very close to a major sector sell signal.  Remain heavily underweight energy for the time being.”

Since then energy stocks have continued to deteriorate and oil prices have now broken important support. The next major level of support for oil prices on a weekly basis is $42.50/bbl. A failure there leaves little support until $35/bbl.

However, there is more to the price of oil than just weakness in the energy sector. Oil prices are also a reflexion of what is happening in the actual economy. The Fed should be paying closer attention to what is happening in oil prices. As shown below, the decline in oil prices suggests not only a real lack of inflationary pressures but are also a threat to the mild recovery in earnings in the last quarter. This weakness is also feeding back through the interest rate complex as well.

As I stated yesterday:

“While the Federal Reserve clearly should not raise rates further in the current environment, it is clear they will remain on their current path. This is because, I believe, the Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates will accelerate a potential recession and a significant market correction, from the Fed’s perspective it might be the ‘lesser of two evils. Being caught near the ‘zero bound’ at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline.

In other words, they already likely realize they are screwed.”

There are ample data points suggesting the Fed has already “missed their window”  for hiking rates. At this juncture, it is much more likely we will be talking about restarting QE in 2018 rather than how the “reduction of the balance sheet” is proceeding. Of course, such a conversation will most likely flow in conjunction with the onset of a “recessionary drag” in the economy and a decline in asset prices.

However, for now, “hope” remains the emotion of choice.

Here is what I am reading this weekend.


Politics/Fed/Economy


Markets


Research / Interesting Reads


“Buy In Haste. Repent At Leisure.” – Unknown

Questions, comments, suggestions – please email me.

Data Says Fed Is Making A Mistake

In their policy announcement last week, the members of the FOMC claimed:

“Information received since the Federal Open Market Committee met in May indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.”

Economic data has continued to remain extremely soft given the rise in confidence. We addressed previously that while the “soft data” was hitting the highest levels seen since the “Great Recession,” actual economic activity had failed to catch up.  As noted on last week:

“For the 13th straight week, US economic data disappointed (already downgraded) expectations, sending Citi’s US Macro Surprise Index to its weakest since August 2011 (crashing at a pace only beaten by the periods surrounding Lehman and the US ratings downgrade). The last time, Us economic data disappointed this much, Ben Bernanke immediately unleashed Operation Twist… but this time Janet Yellen is hiking rates and unwinding the balance sheet?”

This is quite confusing, considering the Fed is supposed to be “data dependent.” Ever since 2011, I have tracked the Fed’s economic forecasts relative to reality. If they are using economic data to guide their forecasts and policy actions, the following table and graph should scare you.

However, despite the clear evidence that economic growth is hardly running at levels that would be considered “strong” by any measure, the Fed is “tightening” monetary policy. This is ironic considering the ENTIRE PURPOSE of TIGHTENING monetary policy is to SLOW economic growth to keep inflationary pressures at bay. 

Neal Kashkari also noted the disconnect between Fed policy and the economy:

“At the same time the unemployment rate was dropping, core inflation was also dropping, and inflation expectations remained flat to slightly down at very low levels. We don’t yet know if that drop in core inflation is transitory. In short, the economy is sending mixed signals: a tight labor market and weakening inflation.”

Kashkari is right in worrying that the Fed is placing too much faith on the Phillips Curve which predicts a tighter reverse relationship between the unemployment rate and inflation than has actually been seen in recent years. This is particularly the case given the problems with the underlying U-3 employment rate calculation as discussed just recently. To wit:

The Bureau of Labor Statistics (BLS) has been systemically overstating the number of jobs created, especially in the current economic cycle. Furthermore, the BLS has failed to account for the rise in part-time and contractual work arrangements, while all evidence points to a significant and rapid increase in the so-called contingent workforce as full-time jobs are being replaced by part-time positions, resulting in double and triple counting of jobs via the Establishment Survey.

Lastly, a full 93% of the new jobs reported since 2008 and 40% of the jobs in 2016 alone were added through the business birth and death model – a highly controversial model which is not supported by the data. On the contrary, all data on establishment births and deaths point to an ongoing decrease in entrepreneurship.”

Neal goes on to identify the risk:

“In the 1970s, that faith led the Fed to keep rates too low, leading to very high inflation. Today, that same faith may be leading the Committee to repeatedly (and erroneously) forecast increasing inflation, resulting in us raising rates too quickly and continuing to undershoot our inflation target.”

However, one really needs to look no further than the bond market which is also screaming the Fed is once again, as they always have, making a monetary policy mistake. The chart below shows, GDP as compared to both the 5- and 10-year inflation “breakeven” rates.

The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting.

While none of this suggests a problem is imminent, nor does it RULE OUT higher highs in the markets first, there is mounting evidence the Fed is headed towards making another mistake in their long line of creating “boom/bust” cycles.

Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession. However, the timing between the first rate hike and the next recession is dependent on the level of economic growth at that time.

When looking at historical time frames, one must not look at averages of all rate hikes but rather what happened when a rate hiking campaign began from similar economic growth levels. Looking back in history we can only identify TWO previous times when the Fed began tightening monetary policy when economic growth rates were at 2% or less.

(There is a vast difference in timing for the economy to slide into recession from 6%, 4%, and 2% annual growth rates.)

With economic growth currently running at THE LOWEST average growth rate in American history, the time frame between the first rate and next recession will likely not be long.

The Federal Reserve is quickly becoming trapped by its own “data-dependent” analysis. Despite ongoing commentary of improving labor markets and economic growth, their own indicators are suggesting something very different.

While the Federal Reserve may hike interest rates simply to “save face,” there is indeed little real support for them doing so. Tightening monetary policy further will simply accelerate the time frame to the onset of the next recession. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

While the Federal Reserve clearly should not raise rates further in the current environment, it is clear they will remain on their current path. This is because, I believe, the Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates will accelerate a potential recession and a significant market correction, from the Fed’s perspective it might be the ‘lesser of two evils. Being caught near the “zero bound” at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline.

In other words, they already likely realize they are screwed.

Are you kidding? Are you kidding? No one knows what you’re doing.  – Economist John Taylor in response to William Dudley’s (President Federal Reserve Bank of New York, Vice Chairman of the Federal Open Market Committee) comment that the Federal Reserve (Fed) has been very clear in their discussions about monetary policy.

For the last few years the Fed has repeatedly emphasized that they want to be as open and transparent about monetary policy actions as possible. Amid those reassurances, amateur and professional Fed watchers continue to be flummoxed by the vagaries of language used in speeches, lack of adherence to implied actions and outright contradictions between their words and deeds. As evidenced by the opening quote, one wonders whether they are being intentionally delusory or whether their hubris makes them genuinely oblivious to their own obfuscations.

Confusion

In 2012, the Fed published a Statement on Longer-Run Goals and Monetary Policy Strategy (LINK). That statement has been updated each January since. The opening sentence of that statement contains an interesting modification to its “dual” mandate:

“The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates.

While maximizing employment and engineering stable prices are the official congressionally mandated objectives, the term “moderate long-term interest rates” has never been a part of the congressional mandate. Needless to say, this is confusing and erroneous.

Ironically, with regard to its intent to explain monetary policy decisions as clearly as possible, the statement continues:

“Such clarity facilitates well-informed decision-making by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.”

So following the erroneous statement in the opening regarding their mandate, they then provide a lecture on the importance of Fed clarity to our democratic society.

Furthermore, the document is mislabeled as it contains nothing on monetary strategy. The statement only discusses goals presented in an obtuse fashion based on their congressional mandate which they confounded in the first sentence. As for monetary policy strategy (and to emphasize the point) the document conveys nothing coherent about the reaction function of the policy-setting body under scenarios where deviations from the goals emerge.

The members of the Fed have gone to great lengths in countless speeches, congressional testimonies and press conferences to portray a decision-making body that is disciplined and rigorous. Further, they incessantly attempt to set the record straight about their positive contribution to prior periods of economic and financial instability. In their view, they have never been complicit in creating economic malaise and always play the role of the good physician coming to the aid of the country in troubling economic periods. As demonstrated via the confusion mentioned above, their perspective is inconsistent and deceptive.

To offer an illustration of such inconsistencies:

At the end of 1997, the 6-month average rate of inflation as measured by the Core PCE deflator (the Fed’s preferred inflation measure) was 1.43%, the average unemployment rate was 5.2% and the average Fed Funds rate was 5.50%.

At the end of 2003, the 6-month average rate of inflation (Core PCE) was 1.87%, the average unemployment rate was 5.98% and the average Fed Funds rate was 1.0%.

While there are a variety of other considerations for the economy when analyzing the two periods, data related to the two mandated objectives of the Fed were similar and trending in the “right” direction (inflation up, unemployment down). Despite those facts, the Fed Funds interest rate differential between the two periods, 4.50%, is enormous. Contrary to the insistence of the Fed, there is substantial evidence that the long period of low interest rate policy followed by well-telegraphed quarter-point interest rate hikes preceding the financial crisis of 2008 were major factors in generating the instabilities that almost bankrupted the financial sector.

Now, consider conditions today. The average rate of inflation (Core PCE) for the last 6-months is 1.82%, the average unemployment rate is 4.50% and the Fed Funds rate was just increased to 1.00% following 7 years at essentially 0.00%. Taking into account the size of the Fed’s balance sheet ($4.4 trillion) due to quantitative easing, the level of Fed-provided accommodation remains extraordinary even when compared to the aggressively easy monetary policy of the early 2000’s.

The argument for a more normal policy stance is stronger today than it was in either of the two prior instances, and yet the Fed’s stance is stubbornly and unjustifiably extreme.

In fairness, no two time periods are the same and policy responses are never identical. However, if the intent of monetary policy actions are aimed at ensuring the health of the economy, then it is also plausible and logical that policy, improperly applied may produce sick and unstable conditions. Interestingly, that fact is freely acknowledged by current Fed members with regard to monetary policy of the 1970’s and the Great Depression era. Why then, are the increasingly aggressive and interventionist policies of the last 20 years not a concern or even considered a factor in causing the recent boom-bust cycles by those very same Fed members? Even more importantly, why does the market acquiesce and encourage what are certain to be revealed as major policy errors? The good news is that a lot of money can be made by investors who properly identify central banker mistakes.

Summary

Current Fed policy is grossly inconsistent with the actions they have taken in the past and the rules they themselves have discussed in post-crisis years. Evidence of that fact abounds. There is an acute lack of clarity about the strategy for policy normalization, specifics about what dictates their decision-making and how they will go about it. In the late 1970’s and early 1980’s, Paul Volcker was so clear about his policy objectives that he rarely needed to discuss them when he made public comments. Despite the difficulties associated with extracting the country from prior bad monetary policy, everyone knew his intent was to conquer run-away inflation and restore healthy economic growth.

Given the data comparison above and their mandate, there are sound reasons for the Fed to be much more aggressive in raising the Fed Funds rate and reducing the size of their balance sheet. The truth is they are concerned that such “hawkish” actions might greatly reduce the prices of many financial assets. Despite the short-term pain, acknowledging that current eye-watering valuations of many assets are predicated on Fed policy and not fundamentals would seem to be a prudent first step toward “normalization”.  Watching the Fed Chairman evade direct answers on the topics of bubbles and policy normalization leaves no doubt that confusion, not clarity, will continue to be the Fed’s tool of choice.

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The first year in retirement is a form of rebirth.

I deem it the black hole. A period that’s a bit exciting, somewhat disconcerting, but eventually a clear perspective is forged; a way out of the old habits and an ease into the new becomes reality.

The initial phase of retirement creates a great opportunity to examine a budget through the eyes of a fresh, and hopefully enriching cycle of life.

One path to the light, a source of empowerment, is to take control over household cash and embrace methods to enhance the flow. Knowing the source of cash and the path it follows, will accelerate an exit from the dreaded black hole.

Think of it this way: Wealth accumulated and earmarked for retirement is like a glacier molded from years of discipline and sacrifice. As a retiree, a game plan to convert accumulated assets (ice) into liquid (water) is becomes paramount. One must be in defrost mode: recognize and take advantage of simple actions that can increase liquidity and provide a greater understanding of spending and money habits.

The methods identified are from years of coaching new retirees and monitoring their progress. So far, so good. There are several ideas that may provide a unique perspective and possibly spark methods you can initiate as a newbie to retirement. Even veteran retirees can utilize these tips and rethink the way they’ve been approaching cash flow.

Here goes:

Go micro the first year.

For no less than six months into retirement, get super-close to expenditures. I mean every item, each category, every service and product – track all you spend, right down to the cents. Dig deep and employ a notebook and a pencil to follow the cash. Going electronic or using a smartphone app just won’t do for this endeavor. Manual methods keep you closer to the data.

Micro-budgeting is not fun, but it will help you intimately engage with spending trends. From experience, new retirees seem to find great peace in this exercise. There’s a feeling of control that provides ease of mind.

Micro-budgets are old-school and as far from pretentious as you can get. The method of micro-budgeting is designed to increase awareness through simplicity.

Yes, it’s time-consuming, occasionally monotonous; however the goal is worth it – to uncover weaknesses and strengths in your plan and build a cash direction sensitivity is everything. Micro-budgeting generally works best when there’s a life-changing event in your household like retirement, change in employment status, or a health-related episode.

At the end of each month, compare outflow to the monthly account distributions you’ve planned for as part of a tax-efficient retirement distribution strategy. We recommend at least two years prior to a retirement date you and a financial partner, preferably a fiduciary, team up to undertake a prep-for-retirement exercise that stress-tests your household cash flow requirements through actual, past stock market cycles.

By the time you’re micro-budgeting, the first planned monthly distribution should have already electronically been deposited in your checking account.

In a majority of cases, new retirees while micro-budgeting and in general, have a tendency to spend less than they’ve originally planned. Perhaps it’s a very human tendency to be cautious maneuvering through unfamiliar terrain or the black hole. Regardless, document the surplus if any, and circle or underline the number.

Embrace and establish an online high-yield savings account.

I can appreciate how retirees are trepidatious when it comes to online banking, but please hear me out.

I’m sorry. Your neighborhood bank is a dinosaur. Rarely, do consumers walk into a bank branch to do business. Most important, even though the Federal Reserve appears to be less data-dependent and determined to raise rates regardless of sub-optimal economic conditions, those hikes don’t appear to be translating to higher interest rates for bank savings and money market vehicles. Remember your main objective is to increase cash flow. One easy method to accomplish the task is to open an online bank savings account and establish an electronic link to your brick & mortar checking.

With lower expenses and attractive yields, the proliferation of online banking can’t be ignored. These institutions clearly have less overhead and the result is higher savings rates for consumers. Online banks share the same FDIC insurance as their outdated brethren and are just as cyber secure as any other financial establishment including your brokerage, retirement and credit account custodians.

My favorite online bank is Synchrony, however, Nerdwallet, a virtual hub of financial consumer information, maintains an updated list of the best high-yield savings accounts in the country. Their latest compilation is identified here.

Every month, transfer the surplus immediately, identified through micro-budgeting, from checking to online savings. Then forget about it. Yes, you read correctly. Forget about it. For now.

Learn to love and take advantage of credit.

I find new retirees experience a drop in their credit scores and refrain from using credit, which could be a mistake, especially through this unique period of lower-for-longer borrowing rates. The goal is to know when it’s smart to use credit compared to tapping precious liquid resources. This can be an incredibly advantageous endeavor through the early years of retirement where spending on discretionary categories like vacations, travel and major purchases pertaining to home improvement are at their zenith.

For example, a new retiree client recently decided to take advantage of Best Buy’s zero-percent interest credit card offer for quality home electronic upgrades. He takes comfort in knowing he has the cash to pay in full immediately but why do it when he can make minimum monthly payments and have cash earn interest in an online savings vehicle for two years?

Those who micro-budget are in control, disciplined and are motivated to boost cash flow through similar methods and utilize credit to work for them, not against them. In addition, smart credit management that includes timely payments, helps keep his respectable FICO® credit score (over 780), intact which can come in handy for future credit-based decisions.

Smart retirees are not in a hurry to close their credit card accounts. They’ll look to aggressively utilize the ones that provide the greatest benefits to their households; whether gathering points for travel, cash back or rewards for goods and services, credit card companies want your business and new retirees are active enough to take advantage of special offers.

Several of the best credit card offers are available at www.comparecards.com. In addition, many offer free access to FICO®, a major provider of credit scoring.

Don’t fear senior discounts, search for them.

I know. You’re not a senior. Far from it. However, if you’re willing to place ego aside, think with a micro-budget mentality, there is a plethora of bargains there for the taking. I observe deep emotional barriers when it comes to embracing just the thought of senior discounts.

Listen, I understand. Personally, I think the word ‘senior’ is tremendously outdated. Let’s re-phrase, shall we? Let’s deem them ‘earned retirement rewards’ to clear mental hurdles.

A new retiree I coach has managed to increase her monthly cash flow by an impressive 10% using ‘retirement rewards.’ She was excited to share her micro-budget with me. Frankly, I was so excited I have overcome my own internal tension with senior, I mean ‘retirement rewards.’

The most comprehensive list I’ve researched is available here from www.bradsdeals.com. Through www.seniordiscounts.com, you can search through over 250,000 listings in the largest electronic directory of discounts.

Be smarter with Social Security and Medicare decisions.

The goal of a qualified financial planner is to guide, educate and make an intimidating process easier to comprehend. It’s crucial that Social Security and Medicare planning is an integral part of retirement cash flow analysis. The wrong decisions can cost a retiree multiple thousands of dollars and or permanent penalties and unexpected tax implications.

What you believe about Social Security is most likely incorrect. Keep in mind that Social Security is indeed an asset on your balance sheet and seasoned planners can calculate the lump sum required to replicate monthly lifetime payments. Frankly, the amount needed would probably stun you.

Once new retirees see how their decisions can impact on occasion, hundreds of thousands of dollars received over a retirement lifetime, it’s easier to make the optimum choice that results in the greatest retirement and or survivor payouts for recipients, spouses, and occasionally, minor children.

Taking Social Security early (age 62), can be an expensive error. There’s no assurance benefits recipients will be protected so to file for benefits early solely based on a belief “that it won’t be there,” is more politically-driven conclusion and not based on facts and individual needs.

Although the OASDI Trustee’s projections under their intermediate cost scenario. indicates the trust fund will be exhausted by 2034, close to 80% of funding will continue due to then-current workers’ payroll taxes supporting retiree benefits.

There are four reform proposals on the table, currently. Let’s face it – the program is too crucial to be allowed to falter. Responsible planners are required to work with retirees’ personal situations today; it’s best to devise a plan to gain the most benefits.

I can’t stress enough how important the right Social Security decision will be to your household cash flow success, especially in the face of probable future low returns on risk assets like stocks, longer lifespans and increasing inflationary pressures.

Healthcare expenses can be the most lethal nemesis to a satisfying and financially secure retirement. Fidelity Investments estimates that the total potential costs of healthcare in retirement for a married couple of average life expectancy is $260,000.

When it comes to Medicare, new retirees must be informed of standard and special enrollment period windows for Part A and B, especially if they’ve been covered by an employer’s plan or considering temporary COBRA health coverage in the case of employment loss.

Take note there is a permanent annual penalty of 10% on Part B premiums for every 12-month period if standard or special enrollment periods are missed. These penalties are tacked on premiums that are determined based on modified adjusted gross income levels and adjusted every year.

For example, if an eligible couple’s modified adjusted gross income exceeds 170,001 in 2017, they will each face premiums of $187.50 a month.

A Medicare-savvy financial partner should help retirees create a tax-efficient retirement account withdrawal strategy and consider the impact of income on premiums and of course, avoid forever penalties.

It’s critical to understand when to enroll and the type of supplemental health insurance program is required to compensate for the holes in coverage of Part A and B. I compare Medicare insurance to Swiss cheese. Medigap insurance most likely will be required to close multiple coverage breaks depending on your personal situation, health issues and even travel habits.

Unfortunately, based on a study by Merrill Lynch and Age Wave, 43% of retirees believe Medicare alone will cover nearly all their healthcare costs in retirement.

Many retirees will overpay for Part D for prescription drug coverage and ignore the annual open enrollment period from October 15 to December 7th.  Every year a cash-flow aware retiree should spend time investigating plans through www.Medicare.gov or consult a qualified health insurance provider to compare current coverage and costs to taking on a new plan.

Part D coverage is optional. However, there’s a 1% lifetime penalty that may be incurred if a retiree isn’t deemed to have ‘creditable’ drug coverage and goes longer than 63 days without it before attempting to sign up for Part D. This penalty is multiplied by the number of months the recipient could have had Part D, but didn’t. The 1% is based on something called the national base beneficiary premium which is $35.63 this year.

Frankly, unless offered ‘creditable’ coverage as part of employer retirement benefits, which is rare, a retiree should consider Part D coverage even if they’re currently not taking medications. Initiating coverage may be less costly than incurring lifetime penalties. You just need to do the math.

Cash is the life-blood of any household, especially retiree households.

After the first year in retirement has passed, I notice how maximizing cash flow becomes second nature. Micro-budgets are no longer required as a mindset has been forged and opportunities to bring in cash are pursued.

And the black hole becomes nothing but a memory.

Oh, and about that surplus you’ve been cordoning off in an online bank savings account?

Why not spend it on a unique experience. One you’ll remember for the rest of your life.

Consider it a bonus for a year’s worth of diligence.

Discipline deserves its reward.

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


On Monday, the markets broke out, again, to all-time highs. This is not surprising and something that I noted over the weekend. To wit: 

“Stepping back from the sector-specific action, if you only looked at the S&P 500 to judge what was happening in the markets, you wouldn’t suspect anything was wrong.”

“The market breakout remains intact currently with support at 2400 holding firm. The bullish trend line, which also intersects at 2400 remains critically important as the secondary buy/sell signal remains in positive territory. The only negative currently, despite improvement, is the ‘weekly sell signal-1’ remains triggered which keeps us on ‘alert.’ (It is also worth noting both signals remain at VERY high levels which suggest current upside remains somewhat limited.)

You can understand why more and more commentary is beginning to succumb to the ‘siren’s song’ of why ‘this time is different.’ Whether it is terrorist attacks, poor economic data, geopolitical tensions, or plunging oil prices, the market has continued its advance. It certainly seems to be ‘bulletproof.’” 

Last week, we added additional exposure for the second time since the “breakout” occurred.

Not surprisingly, I have gotten many emails questioning the addition given the current extension, over valuation and excess bullishness in the market. I can certainly understand the confusion.  Buying “breakouts” is a function of participating in a momentum driven market and clearly “momentum” is in full swing currently. As I discussed with one of the firm’s clients on Friday, while the long-term return outlook is not favorable, in the short-term we have to invest in order to create returns when opportunities exist. In this regard, we buy “breakouts” when they are confirmed, as the recent breakout has been, because “new highs tend to lead to further new highs.” 

Despite, one news headline to the next, the market has continued to push higher and last week’s test of “support,” set the market up for Monday’s move to “new highs.” While sustainability remains key, we remain invested currently with very tight stops, and some hedges, already in place.

But it is in that inherent breakout that we continue to see the rise of exuberance over the reality of fundamentals.

“There is very little concern about the risk being taken on by investors currently without any regard for the underlying risk as they chase ‘yield and return.’”

“The forgotten piece of this ‘fairytale’ is that RISK = How much you LOSE when you are wrong. 

Currently, the risk/reward ratio is currently heavily skewed against investors in both the short, intermediate and long-term outlook.”

The Evaporation Of Risk

As stated, the word “RISK” is not normally associated with positive outcomes.

I was visiting with a new client of the firm last week who had just transferred over from one of the “big box” financial firms. Of course, as usual, she began to regurgitate the media-driven myths of how she was a “long term” investor, how she was diversified and that she was willing to ride out the “wiggles” in the market.

It takes me only a couple of questions to quickly derail these myths.

  1. What did you do in 2001-2002 and/or 2008?
  2. How did you feel?
  3. Are you willing to do that again?

Since the “dot.com” bust, when I began asking those questions, I have NEVER had anyone tell me:

  1. I sold near the top and bought near the bottom. (Sell High/Buy Low)
  2. It was a truly terrific experience watching half of my money disappear. 
  3. Absolutely, just tell me when so I can get some popcorn.

In this particular case, she happened to be an avid “poker player” and enjoyed going to Las Vegas for a “few hands” at the tables.

Poker is an extremely easy comparison to investing as the general rules of risk management apply to both. The conversation was quick.

“Do you go ‘all in’ on every hand your are dealt?” 

“Of course, not” she responded.

“Why not?”

“Because I will lose all my money,” she said.

“You say that with a lot of certainty. Why?”

“Well, I am not going to win every hand, so if I bet everything, I will certainly lose everything” she stated.

“Correct. So why do you invest that way?”

“………….Silence………………….”

The issue of “risk,” as stated above, whether it is in the financial markets or a hand of poker is the same.  It is simply how much money you lose when the “bet” you made goes wrong.

In poker, most individuals can not calculate the odds of drawing a winning hand. However, while they may not know the odds of drawing a “full house” in a 7-card poker hand is just 2.6%, they do know the odds of “winning” with such a hand are fairly high. Therefore, they are comfortable betting heavier on that particular hand.

But when it comes to investing, they are comfortable betting the retirement savings on a market which, at current valuation levels, has a long history of delivering less than optimistic results. I have shown you the following chart before, and statistically speaking the odds simply aren’t in your favor.

Despite this simple reality, investors continue to chase stocks as if future returns over the next 10-years will be as profitable as the last 10-years. This most likely will not be the case.

Yet, the “evaporation of risk” continues to accelerate as the market seemingly becomes ever more immune to “bad news,” or should I just say “news.”

The S&P 500 P/E to VIX ratio is also elevated to levels that have normally warned that you are betting on a losing hand.

The issue of understanding risk/reward is the single most valuable aspect of managing a portfolio. Chasing performance in the short-term can seem to be a profitable venture, just as if hitting a “hot streak” playing poker can seem to be a “no lose” proposition.

But in the end, the “house always wins” unless you play by the rules.

8-Rules Of Poker:

1) You need an edge

As Peter Lynch once stated:

“Investing without research is like playing stud poker and never looking at the cards.”

There is a clear parallel between how successful poker players operate and those who are generally less sober, more emotional, and less expert. The financial markets are nothing more than a very large poker table where your job is to take advantage of those who allow emotions to drive their decisions and those who “bet recklessly” based on “hope” and “intuition.”

2) Develop an expertise in more than one area

The difference between winning occasionally and winning consistently in the financial markets is to be able to adapt to the changing market environments. There is no one investment style that is in favor every single year – which is why those that chase last years performing mutual funds are generally the least successful investors over a 10 and 20 year period.

As the great Wayne Gretzky once said:

“I skate where the puck is going to be, not where it has been.”

3) Figure out why people are betting against you.

“We know nothing for certain.” We know what a company’s business is today, maybe even what they are most likely to do in the coming months. We can determine whether the price of its stock is trending higher or lower. But in the grand scheme of things, we don’t know much. In fact, we are closer to knowing nothing than to knowing everything, so let’s just round down and be done with it.

Managing a portfolio for “what we don’t know” is the hardest part of investing. With stocks, we have to always remember that there is always someone on the other side of the trade. Every time some fund manager on television encourages you to “buy,”someone else has to be willing to sell those shares to you. Why are they selling? What do they know that you don’t?

3) Don’t assume you are the smartest person at the table. 

When an investment meets your objectives, be willing to take some profits. When it begins to break down, hedge the risk. When your reasons for buying have changed, be willing call it a day and walk away from the table.

4) It often pays to pass, and 5) Know when to quit and cash in your chips

Kenny Rogers summed this up best:

“If you’re gonna play the game, boy…You gotta learn to play it right – You’ve got to know when to hold ’em. Know when to fold ’em. Know when to walk away.  Know when to run. You never count your money when you’re sittin’ at the table.  There’ll be time enough for countin’ when the dealin’s done.”

This is the hardest thing for individuals to do. Your portfolio is your “hand” and there are times that you have to get rid of bad cards (losing positions) and replace them with hopefully better ones. However, even that may not be enough. There are times that things are just working against you in general and it is time to walk away from the table.

All great investors develop a risk management philosophy (a sell discipline) and combining that with a set of tools to implement that strategy. This increases the odds of success by removing the emotional biases that interfere with investment decisions. Just as a professional poker player is disciplined with his craft, a disciplined strategy allows for the successful navigation of a fluid investment landscape. A disciplined strategy no only tells you when you to “make a bet,” but also when to “walk away.”

6) Know your strengths AND your weaknesses & 7) When you can’t focus 100% on the task at hand – take a break.

Two-time World Series of Poker winner Doyle Brunson joked a bit about his book with which he had thrown around two alternative ideas for titles before going with “Super/System“. The first was How I made over $1,000,000 Playing Poker, and the second equally accurate idea was,How I lost over $1,000,000 playing Golf.

The larger point here is that invariably there will be things in life that you are good at, and there are things you are much better off paying someone else to do.

Many investors believe they can manage money effectively on their own – and they are likely right as long as they are in a cyclical bull market. Of course, this idea is equivalent to being the only person seated at a poker table and the dealer deals all the cards face up. You might still lose a hand every now and then, but most likely you are going to win.

8) Be patient

Patience is hard. Most investors want immediate gratification when they make an investment. However, real investments can take years to produce their real results, sometimes, even decades. More importantly, as with playing poker, you are not going to win every hand and there are going to be times that nothing seems to be “going your way”. But that is the nature of investing; no investment discipline works ALL of the time. However, it is sticking with your discipline and remaining patient, provided it is a sound discipline to start with, that will ultimately lead to long-term success.

Those are the rules. Play by them and you have a better chance of winning. Don’t and you will likely lose more than you can currently imagine. As the old saying goes:

“If you look around the poker table and can’t spot the pigeon, it’s probably you.” 

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In some states, when a couple enters into divorce, the court may award “alimony,” or spousal support, to one of the former spouses for the express purpose of limiting any unfair economic effects by providing a continuing income to the spouse. The purpose is to help that spouse continue the “standard of living” they had during the marriage.

The idea of “maintaining a standard of living,” has become a foundational bedrock in our society today. Americans, in general, have come to believe they are “entitled” to a certain type of house, car, and general lifestyle which includes NOT just the very basic necessities of living such as food, running water and electricity, but also the latest mobile phone, computer, and Internet connection. Really, what would be the point of living if you didn’t have access to Facebook every two minutes?

One of the charts that are often bantered about in the media is the increasing prosperity of the average American as witnessed by the following chart.

But, like most data extracted from the Federal Reserve, you have to dig behind the numbers to reveal the true story.

So let’s do that, shall we?

In America, the problem of maintaining the basic lifestyle is becoming ever more problematic as shown in an updated 2015 Pew Research study.

In the U.S., the poverty line in 2011 was $15.77 per day per capita for a household with four people (the precise poverty line varies by household size and composition). The poverty line is defined as the income three times the cost of an economy food plan as determined by the U.S. Department of Agriculture (Orshansky, 1965). In July 2011, the daily per capita cost of the USDA’s thrifty food plan was $5.07 for a family of four with two children ages 6-8 and 9-11 years.”

In the U.S., the definition of “poor” is enviable in most every other region of the world. Yet, despite higher levels of low income, (now there’s an oxymoron) inflation-adjusted median incomes have remained virtually stagnant since 1998.

But here is why looking at the “median” of personal incomes is misleading as to what is happening within the economy. A recent study from the Chicago Booth Review revealed the underlying problem with income strata:

“The data set reveals since 1980 a ‘sharp divergence in the growth experienced by the bottom 50 percent versus the rest of the economy,’ the researchers write. The average pretax income of the bottom 50 percent of US adults has stagnated since 1980, while the share of income of US adults in the bottom half of the distribution collapsed from 20 percent in 1980 to 12 percent in 2014. In a mirror-image move, the top 1 percent commanded 12 percent of income in 1980 but 20 percent in 2014. The top 1 percent of US adults now earns on average 81 times more than the bottom 50 percent of adults; in 1981, they earned 27 times what the lower half earned.

Given this information, it should not be surprising that personal consumption expenditures, which make up roughly 70% of the economic equation, have had to be supported by surging debt levels to offset the lack wage growth in the bottom 90% of the economy.

Furthermore, this also explains why the gap between wages and the cost of supporting the required “standard of living” continues to expand. 

More importantly, despite economic reports of rising employment, low jobless claims, surging corporate profitability and continuing economic expansion, the percentage of government transfer payments (social benefits) as compared to disposable incomes have surged to the highest level on record.

This anomaly was also noted in the study:

“Government transfer payments have ‘offset only a small fraction of the increase in pre-tax inequality,’ Piketty, Saez, and Zucman conclude—and those payments fail to bridge the gap for the bottom 50 percent because they go mostly to the middle class and the elderly. Pretax income of the middle class (adults between the median and the 90th percentile) has grown 40 percent since 1980, ‘faster than what tax and survey data suggest, due in particular to the rise of tax-exempt fringe benefits,’ the researchers write. ‘For the working-age population, post-tax bottom 50 percent income has hardly increased at all since 1980.’”

Of course, by just looking at household net worth, once again you would not really suspect a problem existed. In the Fed’s latest Flow of Funds report, the Fed revealed households currently held $110.0 trillion in assets with just a modest $15.2 trillion in liabilities, which brought the net worth of the average US household to a new all-time high of $94 trillion. The majority of the increase over the last several years has come from increasing real estate values and the rise in various stock-market linked financial assets like corporate equities, mutual and pension funds.

However, once again, the headlines are deceiving even if we just slightly scratch the surface. Given the breakdown of wealth across America we once again find that virtually all of the net worth, and the associated increase thereof, has only benefited a handful of the wealthiest Americans. 

Despite the mainstream media’s belief that surging asset prices, driven by the Federal Reserve’s monetary interventions, has provided a boost to the overall economy, it has really been anything but. Given the bulk of the population either does not, or only marginally, participates in the financial markets, the “boost” has remained concentrated in the upper 10%. The Federal Reserve study breaks the data down in several ways, but the story remains the same – “if you are wealthy – life is good.”

Fed-Survey-2013-AssetsbyPercentile-091014

The illusion of the decline in the debt-to-income ratios leaves the majority of Americans with an inability to increase consumption, the driver of economic growth, without increasing debt burdens further. For those in the top-10% of the wealth holders, things like higher asset prices, tax cuts, etc. do not lead to further boosts in consumption as they are already consuming as needed. 

The problem is quite clear. With interest rates already at historic lows, the consumer already heavily leveraged and wage growth stagnant, the capability to increase consumption to foster higher rates of economic growth is limited.

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. What monetary interventions have failed to accomplish is an increase in production to foster higher levels of economic activity.

Corporate profitability, which has primarily been a function of cost cutting, increased productivity, stock buybacks, and accounting gimmicks can certainly maintain the illusion of economic prosperity on the surface, however, the real economy remains very subject to actual economic activity.  It is here that the inability to re-leverage balance sheets, to any great degree, to support consumption provides an inherent long-term headwind to economic prosperity.

With the average American still living well beyond their means, the reality is that economic growth will remain mired at lower levels as savings continue to be diverted from productive investment into debt service.  The issue, of course, is not just a central theme to the U.S. but to the global economy as well.  After eight years of excessive monetary interventions, global debt levels have yet to be resolved.

The “structural shift” is quite apparent as burdensome debt levels prohibit the productive investment necessary to fuel higher rates of production, employment, wage growth, and consumption. Many will look back at this point in the future and wonder why governments failed to use such artificially low-interest rates and excessive liquidity to support the deleveraging process, fund productive investments, refinance government debts, and restructure unfunded social welfare systems.

Until the deleveraging cycle is allowed to occur, and household balance sheets return to more sustainable levels, the attainment of stronger, and more importantly, self-sustaining economic growth could be far more elusive than currently imagined.

In the meantime, those in the top 10% of income brackets are very likely enjoying an increase in overall prosperity. For everyone else, it is highly unlikely that debt-to-income ratios have actually improved much. But at least can bask in the reality they are “rich” compared to everyone else in the world.

No! I am not talking about President Trump but rather the crash in both Technology stocks, and Oil prices, which are obstructing the continuation of the “bull market.” 

As I discussed this past Tuesday, the mini “flash crash” in Technology certainly woke investors up.

While there is certainly damage being wrought in the Technology and Discretionary sectors, the rotation to Financials, Energy, Small and Mid-Capitalization areas are offsetting the correctionary process. As shown below, the markets remain confined to the bullish trend currently while the overbought condition is being reduced.”

As shown in the updated chart below, despite all of the “angst” there has been relatively little price deterioration to date.

While the Nasdaq has primarily been under pressure from the unwinding of the excess in the main #FANMAG ($FB, $AAPL, $NFLX, $MSFT, $AMZN & $GOOG) stocks, as shown below, some performance pickup by small and mid-capitalization stocks, as well as emerging markets, limited portfolio damage over the last few days.

As money rotates wildly between sectors and markets, in a clear attempt to stay invested, the risk of a decoupling has risen in recent weeks. This is particularly the case if it either becomes clear Trump’s legislative agenda is not going to progress OR earnings begin to disappoint.

I believe BOTH of those outcomes are highly likely. 

First, with Trump embroiled in investigations, allegations, and general revolt, the ability to progress on legislative agendas has become markedly more difficult. However, the bigger issue is the potential disappointment in earnings expectations as sliding oil prices feed through in the next quarter. With the recent break below $45/bbl, there is a real possibility that a test of $40 is coming. 

With revenue’s and CapEx already suppressed, the negative feedback into earnings, expectations, and outlooks is increasing. I would expect to start seeing earnings expectations through the end of the year get trimmed back in the next couple of months. The problem, of course, is that makes the current valuation arguments that much more difficult to justify. 

That could weigh on investor’s portfolios sooner rather than later.

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


Politics/Fed/Economy


Markets


Research / Interesting Reads


“The stock market is the story of cycles and of the human behavior that is responsible
for overreactions in both directions.” – 
Seth Klarman

Questions, comments, suggestions – please email me.

In Tuesday’s post, “A Shot Across The Bow,” I discussed the recent “Tech Wreck” and the warning sign that was delivered when trading algorithms begin to run in the same direction. To wit:

 “The plunge was extremely sharp but fortunately regained composure and shares rebounded. A ‘flash crash.’

One day, we will not be so lucky. But the point I want to highlight here is this is an example of the ‘price vacuum’ that can occur when computers lose control. I can not stress this enough. 

This is THE REASON why the next major crash will be worse than the last.”

Of course, it generally isn’t long after publishing commentary about the dangers of the current crowding into ETF’s, that I receive some push back.

First, I am not a “broker.” I am a “fee-only” investment advisor which operates under the “fiduciary standard.” While we do charge a below average fee for our services, our focus is on capital preservation and total portfolio returns to achieve our client’s long-term financial planning goals. Our client, and most importantly their hard earned savings, are our priority. (Read more in “The Financial Manifesto.”)

Secondly, I find a consistent uniformity of those who have fallen victim to the “buy and hold” and “passive indexing” mantra such as:

Lastly, these individuals are NOT “passive” investors. They are simply “passive holders” while markets are rising and will become “active sellers” during the next significant decline. 

However, let me clear, I am certainly NOT against using “indexed based” ETF’s for managing exposure to the markets for individuals who wish to have:

  1. Lower trading costs
  2. Higher tax efficiencies
  3. Less turnover
  4. Lower volatility
  5. Access to asset classes not covered in a traditional equity portfolio

But gaining access to those benefits does NOT mean being oblivious to the underlying risk of ownership. The firm I manage money for runs both an all-ETF strategy, as well as a blended ETF/Equity portfolio, we also apply a very strict set investment rules toward the management of “risk” in the portfolio. In other words, the entire practice adheres to Warren Buffet’s primary rules on investing:

  1. Don’t Lose Money
  2. Refer To Rule No. 1.

As is always the case, the time spent making up lost capital is far more detrimental to the long-term investment outcome than simply recouping a missed opportunity for gains.

Which is the point of today’s post.

Rise Of The Machines

While I have written often on the dangers of both ETF’s and “Passive Investing” (See here and here), my friend Evelyn Cheng highlighted confirmed the same yesterday.

Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets, according to a new report from JPMorgan.

‘While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals,‘ Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said in a Tuesday note to clients.

Kolanovic estimates ‘fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago, he said.”

As discussed on previously, as long as the algorithms are all trading in a positive direction, there is little to worry about. As Evelyn noted there is a LOT of money piling into these trades globally.

“‘Derivatives, quant fund flows, central bank policy and political developments have contributed to low market volatility’, Kolanovic said. Moreover, he said, ‘big data strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come.'”

There are two other problems underlying the chase for ETF’s. While investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return. Negative free cash balances are now at their highest levels in market history.

The second problem, which will be greatly impacted by the leverage issue, is liquidity of ETF’s themselves. As I noted previously:

“The head of the BOE Mark Carney himself has warned about the risk of ‘disorderly unwinding of portfolios’ due to the lack of market liquidity.

‘Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”

And then there was, of course, Howard Marks, who mused in his ‘Liquidity’ note:

‘ETF’s have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

What Howard is referring to is the “Greater Fool Theory,” which surmises there is always a “greater fool” than you in the market to sell to. While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price?” 

At some point, that reversion process will take hold. It is then investor “psychology” will collide with “margin debt” and ETF liquidity. As I noted in my podcast with Peak Prosperity:

“It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.”

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

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

If you don’t believe…just go look at what happened on September 15th, 2008.

It happened then.

It will happen again.

But I get it. The markets seem to be in an “unstoppable” bull market. This time certainly “seems different” with ongoing Central Bank interventions. Besides, with interest rates so low, “there is no alternative” for investors to put money.

Therefore, why not fire your advisor, buy a low cost index and just ride the market? Because, things like “Robo-advisors” and “ETF herding” are symptomatic of a lengthy bull market advance where the pain of previous losses has finally been erased.

Client’s don’t pay a fee to chase markets. They pay a fee to employ an investment discipline, trading rules, portfolio hedges and management practices that have been proven to reduce the probability a serious and irreparable impairment to their hard earned savings.

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and a strategy tends to have horrid consequences.

What’s your plan for the second-half of the full market cycle.

Cause when life looks like Easy Street, there is danger at your door – Grateful Dead

On numerous occasions, we have posited that equity investors appear to be blinded by consistently rising stock prices and the allure of minimal risks as portrayed by record low volatility. It is quite possible these investors are falling for what behavioral scientists diagnose as “recency bias”. This condition, in which one believes that the future will be similar to the past, distorts rational perspective. If an investor believes that tomorrow will be like yesterday, a prolonged market rally actually leads to a perception of lower risk which is then reinforced over time. In reality, risk rises with rapidly rising prices and valuations. When investors’ judgement becomes clouded by recent events, instead of becoming more cautious, they actually become more aggressive in their risk-taking.

In our premier issue of The Unseen, 720Global’s premium subscription service, we quantified how much riskier financial assets are than most investors suspect. The message in, The Fat Tail Wagging the Dog, is that extreme historical price changes occur with more frequency than a normal distribution predicts. Reliance upon faulty theories laced with flawed assumptions can lead investors to take substantial risks despite paltry expected returns.

In this article, we further expand on those concepts and present a simple framework to help readers understand the spectrum of risks that equity holders are currently taking.

Risk Spectrum

When one assesses risk and return, the most important question to ask is “Do my expectations for a return on this investment properly compensate me for the risk of loss?” For many of the best investors, the main concern is not the potential return but the probability and size of a loss.  A key factor to consider when calculating risk and return is the historical reference period. For example, if one is to estimate the risk of severe thunderstorms occurring in July in New York City, they are best served looking at many years of summer meteorological data for New York City as their reference period. Data from the last few weeks or months would provide a vastly different estimate. Likewise, if one is looking at the past few months of market activity to gauge the potential draw down risk of the stock market, they would end up with a different result than had they used data which included 2008 and 2009.

No one has a crystal ball that allows them to see into the future. As such the best tools we have are those which allow for common sense and analytical rigor applied to historical data. Due to the wide range of potential outcomes, studying numerous historical periods is advisable to gain an appreciation for the spectrum of risk to which an investor may be exposed. This approach does not assume the past will conform to a specific period such as the last month, the past few years or even the past few decades. It does, however, reveal durable patterns of risk and reward based upon valuations, economic conditions and geopolitical dynamics. Armed with an appreciation for how risk evolves, investors can then give appropriate consideration to the probability of potential loss.

Measuring Risk

The graph below plots the percentage price change of the S&P 500 that one would expect at each respective date given a 3-standard deviation price change. The data is computed based on price changes from the preceding six months. Essentially, the graph depicts expected outcomes for those solely relying on recency biased risk management approaches.  (On a side note, a 3-standard deviation price change should have occurred 14 times over the 17 year period based on a normal distribution. In reality, it happened 249 times!)

Data Courtesy: Bloomberg

Currently, if one is basing their risk forecast on the last six months of price data, they should anticipate that a “rare” 3-standard deviation change will result in a price change of 7.11% (green line). Accordingly, the table below applies a range of readings from the graph above to create an array of potential draw downs. The historical data is applied to the current S&P 500 price to provide current context.

We caution you, major draw downs are frequently much greater than a 3-standard deviation event.

Summary

As mentioned earlier, the best investment managers obsess not about what they hope to make on an investment but what they fear they could lose. At this juncture, current market dynamics offer a lot of reasons one should be concerned. For those who rest assured that the future will be representative of the immediate past, you likely already stopped reading this article. For those who recognize that regime shifts to higher volatility tend to follow periods when risk is under-appreciated, valuations are high and economic growth feeble, this framework should be a beneficial guide to better risk management. Although the timing is uncertain, we are confident that it will pay handsome dividends at some point in the future.

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“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


I wanted to pick up on a discussion I started in this past weekend’s missive, with respect to both Friday’s rout in technology stocks as well as Monday’s rather nasty open. While the issue seemed to be a simple short-term rotation in the markets from large capitalization Technology and Discretionary stocks into the lagging small and mid-capitalization stocks, the sharpness of the “Tech Break” on Friday revealed an issue worth re-addressing. To wit:

Both Discretionary and Technology plunged on Friday as a headline from Goldman Sachs questioning ‘tech valuations’ sent algo’s running wild. The plunge was extremely sharp but fortunately regained composure and shares rebounded. A ‘flash crash.’

One day, we will not be so lucky. But the point I want to highlight here is this is an example of the ‘price vacuum’ that can occur when computers lose control. I can not stress this enough. 

This is THE REASON why the next major crash will be worse than the last.”

I am not alone in this reasoning. Just recently John Dizard wrote for the Financial Times:

“The most serious risks arising from ETFs are the macro consequences of too much capital being committed in too few places at the same time. The vehicles for over-concentration change over time, such as the ‘Nifty Fifty’ stocks back in 1973, Mexican and Argentine bonds a few years after that, internet shares in 1999, and commercial property every other decade, but the outcome is the same. Investors’ cash goes to money heaven, and there is a pro-cyclical decline in productive investment.

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. Since US growth stocks such as Avon, the cosmetics company, Polaroid, the photography group, and IBM, the computer company, outperformed the market, growth-orientated portfolio managers raised more money in the early 1970s, which then led to more cash going to buy the same stocks.”

Andrew Lapthorne from Societe Generale also weighed in:

“The sell-offs themselves are not particularly unusual, but the uniformity of the prices moves all on the same day indicates a market driven by price chasing momentum, with investors heading for the door all at the same time.

Indeed, those S&P 500 stocks which sold-off on Friday were almost all from the strongest performing decile over the previous 12 months (the r-squared on the S&P 500 line in the chart below is 85%). Within Nasdaq, the relationship is even stronger at 95%.

Such a uniform sell-off strikes us as systematic, especially as the relationship weakens once you look at the broader and less liquid Nasdaq composite. For price chasing investors, Friday’s plunge serves as a warning; when it’s time to head for the door, you better move fast.”

These points are absolutely correct, and as I addressed in the Passive Indexing Trap:

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the ‘herding’ into ETF’s begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments. Don’t believe me? It happened in 2008 as the ‘Lehman Moment’ left investors helpless watching the crash.”

“Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.

Currently, with complacency and optimism near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough.”

Warning Shot

As was seen on Friday, and again on Monday, the consequence of a “rush for the exits” can leave investors a bit flat-footed in the process. However, don’t mistake the importance of that statement.

One of the biggest problems facing investors is ultimately when “something goes wrong.” When this happens, the initial response is paralysis, followed by a bit of panic, before ultimately falling prey to the host of emotional mistakes that repeatedly plague investors time and again. 

This time is likely to be no different.

Currently, I do not believe that we have begun the next major corrective cycle. In fact, the current rout has all the earmarks of another “buy the dip” move to feed the ongoing bullish mantra.

While there is certainly damage being wrought in the Technology and Discretionary sectors, the rotation to Financials, Energy, Small and Mid-Capitalization areas are offsetting the correctionary process. As shown below, the markets remain confined to the bullish trend currently while the overbought condition is being reduced.

However, this should be a clear “warning shot” to investors who have piled into ETF’s in the hopes indexing will offset the penalties of not paying attention to the risk they have taken on. 

“While passive indexing works while all prices are rising, the reverse is also true.”

Importantly, it is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are stacked against substantial market gains from current levels.

As my partner, Michael Lebowitz, noted in a recent posting:

“Nobody is going to ring a bell at the top of a market, but there are plenty of warped investment strategies and narratives from history that serve the same purpose — remember Internet companies with no earnings and sub-prime CDOs to name two.”

Once prices fall enough the previously “passive indexer” becomes an “active panic seller.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic and damaging ending.

In the near term, over the next several months or even a year, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity. However, of that, there is no guarantee.

As Ben Graham stated back in 1959:

“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’

The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound,  then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.

In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”

He is right, of course, things are little different now than they were then.

What is important to remember is that for every “bull market” there MUST be a “bear market.” While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline. 

Oh…so you say you’re going to “sell” those “passive ETF’s” before that happens?

Ahh! Well, you are not so “passive” after all.

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Lately, there has been a lot of chatter about the “Return Of Animal Spirits” as the catalyst to drive markets higher…and higher…and higher. But exactly what does that mean?

Animal spirits came from the Latin term “spiritus animalis” which means the breath that awakens the human mind. Its use can be traced back as far as 300BC where the term was used in human anatomy and physiology in medicine. It referred to the fluid or spirit that was responsible for sensory activities and nerves in the brain. Besides the technical meaning in medicine, animal spirits was also used in literary culture and referred to states of physical courage, gaiety, and exuberance.

It’s more modern usage came about in John Maynard Keynes’ 1936 publication, “The General Theory of Employment, Interest, and Money,” wherein he used the term to describe the human emotions driving consumer confidence. Ultimately, the “breath that awakens the human mind,” was adopted by the financial markets to describe the psychological factors which drive investors to take action in the financial markets.

The 2008 financial crisis revived the interest in the role that “animal spirits” could play in both the economy and the financial markets. The Federal Reserve, then under the direction of Ben Bernanke, believed it to be necessary to inject liquidity into the financial system to lift asset prices in order to “revive” the confidence of consumers. The result of which would evolve into a self-sustaining environment of economic growth.

Ben Bernanke & Co. were successful in fostering a massive lift to equity prices since 2009 which, in turn, did correspond to a lift in the confidence of consumers. (The chart below is a composite index of both the University of Michigan and Conference Board surveys.)

Unfortunately, despite the massive expansion of the Fed’s balance sheet and the surge in asset prices, there was relatively little translation into wages, full-time employment, or corporate profits after tax which ultimately triggered very little economic growth.

The problem, of course, is the surge in asset prices remained confined to those with “investible wealth” but failed to deliver a boost to the roughly 90% of American’s who have experienced little benefit.  In turn, this has pushed asset prices, which should be a reflection of underlying economic growth, well in advance of the underlying fundamental realities. Since 2009, the S&P has risen by roughly 220%, while economic and earnings per share growth (which has been largely fabricated through share repurchases, wage and employment suppression and accounting gimmicks) have lagged.

The stock market has returned almost 80% since the 2007 peak which is more than twice the growth in GDP and nearly 4-times the growth in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not as subject to manipulation.) The all-time highs in the stock market have been driven by the $4 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, PE expansion, and ZIRP. With Price-To-Sales ratios and median stock valuations not the highest in history, one should question the ability to continue borrowing from the future?

A Late Stage Event

Here’s a little secret, “Animal Spirits” is simply another name for “Irrational Exuberance,” as it is the manifestation of the capitulation of individuals who are suffering from an extreme case of the “FOMO’s” (Fear Of Missing Out). The chart below shows the stages of the previous bull markets and the inflection points of the appearance of “Animal Spirits.” 

Not surprisingly, the appearance of “animal spirits” has always coincided with the latter stages of a bull market advance and has been coupled with over valuation, high levels of complacency, and high levels of equity ownership.

Just last week Ed Yardeni penned a piece on this issue of “Animal Spirits.” To wit:

“So far, the current bull market has marched impressively forward despite 56 anxiety attacks, by my count. They were false alarms. I remain bullish. My long-held concern is that the bull market might end with a melt-up that sets the stage for a meltdown. The latest valuation and flow-of-funds data certainly suggest that the melt-up scenario may be imminent, or underway.”

A more anecdotal sign came from Joe Ciolli via Business Insider:

“Buy low, sell high. It’s a classic adage — one that has helped stock investors reap consistent gains for the better part of seven decades.

Until now.

Having returned 5% on average each year from 1940 through 2007, the so-called value trade has lost 2% per year over the past decade, according to Goldman Sachs data. It’s down 10% this year alone, badly lagging an S&P 500 that has climbed 8.7%.”

Since “the price you pay day is the value you receive tomorrow,” as famously noted by Warren Buffet, it should not come as a surprise that “value investing” is lagging the “momentum chase” in the market currently. But again, this is something that has historically, and repeatedly occurred, during very late stage bull market advances as the “rationalization” for a “never-ending bull market” are promulgated.

Given the length of the economic expansion, the risk to the “bull market” thesis is an economic slowdown, or contraction, that derails the lofty expectations of continued earnings growth. More importantly, it is the realization of the inability to pass the legislative agenda the markets have been banking on to support further earnings expansion that could be the problem.

The bottom line is the hunt by investors for growth over value has always set the stage for exceptionally poor returns over the subsequent decade.

Of course, the rise in “animal spirits” is simply the reflection of the rising delusion of investors who frantically cling to data points which somehow support the notion “this time is different.”  As David Einhorn once stated:

The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen.”

Is this time different? Most likely not. This was a point James Montier noted recently,

Current arguments as to why this time is different are cloaked in the economics of secular stagnation and standard finance workhorses like the equity risk premium model. Whilst these may lend a veneer of respectability to those dangerous words, taking arguments at face value without considering the evidence seems to me, at least, to be a common link with previous bubbles.

While individuals are quick to dismiss the rising risks in the markets, it would be wise to remember the same beliefs were held in 1999 and 2007. Throughout history, financial bubbles have only been recognized in hindsight when their existence becomes “apparently obvious” to everyone. Of course, by that point is was far too late to be of any use to investors and the subsequent destruction of invested capital.

This time will not be different. Only the catalyst, magnitude, and duration will be.

Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:”

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

For now, the revival of “animal spirits” can certainly continue to drive markets higher in the short-term. The only question is will you know the difference between the next “buy the dip” opportunity and the “last call for alcohol?” 

Just be careful or those “animal spirits” may just wind up biting you.

I received an email this morning that is symptomatic of the current psychology prevailing in the market currently:

“It seems to me like much of the market movement these days due by the huge increase in algo-driven trading and also by direct or indirect CB intervention. Every time you see the market dip, even just a little, you get what seemingly used to be a rare, V-shape rally. It’s like a shot of liquidity hits the market at just the right time or right technical level, the algos hit it, and the market just shoots higher. We don’t even get a 5% drop anymore.”

It certainly does seem that way. As I posted just last week, the reinvestment of the Fed’s balance sheet has certainly been very well timed. Each time the market has stumbled, the Fed has been there to provide the “safety net.”

But it hasn’t been just stocks “on a run” as of late, but bonds as well. Interestingly, despite the current exuberance of earnings growth, expectations of “Trumponomics,” and a “hawkish” Fed hiking rates, the bond market continues to reflect weak economics, sliding inflation and concern about legislative progress.

Economic data is not buying it either. Headline after headline, as of late, has continued to disappoint from new and existing home sales, to autos, to inventories and now employment. This also put the Fed at risk of further rate hikes this year as noted on Thursday:

“It appears traders are losing faith in the rest of the year as the odds of a hike occuring in December is now above that of September (as both drop to around 25%). As economic data has crashed since The Fed hiked rates in March, so the markets expectations has dropped to just 1.44 rate-hikes this year (one in June guaranteed), well below The Fed’s guidance of 2 more rate-hikes minimum.”

Of course, while the mainstream media continues to espouse the “just buy everything” mantra, it certainly seems that CEO’s are paying more attention to the collapse in the economic data. 

Just something to think about because “the everything bump” typically doesn’t last long. 

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


Politics/Fed/Economy


Markets


Research / Interesting Reads


“The difference between playing the stock market and the horses is that one of the horses
must win..” – 
Joseph Abramowitz

Questions, comments, suggestions – please email me.

The “Bond Bears” just can’t seem to catch a break. 

Beginning in mid-2013, there have been numerous calls the 30-year bond bull market was dead. The reasoning was simplistic enough – economic growth was set to return pushing inflation, and ultimately interest rates, higher. Unfortunately, as each year has come and gone, economic growth has failed to return with real economic growth averaging just 1.9% since the turn of the century.

As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship can be clearly seen in the chart below.

Okay…maybe not so clearly. Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate.

As you can see, the level of interest rates is directly tied to the strength of economic growth, wages and inflation. With roughly 70% of economic growth derived from consumption, the trend of wage growth should not be readily dismissed.

Ed Harrison at Credit Writedowns noted:

“What I can say is that the credit markets have been right all along the way. At important points in time when the Fed signaled policy changes, credit markets have correctly interpreted how likely those changes were going to be. The perfect example is the initial rate hike path set out in December 2015. This was totally wrong and the credit markets were telling us so, right from the start.”

He is absolutely correct.

It was the analysis of the credit markets that has kept me on the right side of the interest rate argument in repeated posts since 2013.

However, Ed nails what Wall Street continues to deny in one sentence:

“What credit markets are saying right now screams secular stagnation.”

Since 2009, asset prices have been lofted higher by artificially suppressed interest rates, ongoing liquidity injections, wage and employment suppression, productivity-enhanced operating margins, and continued share buybacks have expanded operating earnings well beyond revenue growth.

The Fed has mistakenly believed the artificially supported backdrop they created was actually the reality of a bright economic future. Unfortunately, the Fed and Wall Street still have not recognized the symptoms of the current liquidity trap where short-term interest rates remain near zero and fluctuations in the monetary base fail to translate into higher inflation. 

Combine that with an aging demographic, which will further strain the financial system, increasing levels of indebtedness, and lack of fiscal policy, it is unlikely the Fed will be successful in sparking economic growth in excess of 2%. However, by mistakenly hiking interest rates and tightening monetary policy at a very late stage of the current economic cycle, they will likely be successful at creating the next bust in financial assets. 

Furthermore, as Ed noted:

“And if this share price actually did indicate higher economic growth, not just higher profits, then US government bond yields would be rising due to future rate hike expectations as nominal GDP would be boosted by full employment and increased inflation. But that’s not what’s happening at all.

Instead, the US 10-year bond is pretty close to 2% and the yield curve is flattening. So, what I see the bond markets saying is that future rate hikes by the Fed will be limited due to low nominal GDP growth aka secular stagnation.”

The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds.

However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter.

Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth. 

Given the current demographic, debt, pension and valuation headwinds, the future rates of growth are going to be low over the next couple of decades – approaching ZERO.

While there is little left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Therefore, bond investors are going to have to adopt a “trading” strategy in portfolios as rates start to go flat-line over the next decade.

Of course, you don’t have to look much further than Japan for a clear example of what I mean.

But, for now, Wall Street continues to ignore the giant “secular stagnation” sign staring them in the face.

With the markets breaking out to new highs, it is not surprising to see a continued stream of analysis grappling for bits of data to support the bullish mantra. As you know, I have increased equity allocations in models with the breakout, but this is a tactical position only as the fundamentals simply do not support the rising risk levels currently.

However, despite 8-years of a bull market advance, one of the prevailing myths that seeming will not die is that of “cash on the sidelines.” To wit:

“Underpinning gains in both stocks and bonds is $5 trillion of capital that is sitting on the sidelines and serving as a reservoir for buying on weakness. This excess cash acts as a backstop for financial assets, both bonds and equities, because any correction is quickly reversed by investors deploying their excess cash to buy the dip,” Nikolaos Panigirtzoglou, the managing director of global market strategy at JPMorgan, wrote in a client note.

This is the age old excuse why the current “bull market” rally is set to continue into the indefinite future. The ongoing belief is that at any moment investors are suddenly going to empty bank accounts and pour it into the markets. However, the reality is if they haven’t done it by now after 3-consecutive rounds of Q.E. in the U.S., a 200% advance in the markets, and ongoing global Q.E., exactly what will that catalyst be?

However, Clifford Asness previously wrote:

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

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

Furthermore, despite this very salient point, a look at the stock-to-cash ratios also suggest there is very little available buying power for investors current.

Each month, the Investment Company Institute releases information related to the mutual fund industry. Included in this data is the total amount of assets invested in mutual funds, ETFs and money market funds. As a rough measure of investor sentiment, this indicator looks at the total assets invested in equity mutual funds and ETFs, and compares it to the total assets invested in the safety of money market funds.

The higher the ratio, the more comfortable investors have become holding stocks; the lower the ratio, the more uncertainty there is in the market. Currently, with the ratio at the highest level on record there is little fear of holding stocks.

Negative free cash balances also suggest the same as investors have piled on the highest levels of leverage in market history.

Furthermore, with investors once again “fully invested” in equities, it is not surprising to see cash and bond allocations near historic lows.

Cash on the sidelines? Not really.

Everyone “all in the boat?” Absolutely.

Historical outcomes from such situations? Not Great.

 “The year 1915 was fated to be disastrous to the cause of the Allies and to the whole world. By the mistakes of this year the opportunity was lost of confining the conflagration within limits which though enormous were not uncontrolled. Thereafter the fire roared on till it burnt itself out. Thereafter events passed very largely outside the scope of conscious choice. Governments and individuals conformed to the rhythm of the tragedy, and swayed and staggered forward in helpless violence, slaughtering and squandering on ever-increasing scales, till injuries were wrought to the structure of human society which a century will not efface, and which may conceivably prove fatal to the present civilization.” – Winston S. Churchill – The World Crisis: 1915

After reading that quote several times, it remains shocking that the politicians and individuals of that era unconsciously “conformed to the rhythm of the tragedy.” The paragraph above from Winston Churchill, describes the mass mindset of World War I when it was still in its infancy. War-time narratives, nationalism, destruction and the tremendous loss of life led most people to quickly accept and acclimate to an event that was beyond atrocious. Amazingly, less than a year before the period Churchill discusses, the same people likely would have thought that acceptance of such a calamity would be beyond comprehension.

Wars and markets are obviously on two different planes, and we want to make it clear the purpose of this article is not to compare the evils of war to financial markets. That said, we must recognize that quick acceptance of abnormal circumstances, as Churchill describes, is a trait that we all possess. The implausible, the absurd, and the extraordinary can quickly become the norm. Assumingly, this coping mechanism enables us to retain our sanity when events are far from normal.

The Fog of Markets

The seemingly unabated march upwards in stock prices occurring over the last eight years has had a mind-numbing effect on investors. The relentless grind higher is backed by weak fundamentals providing little to no justification for elevated prices. Indeed, if there was no justification for such valuations during the economically superior timeframe of the late 1990’s, how does coherent logic rationalize current circumstances? For example, feeble economic growth, stagnating corporate earnings, unstable levels of debt, income and wage inequality and a host of other economic ills typically do not command a steep premium and so little regard for risk. This time, however, is different, and investors have turned a blind eye to such inconvenient facts and instead bank on a rosy future. Thus far, they have been rewarded. But as is so often the case with superficial gratification, the rewards are very likely to prove fleeting and what’s left behind will be deep regret.

Despite our education and experience which teach the many aspects of the discipline of prudent investing, investors are still prone to become victims of the philosophy and psychology of the world around them. These lapses, where popular opinion-based investment decisions crowd out the sound logic and rationale for prudence and discipline, eventually carry a destructively high price.

Investors, actually the entire population, have become mesmerized by the system as altered and put forth by the central bankers. We have somehow become accustomed to believe that debt-enabling low interest rates make even more debt acceptable.  Ever higher valuations of assets are justifiable on the false premise of a manufactured and artificial economic construct.

From Winston Churchill, we move to John Hussman of Hussman Funds. The following quote discusses the mindset permeating the stock market:

“Investors and even financial professionals rarely recognize asset bubbles while they are in progress. As the price of a financial asset rises, investors have an increasing tendency to use the past returns and the past trajectory of the asset as the basis for their future return expectations. The more extended the advance, and the higher valuations become, the more stable and promising the investment can appear to be, when judged through the rear-view mirror. That extrapolation was at the root of the tech bubble that ended in 2000, and the mortgage bubble that ended in 2007. It is also at the root of the very mature bubble that has again been established today. -John Hussman Weekly Market Commentary February 6, 2017

Summary

Presently, the Trump administration is under increasing levels of scrutiny of a variety of forms; falling probabilities of meaningful tax reform, deep uncertainty around healthcare reform, delays and question marks surrounding infrastructure spending as well as possible pre-election dealings with Russia including potential perjury charges for some campaign staffers and other administration officials. Furthermore, Janet Yellen, Chairman of the Federal Reserve, appears uncharacteristically determined to maintain a path of higher interest rate and has recently discussed the possibility of reducing the Fed’s balance sheet.

These events should cause concern for investors. The recent run-up in valuations is based on a belief that the new administration will pass pro-growth legislation. Conversely, expanding valuations of the last eight years have been on the back of extremely accommodative monetary policy. Despite the threats to both factors, one presented by a Trump administration that is on the defensive and the other, a Fed looking to raise rates sooner, the equity market remains higher still. Muscle memory has taken over and investors do not show the slightest concern for risk. Per Hussman, “investors are accepting this current bull market with increasing dedication.”

As history demonstrates, conformity to the irrational can and often does persist beyond conceivable limits yet incoherence of behavior is not sustainable indefinitely.  Sanity, reality and a large dose of fear will eventually reassert themselves and force the market to adjust to appropriate levels. Interestingly, when prices finally do adjust and valuations promise generous returns, investors will find themselves caught up in the “rhythm of the tragedy” and believe that prices are only going lower.

It is difficult to maintain convictions that run counter to most investors and the tape. Animal spirits and the siren song of faulty popular logic effectively draw investors in as events pass “largely outside the scope of conscious choice”. Yet, rationality will prevail as it always has throughout human history and those on the right side of it will be rewarded appropriately.

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“You’re going to die if you stay there.”

In 2011, I was being ripped apart by internal conflict.

My physical health was in decline; mentally, the daily stress of my job blossomed severe depression. A heavy feeling I hadn’t experienced since I was 10 years old, when my parents divorced, overwhelmed me. A noticeable twitch in my left eye made it uncomfortable to do television appearances.

Sleep was rare.

I witnessed a successful 14-year career crumble right before my eyes and I couldn’t do a thing to stop it.

Thanks to coaching from friend, mentor and bestselling author James Altucher, I reluctantly began to face the truth: My former employer’s once client-centric environment, was dissolving. My role as trusted adviser to clients and their families was consistently being diluted.

As Financial Consultant Vice-President (all consultants were Vice-Presidents. It was all for appearance), I was reduced to a non-descript face of a large organization; a product pusher with tremendous sales goals on my back that left little time for clients I’d otherwise meet on a regular basis.

Torn between the responsibilities to clients I’ve assisted for over a decade and goals to sell and move people on, like cattle, I began to search for guidance, perspective.

I found a savior in James. I flew to New York as quickly as I could get there. We walked for miles up and down summer-humid city avenues; I was so focused, all I could do is listen deep to what he had to say. The world around me fell silent except for his words. I knew my life had to take a different path. Much was at stake.

“Rich, you need to make a choice. They care about shareholders, not clients. That’s how it works. For some reason you’ve been insulated. One thing I do know. If you stay, you’re going to need to sacrifice who you are. And my thought is you’re going to die if you stay.”

He was correct. I never forget his wisdom. My focus was about to shift.

On the return flight to Houston, I drafted a personal mission statement, a manifesto which motivated me to continue to assist clients in the manner they deserved, regardless of how detrimental it was to my career. I knew it wasn’t going to end well short term. In my gut, I felt what I needed to do to make it right for my universe (and sanity) for the long haul.

All that mattered was I act as fiduciary, until the point I could no longer. My loyalty was to remain first with clients. Not an organization that in the past, had allowed front-line employees to suffer black marks on their securities licenses by obfuscating what was truly going on with a series of in-house fixed income mutual funds that blew up during the financial crisis.

I never regret the choice to leave a political bureaucracy and the brokerage industry, overall.  As a registered investment adviser under The Investment Advisers Act of 1940, I have a clear fiduciary duty to clients. It’s where I do my finest work professionally. I am no longer required to serve shareholder’s agendas.

Candidly, it changed the path of my life. Although the early results were less than desirable as a nasty fight with my former employer took a financial and physical toll, where I am today proves undeniably, that it was the best decision.

Manifestos are guidelines that define how you walk the line. They’re backed by passionate words and followed by actions which validate those words every day. If followed, manifestos are intended to protect what’s important; they’re born of pathos. Manifestos are inspired by tough lessons that shake you up enough to alter your path.

Lance Roberts and I set out to define the guidelines that comprise the RIA manifesto. These beliefs drive us, they’re part of who we are and what we strive to communicate to listeners and readers. I affectionately refer to them as the DNA or the core of Roberts & Rosso, or “R-Squared.”

We present…

The Real Investment Advice Financial Manifesto.

ONE: Market & Economic Conditions Require Perspective Of An Eagle.

Eagles observe from above; they’re masters of the skies with wingspans that extend over seven feet. They survey the landscape from great altitudes which provides a holistic perspective of the terrain.

Bulls & bears are too close to the ground, myopic, and defend narrow perspectives based on their agendas, not yours. Eagles have vision more than five times sharper than a human’s. When it comes to observations, eagles can observe what’s moving from 1,000 feet above the earth and spot a rodent target over an area of three square miles from a fixed perch. Data gathered and analyzed must be clear of agenda which ostensibly, motivates us to undertake investigation devoid of bias and spin.

TWO: Risk Management Is Not Choice, It’s Necessity.

There’s no gray area. Either you manage downside risk, or you don’t. During ebullient periods in the stock market when “investment risk,”tends to be eschewed for the pursuit of gains, should investors grow increasingly cautious. Unfortunately, many succumb to the euphoria.

It is vital to manage downside risk during periods like now where markets “only seem to go up” and statements such as “investing is about ‘time-in’ the market rather than ‘timing’ the market” are frequently communicated.

What’s rarely discussed (except by those with an eagle’s purview), is the damage to investor returns when market losses are incurred. On average, bear markets generate drawdowns or losses close to 40% which require a 66.67% return to get back to even.

THREE: Stock Averages Don’t Expire, You Do.

Legendary investors like Warren Buffett are investors. They’re allocating capital to companies that will benefit decades, perhaps centuries of shareholder wealth. As a human being with a finite life to accumulate and then distribute assets, you’re not afforded such a luxury of time, that’s why you’re merely a speculator who hopes you purchase at a price and hopefully liquidate higher.

Unlike Mr. Buffett’s company that can purchase other companies and replace top executives, affect boards of directors, you have zero control over the direction of an individual company, a stock index or mutual fund manager. You are simply SPECULATING on the price you paid for an asset that you HOPE to sell at a higher price to someone else in the future. That is, in its most basic form, a speculation. Hey, there’s nothing wrong with being a speculator. Wall Street was founded by them. The goal is to understand how the stock market is a crap shoot and can humble you at a moment’s notice.

FOUR: Diversification Is Not Risk Management, It’s Risk Dilution.

Understanding the difference may save your financial life.

What are the odds of one or two companies in a balanced portfolio to go bust or face an industry-specific hazard at the same time?

What’s the greater risk to you? One company going out of business or underperforming or your entire stock portfolio suffers losses great enough to change your life, alter your financial plan.

You already know the answer.

Diversification is not risk management, it’s risk reduction.

  • When your broker preaches diversification as a risk management technique, what does he or she mean?
  • It’s not risk management the pros believe in, but risk dilution.
  • There’s a difference. The misunderstanding can be painful.

To you, as an investor, diversification is believed to be risk management where portfolio losses are controlled or minimized. Think of risk management as a technique to reduce portfolio losses through down or bear cycles and the establishment of price-sell or rebalancing targets to maintain portfolio allocations. Consider risk dilution as method to spread or combine different investments of various risk to minimize volatility.

Even the best financial professionals only consider half the equation.

Beware the lamb (risk management) in wolf’s clothing (risk dilution).

The goal of risk dilution is to “cover all bases.” It employs vehicles, usually mutual funds, to cover every asset class so business risk can be managed. The root of the process is to spread your dollars and risk widely across and within asset classes like stocks and bonds to reduce company-specific risk.

There’s a false sense of comfort in covering your bases. Diversification in its present form is not effective reduce the risk you care about as an individual investor – risk of loss.

Today, risk dilution has become a substitute for risk management, but it should be a compliment to it.

Risk dilution is a reduction of volatility or how a portfolio moves up or down in relation to the overall market.

Risk dilution works best during rising, or up markets as since most investments move together, especially stocks. 

Don’t be fooled.

FIVE: Brokers Hold Allegiance To Employers, Fiduciaries Are Bound To Clients.

You’re best to seek out a fiduciary, a professional or an organization that places your interests first.

Financial 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.

SIX: When It Comes To Money Decisions, Think Full Circle.

Money is fungible. It shouldn’t be compartmentalized.

Don’t perceive every financial challenge as a straight edge with a beginning and conclusion. It leads to narrow thinking and sub-optimization at the point of action.  Round out your thought process. Go where you never been before. When presented with a financial decision, break down the walls, goals, compartments and picture how all your dollars can flow free from their different types of accounts and work together to achieve the greatest impact to your bottom line.

Think rooftop, not basement. When you bust down the walls between dollars, you begin to think bigger (and smarter). You’re up on the roof looking out and over the landscape of your finances. You begin to see how fungible money is.

Most of the time, we rummage in the basement where it’s dark and narrow because of the laser-focus on the problem. Unfortunately, the longer we concentrate, the less we observe lucrative options hiding in plain sight. That’s why financial decisions should begin from a holistic perspective (roof) and then narrowed down to the basement or specific issues at hand.

For example, when gasoline prices were shy of 4 dollars a gallon (feels like an eternity ago), I was inundated with inquiries about trading in paid-off automobiles for new gas-efficient options. In other words, I was being asked whether spending $32,000 was worth the saving of $600 a year at the gas pump. The numbers didn’t work out advantageously.

Once you consider the opportunity cost of spending five figures, well, you’re on the roof and seeing things from a clearer perspective. From there, dollars may flow to higher uses or in these cases, not flow inefficiently to paying additional debt from automobile loans.

SEVEN: Mind The Surprise Gap.

The gap between returns you expect as you accumulate and those realized when you seek to re-create the paycheck in retirement, can lead to unwelcomed, life-changing surprises.

What Your Financial Planning Must Consider:

  • 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 9 years, and low interest rate environment, have 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.

Unfortunately, you cannot INVEST your way to a successful retirement goal. As the last decade should have taught, the stock market is not a “get wealthy for retirement” scheme. You cannot under-save for 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.

EIGHT: Brokers Believe In One Cycle And That’s “Bull.”

Many brokers are trained and indoctrinated with the accumulation stage in mind. They try to help clients accumulate, not manage nor distribute wealth.

Every market cycle is allegedly a great opportunity to invest, or to dollar-cost average. Many brokers are unaware that when you switch from accumulation to distribution, almost all of the math turns on its head. In other words, every market is a bull market.

Many of the great concepts that are good for accumulation become useless or downright dangerous during the distribution period.

Never discount luck in your plan. When you retire, where you are in a cycle at that time, is indeed luck. Will you experience a market return headwind or tailwind? A broker only perceives great return tailwinds and minimizes the impact, time and discipline it takes to endure a bear or flat cycle (yes, they do occur).

NINE: There’s No Such Thing As Passive Investing, Only Passive Investments.

Understanding the difference will save your investing life.

Passive investing is not safe. Not by a long shot. To clarify: Passive is an investment type. It is NOT an investing process nor a manner to which RISK is managed.

The clearest thought I can conjure up about passive investments and bear markets is I have the finest potential to lose money at low internal costs. Never forget – Once wealth is allocated to stocks, it’s active. On occasion, radioactive. Plain and simple. Index positions must be risk managed. They bear the full risk of markets. The highs and the lows. There’s no escape-risk-free card.

TEN: Compound Interest Is An Enduring Myth.

Compound interest is the coolest story ever, but that’s about it. 

You so want to believe.

And there was a time you could.

But not so much today.

Albert Einstein is credited with saying “compound interest is the eighth wonder of the world.”

I’m not going to argue the brilliance of Einstein although I think when it comes down to today’s interest-rate environment he would be quite skeptical (and he was known for his skepticism) of the real-world application of this “wonder.”

First, Mr. Einstein must have been considering an interest rate with enough “fire power” to make a dent in your account balance.

Over the last nine years, short-term interest rates have remained at close to zero, long term rates are deep below historical averages and are expected to remain that way for some time.

Indeed, compounding can occur as long as the rate of reinvestment is greater than zero, but there’s nothing magical about the “snowballing” effect of compounding in today’s rate environment.

Most important: Compounding only works when there is ZERO CHANCE of principal loss. It’s a linear wealth-building perspective that no longer has the same effectiveness considering two devastating stock market collapses which have inflicted long-term damage on household wealth.

What good is compounding when the foundation of what I invested in is crumbling?

Don’t give compound interest another precious thought.

If it comes along, consider it a great gift. A bounty.

Fine tune what you can control and that primarily has to do with how you increase household earnings power and manage debt.

We believe the eighth wonder of the world is human resolve in the face of economic reality post-Great Recession.

Not compound interest.

Soon, the 10 tenets will be available in postcard, PDF, and poster form as we turn our RIA manifesto into an aesthetically pleasing creative endeavor.

And if blood could replace ink, we’d do it as we embody every sentence.

As we’ve learned through experience, we seek to share, educate and never let down our guards for clients, readers and financial professionals who believe in our mission.

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


As I discussed in this past weekend’s missivethe breakout of the market to new highs keeps our allocation model nearly fully allocated. However, while we are long, we are still holding onto a little larger than normal cash pile, and raised stop levels, to hedge some volatility risk during the summer months. (Stops have now moved up to the bottom of the bullish trendline as shown in the chart below which coincides with the 100-day moving average which has been a running support line.)

One thing that keeps us a bit more cautious currently is the intermediate term “sell signal” which remains in place from very high levels. That, as shown below, and with a push into 3-standard deviations above the moving average, has not historically had the best outcomes. So, we’re cautious.

This is a very confusing market and the arguments between the “bulls” and the “bears” runs deep. It is these emotional biases of being either “bullish” or “bearish,” primarily driven by the media, which keeps you from truly focusing on long-term outcomes. You either worry about the next downturn, or are concerned you are missing the rally. Therefore, you wind up making short-term decisions which negate your long-term views.

Understanding this is the case, let’s take a look at the technical case for the markets from both a bullish and bearish perspective. From there you can decide what you do next.

THE BULL CASE

1) Central Banks Won’t Let The Markets Crash

This is the primary support of the bullish case, and frankly, one that is difficult to argue with. Despite all of the hand-wringing over valuations, economics or fundamental underpinnings, stocks have been, and continue to be, elevated due either to “direct” or “verbal” accommodation.

I discussed this idea in “The Illusion Of Permanent Liquidity:”

“But what ongoing liquidity interventions have accomplished, besides driving asset prices higher, is instilling a belief there is little risk in the markets as low interest rates will continue or only be gradually tightened.”

As I showed just recently, while the Fed may not be “actively” engaged in further liquidity injections via “Quantitative Easing,” there is certainly a fairly suspicious pattern as to the timing of the “reinvestment” of the balance sheet.

But it isn’t just the “Fed” that has pushed asset prices higher, but every major Central Bank globally with almost all of them pushing record levels of assets.

“Bad news is good news” has been the “siren’s song” for the bulls since “low rates for longer” and continued interventions and verbal accommodation keeps the “global chase for yield” intact.

2) Stocks Made A Successful Retest Support & Broke Out

After a good bit of “sideways churning” beginning in March, the market was finally able to muster enough strength to break of the 3-month long trading range and move to new highs. While much of the move came from very light volume, the breakout occurred which is bullish and does suggest higher asset prices in the near term. 

The dashed black lines show the short-term “buy” and “sell” signals with the latest “buy” signal being triggered with the price “breakout” at the end of May.

The market was successfully able to defend crucial support following a “sharp sell-off” on a one-day concern the current Administration “may” have obstructed an investigation. Such was quickly dismissed as #FakeNews by the markets and the markets rapidly regained footing in ongoing anticipation of “tax cuts/reforms.”

Importantly, the “sell signal,” which is shown in the lower part chart above, was also just as quickly reversed removing downward pressure on the market in the short-term. While the markets remain extremely overbought in the short-term, and some corrective action is likely, any such correction that does not violate the recent “breakout” and/or critical support levels, will keep the current bull market advance intact. 

3) Advance-Decline Line Is Improving

The participation by stocks in the recent bullish advance has been strong enough to push the advance-decline line back onto a short-term “buy signal” as well.

After languishing since the beginning of the year, both the number and volume of stocks on the NYSE are now participating in the advance. The rise in participation supports the bullish momentum behind stocks currently and should not be dismissed.

Currently, as shown above, the short-term dynamics of the market remain bullishly biased. This suggests equity exposure in portfolios remains warranted for the time being. However, let me be VERY CLEAR – this is VERY SHORT-TERM analysis. From a TRADING perspective, this remains a bull market at the current time. This DOES NOT mean the markets are about to begin the next great secular bull market. Caution is highly advised if you have an inherent disposition to “hoping things will get back to even” if things go wrong, rather than selling.


THE BEAR CASE

The bear case is more grounded in longer-term price dynamics – weekly and monthly versus daily which suggests the current rally remains a reflexive rally within the confines of a more bearish backdrop.

1) Bonds Ain’t Buyin’ It

As I noted this past weekend:

“The biggest problem I have currently is simply that bonds are NOT buying the rally. As I discussed last week, and as we saw on Friday, bonds continue their ‘bullish bias’ and broke through key support levels suggesting lower rates to come.”

With interest rates still overbought, and on an important “sell signal,” the downside break from the recent consolidation process suggests lower rates/higher bond prices in the near term. 

On a longer-term basis, this suggests that either bonds (risk-off) or stocks (risk-on) is wrong. My suspicion is that ultimately stocks will take the hit as the “credit market,” which analyzes actual balance sheet risk, tends to be right more often than not. 

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 every previous bull market peak in history. Given the deterioration in revenues, valuations, corporate profits, and weak economics, the backdrop between today and the end of previous bull markets remains consistent. 

3) M&A Ain’t “M’n or A’n”

A recent post via Business Insider brought to light an interesting view to a longer-term driver of market support.

“M&A lawyers argue the ‘uncertainty’ factor, which has come about recently, given some unpredictable aspects of the new Trump administration, has been the issue. It only may explain the last six months, but the trend has been poor for about two years or more. In the past, there has been some correlation with the S&P 500 and thus it could generate more legitimate fears than some of the other excuses that are put forth for not wanting to buy American equities.”

This year through June 5, 7,561 deals were announced, the lowest count since 2013, according to S&P Global Market Intelligence. While M&A volume reached a record $2.055 trillion 2013, the volume has slipped in 2016 to just $1.7 trillion.

Given the length and maturity of the current economic expansion, tighter monetary policy in the U.S. and a lack of legislative agenda moving forward in Washington, there is further risk of M&A support being pulled from the markets.


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 remaining to warrant some equity risk on a very 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 2500, or more, as some analysts currently expect? It is quite possible given the ongoing interventions by global Central Banks, bullish optimism and the rising belief “this time is different.” 

The reality, of course, is that while the markets could reward you with 100 points of upside, there is a risk of 600 points of downside just to retest the lows of 2016.

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

A recent article by Joe Ciolli stated the equity bull market’s biggest catalyst looks like it’s here for the long haul. To wit:

“Profit expansion — which has historically been the biggest contributor to share-price appreciation for US corporations — is churning at a rate not seen in almost six years.

“The recent surge confirms the sustainability of the earnings recovery that started in early 2016,” a group of Morgan Stanley equity strategists led by Michael J. Wilson wrote in a client note. “The momentum of earnings revisions breadth like that seen recently is often synonymous with higher equity prices over a 12-month horizon.”

While the above statement is absolutely correct, the problem is the markets are now on the tail end of that expansion where year-over-year comparisons were extremely easy. As I noted in this past weekend’s newsletter it is quite likely the spat of earnings growth seen over the last couple of quarters will soon end as year-over-year comparisons get decidedly tougher. 

As you can see, both above and below, the market does indeed respond to earnings growth. As stated, with earnings back to their previous peak, the rate-of-change will begin to slow quickly.

Considering that earnings estimates are generally overstated by roughly 30%, the actual net decline in earnings growth will likely be far sharper than currently anticipated.

More importantly, since the bulk of the expected increase in earnings estimates are based on tax cuts/reforms, when it becomes apparent those legislative policies are not forthcoming, those estimates will be ratcheted lower. With the market trading well ahead of earnings growth currently, the risk of disappointment is extremely high.

The chart below shows the 3-year rate-of-change in reported earnings per share and the S&P 500. Not surprisingly, considering the cyclical nature of the economy, we are closer to the end of the current cycle than not.

Much of the recent rebound in earnings came from the sharp rise in oil prices as shown below. But, with those prices once again on the decline, it is quite likely forward earnings are overly optimistic currently.

Corporate Profits Tell A Different Story

As I have discussed previously, the operating and reported earnings per share are heavily manipulated by accounting gimmicks, share buybacks, and cost suppression. To wit:

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

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

However, if we analyze corporate profits (adjusted for taxes and inventory valuations) we find a very different story. Since the lows following the financial crisis, the S&P 500 has grown by 266% versus corporate profit growth of just 98%.

Important Note: The profits generated by the Federal Reserve’s balance sheet are included in the corporate profits discussed here.  As shown below, actual corporate profitability is weaker if you extract the Fed’s profits from the analysis. As a comparison, in the first quarter of 2017, Apple reported a net income of just over $17 billion for the quarter. The Fed reported a $109 billion profit.

With corporate profits still at the same level as they were in 2011, there is little argument the market has gotten a bit ahead of itself. Sure, this time could be different, but it usually isn’t. The detachment of the stock market from underlying profitability suggests the reward for investors is grossly outweighed by the risk. 

But, as has always been the case, the markets can certainly seem to “remain irrational longer than logic would predict.” This was something Jeremy Grantham once noted:

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.”

Grantham is correct. As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP we see a clear process of mean reverting activity over time. Of course, those mean reverting events are always coupled with a recession, crisis, or stock market crash.

More importantly, corporate profit margins have physical constraints. Out of each dollar of revenue created there are costs such as infrastructure, R&D, wages, etc. Currently, one of the biggest beneficiaries to expanding profit margins has been the suppression of employment, wage growth, and artificially suppressed interest rates which have significantly lowered borrowing costs. Should either of the issues change in the future, the impact to profit margins will likely be significant.

The chart below shows the ratio overlaid against the S&P 500 index.

I have highlighted peaks in the profits-to-GDP ratio with the orange vertical bars. As you can see, peaks, and subsequent reversions, in the ratio have been a leading indicator of more severe corrections in the stock market over time. This should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability.

Of course, it is often suggested that, as mentioned above, low interest rates, accounting rule changes, and debt-funded buybacks have changed the game. While such could possibly be true, it is worth noting that each of those supports are artificial and finite in nature.

Currently, the aging U.S. economy, where productivity has exploded, wage growth has remained weak and whose households are weighed down by surging debt, remains mired in a slow-growth funk. This slow-growth trajectory has, in turn, put a powerful shareholder base to work increasing pressure on corporate managers not to invest, and to recycle capital into dividends and buybacks instead which has led to a record level of corporate debt. 

These actions, as suggested above, are limited in nature. For a while, these devices kept ROE elevated, however, the efficacy of those actions have now been reached.

Importantly, profit margins and ROE are reasonably well-correlated which is what creates the perception that profit margins mean-revert. However, ROE is a better indicator of what is happening inside of corporate balance sheets more so than just profit margins. The current collapse in ROE is likely sending a much darker message about corporate health than profit margins currently. 

While reported earnings, which are subject to accounting manipulations and share buybacks have indeed declined below the long-term trends, it is not nearly to the extent as shown by both ROE and Corporate Profits.

Furthermore, there has been a lot of focus on traditional P/E ratios which have surged above 25x earnings recently. But, a look at the Price to Corporate Profits Per Share (P/CP) has also exploded to the second highest level on record and, like P/E ratios, is unsustainable long-term. 

It is unlikely that with reported earnings growth likely slowing in the next quarter, we will see a sharp rise in asset prices during the second half of the year as currently expected. But, as long as the Fed remains active in supporting asset prices, the deviation between fundamentals and fantasy will likely continue to stretch extremes. Unfortunately, the end result will be the same as it has always been.

While investor appetites for risk remains robust in the short-term, history suggests that such “willful blindness” has led to particularly bad outcomes. 

I am out of commission today following a small surgery, so I want to thank my new friends at Morningside Hill Capital Management for standing in for me with today’s posting.

The question over the strength of today’s job market is key to understanding the durability of the economy and the markets going forward. Pavel Velkov, CFA, and the entire team at Morningside Hill, take a deep dive into the statistics to get down to the startling conclusion.

“The US jobs market has been described as the backbone of the recovery – 82 months of continuous jobs growth with unemployment hitting 4.5% – the lowest since 2007. However, the perceived strength in jobs creation is at odds with other economic indicators. President Trump ran on a campaign that repeatedly touted “jobs, jobs, jobs.” His emphasis on jobs creation and bringing employment back to America struck a chord with voters. Trump’s election in itself contradicts the popular narrative that the US jobs market is tight and robust. Wages, disposable income, and real earnings growth along with low productivity and overall slow economic growth all challenge the BLS’s jobs numbers and thus Wall Street’s perception that the jobs market is tight.

Since the monthly jobs report is eagerly awaited as the most important piece of economic data for financial markets, it warrants a deep dive in order to understand what is going on under the hood. Before we delve into the data, here are some highlights of our findings.

  • The Bureau of Labor Statistics (BLS) has been systemically overstating the number of jobs created, especially in the current economic cycle.
  • The BLS has failed to account for the rise in part-time and contractual work arrangements, while all evidence points to a significant and rapid increase in the so-called contingent workforce.
  • Full-time jobs are being replaced by part-time positions, resulting in double and triple counting of jobs via the Establishment Survey.
  • A full 93% of the new jobs reported since 2008 and 40% of the jobs in 2016 alone were added through the business birth and death model – a highly controversial model which is not supported by the data. On the contrary, all data on establishment births and deaths point to an ongoing decrease in entrepreneurship.
  • Jobless claims have recently reached their lowest level in 43 years which purportedly signals job market strength. Since hiring patterns have changed significantly and increasingly more people are joining the contingent workforce, jobless claims are no longer a good leading economic indicator. Part-time and contract-based workers are most often ineligible for unemployment insurance. In the next downturn, corporations will be able to cut through their contingent workforce before jobless claims show any meaningful uptick.

Overall, we have found the headline jobs number, unemployment rate and jobless claims to be poor macroeconomic indicators, since they have failed to account for significant shifts in labor market dynamics.”


The US Jobs Market – Much Worse Than the Official Data Suggest by streettalk700 on Scribd

(Note: I am sidelined for the next couple of days due to a small surgery. Will be back to a regular posting schedule on Monday.)

As I discussed this past weekend, the current “bull market” seems unstoppable. Even on Twitter, investors have once again been lulled into the “complacency trap.”


I have often written on the perils and pitfalls of investing, portfolio and risk management and the fallacy of long-term “average” rates of returns. Unfortunately, few heed these warnings until it is generally far too late.

For example, just last week I received an email exposing this problem exactly.

“Explain this to me. I have been listening to all of these people on television talking about how great the market is doing. However, my advisor convinced me back in 1998 to buy a bunch of blue chip stocks and just hold them. Well, almost 20-years later, I am not much better off than where I started and am still a long way from where I need to retire.  I just don’t get it.”

This email goes to the very core of the fallacy that is continually espoused by the mainstream media with reference to “buy and hold,” “dollar cost averaging,” and “compounding.” 

When you are invested in ANY asset that can lose principal value during your investment time horizon, you can NOT compound returns. Compound returns ONLY occur in investments that do not lose principal such bonds, money market accounts and CDs.

Furthermore, the major problem is the loss of “time” to achieve your investment goals. When a major correction occurs in the financial markets, which occur quite frequently, getting back to even is NOT the real problem. While capital can be recovered following a destructive event, the time to reach your investment goals is permanently lost. 

The majority of mainstream commentators continue to suggest that “you can not manage” your money because if you sell, then you are going to “miss out” on some level of the bull market advance. The problem is they fail to tell you what happens when you lose a large chunk of your capital by chasing the bull market to its inevitable conclusion. (See “Math Of Loss”)

While investing money is easy, it is the management of the inherent “risks” that are critical to your long-term success. This is why every great investor in history is defined by the methods by which they manage their investments. When they “buy”, but most importantly when they “sell.”

The difference between a successful long-term investor, and an unsuccessful one, comes down to following very simple rules. Yes, I said simple rules, and they are – but they are the most difficult set of rules for any one individual to follow. Why? Because of the simple fact that they require you to do the exact OPPOSITE of what your basic human emotions tell you to do:

  • Buy stuff when it is being liquidated by everyone else, and;
  • Sell stuff when it is going to the moon.

The 7-Trading Rules

Here are the rules – they are not unique or new. They are time tested and successful investor approved. Like Mom’s chicken soup for a cold – the rules are the rules. If you follow them you succeed – if you don’t, you don’t.

1) Sell Losers Short: Let Winners Run:

It seems like a simple thing to do but when it comes down to it the average investor sells their winners and keeps their losers hoping they will come back to even.

2) Buy Cheap And Sell Expensive:

You haggle, negotiate and shop extensively for the best deals on cars and flat screen televisions. However, you will pay any price for a stock because someone on television told you too. Insist on making investments when you are getting a “good deal” on it. If it isn’t – it isn’t, don’t try and come up with an excuse to justify overpaying for an investment. In the long run – overpaying will end in misery.

3) This Time Is Never Different:

As much as our emotions and psychological makeup want to always hope and pray for the best – this time is never different than the past. History may not repeat exactly but it surely rhymes awfully well.

4) Be Patient:

As with item number 2; there is never a rush to make an investment and there is NOTHING WRONG with sitting on cash until a good deal, a real bargain, comes along. Being patient is not only a virtue – it is a good way to keep yourself out of trouble.

5) Turn Off The Television:

Any good investment is NEVER dictated by day to day movements of the market which is merely nothing more than noise. If you have done your homework, made a good investment at a good price and have confirmed your analysis to correct – then the day to day market actions will have little, if any, bearing on the longer-term success of your investment. The only thing you achieve by watching the television from one minute to the next is increasing your blood pressure.

6) Risk Is Not Equal To Your Return:

Taking RISK in an investment or strategy is not equivalent to how much money you will make. It only relates to the permanent loss of capital that will be incurred when you are wrong. Invest conservatively and grow your money over time with the LEAST amount of risk possible.

7) Go Against The Herd:

The populous is generally right in the middle of a move up in the markets but they are seldom right at major turning points. When everyone agrees on the direction of the market due to any given set of reasons – generally something else happens. However, this also cedes to points 2) and 4); in order to buy something cheap or sell something at the best price – you are generally buying when everyone is selling and selling when everyone else is buying.

These are the rules. They are simple and impossible to follow for most. However, if you can incorporate them you will succeed in your investment goals in the long run. You most likely WILL NOT outperform the markets on the way up but you will not lose as much on the way down. This is important because it is much easier to replace a lost opportunity in investing – it is impossible to replace lost capital.

As an investor, it is simply your job to step away from your “emotions” for a moment and look objectively at the market around you. Is it currently dominated by “greed” or “fear?” Your long-term returns will depend greatly not only on how you answer that question, but how you manage the inherent risk.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham