On election night, my friend Jessica and I were standing in the studios of Fox News in Houston as the ready to provide “color commentary” as the Presidential election proceeded. The newsroom was highly electric with reporters rushing back and forth grabbing the latest data as it poured in.

In between interviews on what a “Trump” election could mean for the country, Jessica and I stood glued to the monitors watching the results as they were reported. While we were both very hopeful that Trump could win the election, but deep down I don’t think we actually believed it. The odds of Trump winning enough of the “swing” states to gain the sufficient number of electoral votes seemed astronomical. Yet, as each of those states began to fall in Trumps favor, a whisper began to spread through the room:

“I don’t believe it…he could actually win this thing.” 

But, as each state did fall to Trump, locking in the electoral votes needed to win, stock market futures went in the same direction. Down 100, 200, 500, 700 points, as panic of a Trump victory swept through the markets. It was going to be a brutal opening on Wednesday morning. 

But then, just as if someone had flipped a switch, it all changed.

The “guy,” whom if elected would crash the markets and the economy, was suddenly the “long awaited Saviour.” As the markets opened the next day, optimism surged on hopes “Trumponomics” would repair the ills which had plagued the economy for the last eight-years. The chart below shows the surge.

Well, here we are 100-days later, with the markets near all-time highs as investors continue to “hope” for the promised reforms. Yet, they remain absent as the challenge to pass reforms came from an unexpected source. It was thought the “real fight” would be between the Republican and Democratic factions of both Congress and Senate. However, it turned out the fight would be between the Republicans themselves leaving the Democrats sitting on the sidelines “eating popcorn and enjoying the show.”  

At each turn the “Trump” administration has run into difficulties in taking action on campaign promises. Rising tensions with Canada and Mexico have led to a reconsideration of withdrawing from NAFTA, global pressures have led to a reconsideration of withdrawing from TPP and the Paris Climate Accord. The “Affordable Care Act,” which was to be repealed, has now shifted into a “replacement” and leaves a bulk of the ACA intact along with the very aspects that continues to inflate health care costs. Tax reform remains a distant promise, along with infrastructure spending and the boarder wall, as the debt ceiling looms and opposition pressure mounts.

At the same time, while optimism has surged, the hard economic data has continued to remain weak with the Atlanta Fed ratcheting down the first quarters GDP growth to just 0.2%.

As discussed yesterday, there is a rising belief this time is different. Yet, the optimism for continued growth in asset prices is based upon the “forward estimates of rising earnings” based on tax cuts which will directly boost earnings per share. But what happens if it doesn’t come?

First, this isn’t the 1980’s, the last time tax reform was passed, with low valuations, high inflation and interest rates and much stronger economic growth to start with. Therefore, the impact of tax cuts will likely be far less than expected. Secondly, tax reform is likely going to be the single most difficult challenge of this Administration as “partisan politics” come into play. Ultimately, tax reform could be far different, and much less robust, than currently anticipated.

So, here we are at the end of the first 100-days, with little progress being made toward the things that count the most with investors. With asset prices currently priced for perfection, the real risk is that of “disappointment.” It will likely pay to “err to the side of caution” for now as the risk is clearly tilted against reward for now.

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

Trump Tax Plan – Everything You Need To Know


Research / Interesting Reads

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, ‘Margin of Safety.’” – Benjamin Graham

Questions, comments, suggestions – please email me.

Just recently, Wealth Management had an interesting interview with Jeremy Grantham in which Jeremy suggests the “rules have changed” for value investors. To wit:

“The market was extremely well-behaved from 1935 until 2000. It was an orderly world in which to be a value manager: there was mean reversion. If a value manager was patient, he was in heaven. The market outperformed when it was it cheap, and when it got expensive, it cracked.

Since 2000, it’s become much more complicated. The rules have shifted. We used to say that this time is never different. I think what has happened from 2000 until today is a challenge to that. Since 1998, price-earnings ratios have averaged 60 percent higher than the prior 50 years, and profit margins have averaged 20 to 30 percent higher. That’s a powerful double whammy.”

He is correct. As shown below the average CAPE ratio level rose, beginning in 1980 to 21.67 from the average of 14.42 over the previous 80-years.

Of course, the bulk of that increase is due to the valuation anomaly of the 1999 “Dot.com” bubble which skewed earnings to astronomical extremes. If we normalize that period, average valuation levels have only slightly increased in recent years. However, there is no argument that fundamental valuation measures have indeed changed, and arguably for the worse.

There is some truth to the argument that “this time is different.” The accounting mechanizations that have been implemented over the last five years, particularly due to the repeal of FASB Rule 157 which eliminated “mark-to-market” accounting, have allowed an ever increasing number of firms to “game” earnings season for their own benefit. Such gimmickry has suppressed valuation measures far below levels they would be otherwise.

While operating earnings are the primary focus of analysts, the media, and hucksters, there are many problems with the way in which these earnings are derived due to one-time charges, inclusion/exclusion of material events, and outright manipulation to “beat earnings.”  This problem has been exacerbated since the end of the financial crisis, as we will discuss more in a moment, to the point to where only 13% of total revenue growth is coming from actual revenue, the rest is from accounting gimmickry, buybacks, and outright fudging.

The Wall Street Journal confirmed as much in a 2012 article entitled “Earnings Wizardry” which stated:

“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”

This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to either flatter, or depress, earnings.


“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.”

Of course, the reason that companies do this is simple: stock-based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. A “miss” of Wall Street expectations can lead to a large penalty in the companies stock price. Therefore, it is not surprising to see 93% of the respondents pointing to “influence on stock price” and “outside pressure” as reasons for manipulating earnings.

Note: For fundamental investors, this manipulation of earnings skews valuation analysis particularly with respect to P/E’s, EV/EBITDA, PEG, etc.

This was brought to the fore again recently by the Associated Press in: “Experts Worry That Phony Numbers Are Misleading Investors:”

“Those record profits that companies are reporting may not be all they’re cracked up to be.

As the stock market climbs ever higher, professional investors are warning that companies are presenting misleading versions of their results that ignore a wide variety of normal costs of running a business to make it seem like they’re doing better than they really are.

What’s worse, the financial analysts who are supposed to fight corporate spin are often playing along. Instead of challenging the companies, they’re largely passing along the rosy numbers in reports recommending stocks to investors.

Here are the key findings of the report:

  • Seventy-two percent of the companies reviewed by AP had adjusted profits that were higher than net income in the first quarter of this year. That’s about the same as in the comparable period five years earlier, but the gap between the adjusted and net income figures has widened considerably: adjusted earnings were typically 16 percent higher than net income in the most recent period versus 9 percent five years ago.
  • For a smaller group of the companies reviewed, 21 percent of the total, adjusted profits soared 50 percent or more over net income. This was true of just 13 percent of the group in the same period five years ago.
  • Quarter after quarter, the differences between the adjusted and bottom-line figures are adding up. From 2010 through 2014, adjusted profits for the S&P 500 came in $583 billion higher than net income. It’s as if each company in the S&P 500 got a check in the mail for an extra eight months of earnings.
  • Fifteen companies with adjusted profits actually had bottom-line losses over the five years. Investors have poured money into their stocks just the same.
  • Stocks are getting more expensive, meaning there could be a greater risk of stocks falling if the earnings figures being used to justify buying them are questionable. One measure of how richly priced stocks are suggesting trouble. Three years ago, investors paid $13.50 for every dollar of adjusted profits for companies in the S&P 500 index, according to S&P Capital IQ. Now, they’re paying nearly $18.

Less than one-year later, individuals are paying nearly $25 for 12-month reported EPS at roughly the same level as they were at the end of 2013.

The obvious problem when it comes to investing and the markets is that playing “leapfrog with a unicorn” has very negative outcomes. While valuations may not matter currently, in hindsight it will become clear that such valuation levels were clearly unsustainable. However, the financial media will report such revelations long after it is of use to anyone.

This Time Is Not Different

The eventual outcome will be the same as every previous speculative/liquidity driven bubble throughout history. The only difference will be the catalyst that eventually sends investors running for cover.

Just as it was in 1999 where “investing like Warren Buffett was like driving Dad’s old Pontiac,” it is near the end of an elongated “bull market cycle,” where price discovery becomes impaired, that investors become lulled into a sense of false security. At the heart of these cycles is always a central thesis. In 1999 it was “dot.com” stocks, in 2007 it was “real estate,” and as noted recently it is now “passive indexing.”

Our evidence suggests the growth of ETFs may have (unintended) long-run consequences for the pricing efficiency of the underlying securities.’

The detrimental effects to the market snowball from there. Fewer trades occur, so liquidity in single stocks deteriorates, raising transaction costs. That only further discourages professional traders, so the price discrepancies remain without the informational arbitrage to close the gaps.”

The problem with the lack of liquidity, as I discussed last week, is what happens when prices revert at a time when leverage is at historical highs.  Throughout history, when prices have deviated more than 10% above their 3-year moving average, corrections and reversions have often followed.

Importantly, the magnitude of those corrections/reversions has often been dictated by the catalyst (the cause of the reversion), the amount of leverage in the system, and the economic damage caused by it.

For example, in 2008, the markets running at roughly 12% above the long-term mean, well below the 40% deviation is 2000, yet the catalyst (Lehman) and the subsequent economic fallout caused by the financial crisis, ripped through the financial markets to the same degree as the “Dot.com crash.”

Furthermore, the biggest market crashes have come from when valuation levels were trading above 23x earnings.

As David Einhorn recently wrote in an update to his investors:

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.”

For longer term investors who are depending on their “hard earned” savings to generate a “living income” through retirement, understanding the “real” value will mean a great deal. As Michael Lebowitz noted yesterday:

“There is no doubt that the market can grind higher to more dizzying valuations. However, there is also strong historical evidence this market will normalize to average valuations. In the wisdom of Bernard Baruch, there are times when you ‘make your money’ by not losing it. Perhaps more importantly, you preserve the ability to buy when better opportunities present themselves.”

Is this time different?

James Montier summed this question up perfectly in “Six Impossible Things Before Breakfast,” 

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 investors insist the markets are currently NOT in a bubble, it would be wise to remember the same belief was 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.”

What Rick Barry and the Atlanta Falcons can teach us about risk management

Something about the crowd transforms the way you think – Malcolm Gladwell – Revisionist History

With 4:45 remaining in Super Bowl LI, Matt Ryan, the Atlanta Falcons quarterback, threw a pass to Julio Jones who made an amazing catch. The play did not stand out because of the way the ball was thrown or the  agility that  Jones employed to make the catch, but due to the fact that the catch easily put the Falcons in field goal range very late in the game. That reception should have been the play of the game, but it was not. Instead, Tom Brady walked off the field with the MVP trophy and the Patriots celebrated yet another Super Bowl victory.

NBA basketball hall of famer Rick Barry shot close to 90% from the free throw line. What made him memorable was not just his free throw percentage or his hard fought play, but the way he shot the ball underhanded, “granny-style”, when taking free throws. Every basketball player, coach and fan clearly understands that the goal of a basketball game is to score the most points and win. Rick Barry, however, was one of the very few that understood it does not matter how you win but most importantly if you win.

The Atlanta Falcons crucial mistake and Rick Barry’s “granny” shooting style offer stark illustrations about how human beings guard their egos and at times do imprudent things in order to be viewed favorably by their peers and the public. It is this protective behavioral trait, rooted in the fear of being different, that frequently weighs on our ability to make decisions that are in our best interests. As equity markets climb to levels that have previously been associated with historic financial bubbles, and portend massive drawdowns, this article is another way of reminding investors that the ability to suppress the ego is needed if one is to mitigate the potential consequences of the current market bubble. As previously discussed in Limiting Losses, controlling drawdowns is paramount to compounding and long-term wealth accumulation.

Dan Quinn

The story of Super Bowl LI will go down as a miraculous comeback and one of the greatest games ever. It could have easily been a relatively boring blow-out, with the commercials and halftime attraction garnering the fans memories. When Julio Jones completed his astounding catch to give the Falcons a first down on the Patriots 23 yard line, Falcons coach Dan Quinn had a decision to make. It was not really a football decision but a basic judgement of risk and reward. He could conform to the conventional path and keep the drive alive in an effort to score a touchdown or he could have had quarterback Matt Ryan take a knee for three straight plays, force the Patriots to use their timeouts, and kick a field goal. With either decision, a score would have, in all likelihood, sealed a victory.

Quinn elected to go for the touchdown. Unfortunately, a quarterback sack and a holding penalty in the series pushed the Falcons backwards to midfield and turned an easy field goal attempt into a punt. The Patriots got the ball back and proceeded to tie the game, sending it to overtime where they ultimately stunned the Falcons.

Rick Barry

Malcolm Gladwell, in his podcast series Revisionist History – The Big Man Can’t Shoot, highlights how ego, pride and the opinion of the masses can prevent us from doing the right thing. The focal point of the narrative is NBA Hall of Famer Rick Barry who had a storied professional basketball career that included being named rookie of the year, 12 all-star game appearances, and an NBA championship. In 1980, at the time of his retirement, his 90% career free throw percentage was the highest in NBA history. Despite all of his accomplishments, Barry is best known by most people as the guy who shot free throws underhanded.

In 1962, Wilt Chamberlin scored 100 points in a single game, which to this day stands as a record. Less well known is that, in that same game, he made 28 free throws which is also a single game record. Chamberlin, a career 51% free thrower shooter, shot 88% from the free throw line on that record-breaking night. It was not a fluke. That was the only game of his career that he shot free throws underhanded. Despite his historic achievement that night, he never shot underhanded again. In his words:

“I felt silly, like a sissy shooting underhanded. I know I was wrong. I know some of the best foul shooters in history shot that way. Even now the best one in the NBA, Rick Barry, shoots underhanded, I just couldn’t do it.

Like Wilt, NBA legend Shaquille O’Neal (“Shaq”) was a terrible free throw shooter. Shaq shot free throws at a paltry 52% while the remainder of league averaged approximately 75% from the “charity stripe”. His shooting percentage was such a liability that, in close games, opposing teams adopted a strategy called “Hack-a-Shaq.” This strategy forced Shaq to the free throw line allowing the opposing team to take advantage of his pathetic free throw shooting. One would think that, given this glaring fault, he would welcome tips for improvement. Rick Barry once approached Shaq about trying his underhand style. Shaq’s reply was I’d rather shoot zero.”

In Gladwell’s podcast, Barry explains why shooting underhanded is not only more natural but produces a softer shot which increases the probability of it going through the hoop. Despite the rewarding mechanics behind the shot and the proven success of Rick Barry as well as others before him, Shaq, Wilt and virtually every other professional and collegiate basketball player refuse to shoot underhanded.

Gladwell gives his two cents about refusing to shoot underhanded by stating:

This is doing something dumb even though you’re aware you are doing something dumb.

Those prescient words are worth contemplating.

Connecting Field Goals and Free Throws to Investing

There are times in life when human beings are so enamored with appearances, driven by our egos and not wanting to appear different, that we do not properly consider the consequences of our actions. Some might consider “settling” for a field goal to be cowardly.  Yet, had the Atlanta Falcons coaches been able to suppress their “fears”, it is very likely they would be Super Bowl LI champions.  Taking the risk of playing for the extra four points, offered by a touchdown, cost them dearly.

Had Wilt Chamberlain been less sensitive to what other people thought and been willing to shoot under handed, he would have raised his per game scoring average by three points and would have the highest career scoring average in the NBA (assuming shooting underhanded allowed him to raise his career free throw percentage from 51% to the league average 75%).  As it stands, he is number two behind Michael Jordan by 0.05 points per game. Similarly, had Shaquille O’Neal been able to put winning above his ego, he certainly would have lead his teams to more victories and possibly additional championships.  Assuming Shaq shot underhanded and made 75% of his free throws instead of 52%, he would have raised his career scoring average by two points per game which would have vaulted him from #21 on the all-time scoring list into the top 10!

Let us consider how Quinn, Barry, Chamberlain and O’Neal reflect the consensus investment perspective. The equity market stands at valuations rarely seen before and ones that have historically been accompanied by tremendous drawdowns. Investors, failing to consider the risks, appear eager to run up the score even further. While “greed is good” as Gordon Gekko said, reaching for nickels in front of a steam roller can be hazardous to your health (and wealth). If investors are staying fully invested because they believe that valuations can stay elevated and Trump’s pro-growth policies can overcome enormous economic and political headwinds that is a highly speculative and very risky posture. However, there are likely a majority who do not understand the magnitude of risk in the markets and instead are following the herd.

If equity market valuations were to normalize, there is compelling precedence for a decline of 50% or more. One could waste precious years riding the market lower and then waiting even longer for the market to recover. One could also take some chips off the table and have those funds available in the future when the market presents a more equitable risk-return tradeoff. Investing is a long-term proposition.  Wealth is most effectively compounded when one limits their losses even at the expense of foregoing some gains.

The graph below shows that as percentage losses grow, the percentage gain required to compensate for the respective loss is increasingly larger than the loss. For example, an investor facing a 50% loss, would need to have a 100% gain to break even. Importantly, the graph does not account for the time and opportunity cost that such a process entails to say nothing of the anxiety.


I made my money by selling too soon” – Bernard Baruch

There is no doubt that the market can grind higher to more dizzying valuations. However, there is also strong historical evidence that this market will normalize to average valuations. In the wisdom of Bernard Baruch, there are times when you “make your money” by not losing it. Perhaps more importantly, you preserve the ability to buy when better opportunities present themselves.

Investors can kick the field goal, shoot underhanded, decrease their exposure to stocks and sit on unrewarding cash balances. Conversely, they can hope that the market continues to do as it has over the past eight years. Given the lesson of the last Super Bowl, is the opportunity cost of forgoing the additional gains worth the price of losing potentially much more? The media, your broker and maybe your friends will tell you to let it ride. Like Shaq, you may decide it is not worth the ridicule to be prudent. Or, like Rick Barry, you may elect to ignore popular opinion knowing excellence and results are what matter most.  Our recommendation is to weigh the benefits and consequences, do your best to ignore peer pressure and play the game to win. Save




“Every man comes to a crossroad somewhere along the way. Johnny Cash came to his crossroad in a place called Nickajack Cave.” – Gary Allan

August 1992

David Gant illegally entered Nickajack in search of giant catfish. He heard they were the biggest in the state of Tennessee.

It turned out too good to be true.

He and his friend ventured too far in while scuba diving and surfaced into a web of flooded passages. Caught in the wet death grip one of the largest, darkest hollows carved into Marion County, near the Tennessee-Georgia border.

Mind you, visitors have embarked on a Nickajack adventure as early as 1850. Union soldiers claimed the cave was 15 miles long cut by a great stream that ran the entire distance. However, in 1967 the Tennessee Valley Authority permanently flooded Nickajack and the land in front of it as they closed the gates of a new dam. Part of the reason to flood the cave was to protect the thousands of gray bats that nest inside.

David Gant and his explorer companion decided to ignore NO TRESPASSING signs and fences designed to keep visitors out.

They should have listened.

Rapidly exchanging signals, the divers dropped lower in the water and swam in the direction they thought to be out, then rose toward the surface. Dead end. The stark reality of the cavern ceiling confronted them.

At that moment, both men panicked. Their dive fins had stirred the siltation on the cave floor into a milky, murky underwater fog, cutting visibility to near zero.

They decided to separate.

The companion swam madly in one direction. Gant in another. The companion was more fortunate.

Deep inside Nickajack, David Gant was certain he was going to die. For hours – how many he could no longer say – he had been floating in darkness, stretching to keep his head above water in a pocket of air only eight inches high. It turned out to be 14 hours.

At first, blundering in this air pocket in near zero visibility had appeared to be incredibly good luck.  As time went on for what seemed like eternity, David felt like his maker had gone from savior to cruel joker.

The air in the space around him was running out; exhausted he could feel the additional effort of his lungs like a 25-pound weight on his chest. His intake felt deep but shallow at a rapid cadence as the level of carbon dioxide around David rose. Hypoxia was taking its toll.

Adventure seekers faced the jaws of Nickajack throughout history and lost their way there permanently. Destined for a hard death. Swallowed by cloying blackness. Like the world collapsing in on itself before permanent lights out.

Hundreds of Chickamaugan Indians were slaughtered there.

“The lake ran red for days,” per a confederate soldier at the time.

October 1967

“The absolute lack of light was appropriate. For at that moment I was as far from God as I’ve ever been. My separation from Him, the deepest and ravaging of the various kinds of loneliness I’d felt over the years, seemed finally complete.” – Johnny Cash in “Cash, The Autobiography.”

Weak from lack of food or sleep and overwhelmed by hopelessness due to an ongoing substance abuse problem, Johnny Cash crawled into a dark damp place to die.

It was his chance to finally end a painful addiction to amphetamines. The singer would die in the cave as it should be. A fitting end for a tormented junkie.

Or so he thought.

After hours of moving crablike on his knees, deep into the system of caves called Nickajack, batteries fading, turning to dark yellow any bright coming from his flashlight, the Man in Black grew increasingly confident he’d never find his way out. He believed he was close to the point of no return. A place where it would be impossible for searchers to rescue him.

He experienced a period of revelation (enveloped in cloying darkness can do that to a person) in that place. Johnny Cash realized that all was not lost. He was overtaken by a rush of clarity and pure inner peace. But could he find a way out? Perhaps he did too well a job at getting lost before he was found.

A calming voice seemed to come out of nowhere. It broke through the blackness like a siren. An unexplained reunion with God occurred.

It took everything he had, after three hours and almost a life lost, to find an exit.

Johnny Cash crawled flat on his belly, nothing left between his body and a damp cave floor as his shirt was scraped – torn to shreds. He felt his way slowly ahead as to not fall off a ledge into an endless pitch black.

He still had much to do with his life. Even though he purposely didn’t keep track of the path followed into the cave, the singer blindly moved toward what he hoped would be an opening – any opening.

Unusually composed, he stumbled upon slivers of hope in the forms of light and wind which eventually guided him to the wide mouth of the cave opening.

A greater force told him he must live. His life held purpose. He needed to go on. Reborn or not for JC, the demons never completely departed.

Johnny Cash spent the remainder of his life working to shackle them.

The Financial Demon In Nickajack Cave – Is Debt.

Multiple passages of debt – student loan, credit card, even mortgage, are killer blades that come out of the nowhere to cut into your net worth.

And your cash will bleed for longer than you think.

I don’t care how mortgage rates are the lowest in 50 years or a college education is worth the experience. The liabilities you incur today are laborious because the payback or the return for the debt incurred has limited positive impact.

Obviously, you’re going to carry debt. Unfortunately, many households have strayed too far into the cave.  It’s going to take years of crawling and determination to get out.

But you can get out. And it will take something close to a revelation to do it.

Even reasonable debt levels in the face of a smaller buffer in emergency savings, stagnant wage growth and ridiculous inflation in college costs, can place you in a corner, striving for Foxygen (financial oxygen).

The demon that exists in the system with us in the American Cave, as I call it, encourages us to buy, consume and use more than our income can adequately cover. Debt is a disease metastasizing through the public and private sector.

Society is addicted to debt like Johnny Cash was to little white pills. Read: The Illusion of Liquidity.

Currently, personal consumption expenditures are roughly 68% of GDP and back to pre-Great Recession levels. It seems we can’t be completely satisfied unless we’re spending. I understand. I like stuff too. Using credit makes it too easy to pull future spending into the present or make up for household cash-flow gaps due to wage stagnation.

Buy now. Pay later. It’s worked for decades. For now, let me be your light out of the debt cave, as tempting as it may be to be enveloped by its embrace.

Debt is stealth. A slow and dangerous sojourn.

How do you know if you’re lost and need an exit strategy?

From here on out, question every financial rule of thumb you’ve read or seen about how much debt you should carry. Create your own to bolster financial survival for you and your family.

Think about it:  Do you think these ‘established’ rules are designed to protect you (the borrower), or mostly to serve the lender?

Widespread financial formulas or rules of thumb seem as ancient as the stalactites which resemble icicles that hang from the ceiling of Nickajack. Many haven’t changed, even in the face of a challenging post-Great Recession landscape.

Have you run across this one? If you’ve been accepted for a loan in your life, I’m certain you have.

It’s Called The Debt-to-Income Ratio.

The formula is simple. Total all household debt monthly payments (don’t include expenses like food, gas, electricity.) Then divide the total by your household’s monthly gross income. Remember, gross income is what you earn before taxes and other deductions.

Lending institutions when deciding whether to provide you a loan, want to see your debt-to-income ratio at 43% or less. In most cases this is the highest ratio a borrower can have and still obtain a mortgage.

For example, a gross income of $50,000 a year breaks down to roughly $4,167 a month. So, $4,167 x 43% = $1,792. You’ll earn a gold star from many financial pros if you don’t exceed this debt limit.

Does this result make you feel warm and fuzzy? Or is the threshold perhaps, too generous, provide too much leeway to take on additional debt?

If you don’t maintain a year’s worth of living expenses in a cash account that’s quickly accessible, if it’s difficult to raise $400 without using a credit card if an emergency arises, or you find socking away 15% for retirement annually impossible, then yea, this rule is downright lethal.

Once income taxes and deductions for benefits like healthcare insurance are deducted from a paycheck, what’s left for many provides very little bandwidth for financial surprises. Retirement savings will suffer and you won’t be able to adequately replenish any type of emergency reserve, as I mentioned previously.

Remember this debt rule is not personalized for your household, which is why you need to take how you create it much more personal than a lender.

Unfortunately, much of the country is lost in a cave.

According to a report by the Economic Policy Institute on “The State of American Retirement,” retirement plan participation has declined across the board for several age groups and surprisingly from baby boomers closing in on retirement.

Per the EPI analysis:

“Participation in retirement plans has declined in the new millennium, with a steeper decline for workers in defined-benefit plans (401ks) than in defined-contribution plans (pensions). For families headed by working-age workers (age 32–61), participation in any type of plan fell from 60 percent in 2001 to 53 percent in 2013. We would have expected participation to increase in the new millennium as the large baby boomer cohort entered their 50s and 60s, when participation rates tend to be high.”

Incredibly eye opening is how most families possess little if any resources accumulated for retirement.

When examining median savings, which is more realistic than average since average can be skewed by above-average or ambitious savers, families between 44 and 49 years possess $6,200 in retirement savings.

Those 50-55 have $8,000 and 56-61 – $17,000.


Take a breath. Consider the severity of the situation. I know: Saving for retirement can be an incredibly daunting task. I’m looking to shake those up who resemble these families. Life-changing improvements don’t occur overnight. Just realize you’re at a financial crossroad.  if you see yourself in a similar situation, take a set period, say 3-5 years to reduce debts and then look to aggressively increase savings.

But Rich, this reduction in debt isn’t easy.

I agree. And I’m not taking away how difficult it can be to reduce debt and/or increase cash flow.

All I know is breaking your own rule (or not creating one), can lead to financial distress.

Listen, I’m not pulling punches. It’s about working your debt-to-income ratio down to 20-30% and sticking to it. This will take sacrifice, big changes, family buy in. Frankly, some may never achieve the goal. I just want to generate awareness so eventually you get as close as possible to the target.

For example, my personal debt-to-income tenet is 20% of gross income. Due to a personal setback combined with a decision to grow a business, I took a 60% household cash flow reduction that threw my rule dramatically out of whack.

Blew it out of the water in fact. My new ratio made me feel like Mr. Gant gasping, reaching for an air pocket as the debt walls closed in on me.

The life change set in motion a series of downsizing steps that lead to me moving back into a former primary residence which I used as a rental property. It’s not as convenient a commute, required a bit of renovation and not as nice as the residence I was in, but the rule is the rule.

The thought of moving was stressful but conditions changed. Ostensibly, so did I need to do the same to bolster my financial situation.

Frankly, many must find any way possible to reduce what’s paid for rent or mortgage. Even if it means downsizing a residence, or have kids share a bedroom. Whatever you need to do. If you’re ‘house poor’ you’re gonna feel like you’re dyin’ every day in four bedrooms, three baths. That sounds like a country song Johnny would record!

If you’ve crunched the numbers and the personal debt-to-income ratio result is not to your satisfaction, there are a few actions that may be considered:

Do not contribute to retirement accounts right now. If your employer provides a match to a contribution, defer enough to receive it but nothing above that point. This is not common advice. We’re told we must save for retirement no matter what. However, unless you hold at least a year’s worth of living expenses in emergency savings and your debt is under control for the most part, worrying about saving for retirement is pointless.

You must re-direct financial resources to wipe out debt, especially credit card, personal loan and auto before maximizing retirement accounts. Until you have the emergency reserves full and installment debt wiped out, just forget retirement for now. I know, unorthodox. It’s all about survival. The key is to create a two to three-year game map to complete the journey, exit the darkness.

Forget about saving for college, temporarily. Stop all contributions to custodial, 529 accounts or whatever you do to save for a kid’s college. Redirect resources to cut debt.

Find a part-time weekend gig. I know you’re exhausted and there are soccer games and football on weekends but bluntly, you may require more cash coming in to the household and wage increases have been close to non-existent and finding a new full-time position takes time.

Why not start a small business doing something you love? I have a friend who became a pet sitter on the weekends because she loves animals. She juggles about 4 dogs on average and it brings in about $500 a month. That’s $6,000 before taxes annually which helps her fill in a budget shortfall.

I know these aren’t easy answers. Only tough decisions. Decisions you perhaps never needed to make in your life.

That’s what happens when you’re lost in a cave. You’d eat your own foot to survive.

Understand there are three winding passageways deep into the debt cave. If not handled correctly, you could be dealing with a life debt and financial shortfall demons.

The entrance to the cave arteries should be emblazoned with neon, blinking signs – WARNING: STUDENT LOAN, CREDIT CARD, AND MORTGAGE DEBT AHEAD. TURN AROUND!

Yes, even mortgage debt can get you in a precarious situation if not handled correctly.

In next week’s FPW, I’ll provide steps on how to exit or prevent entrance to these dark passages.

In the meantime, conserve resources and keep fresh batteries near.

David Gant, with the help of the Tennessee Valley Authority which lowered the level of Nickajack Lake to allow rescuers in to save him, made it.

Overcome by delirium and oxygen deprivation, he asked rescuers if they were angels.

Per www.tnmagazine.org, one of the rescuers claimed – “we’ve been called a lot of things, but not angels.”

You can make it out too.

And how was Johnny Cash found?

Stay tuned.

“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.

Last week, I asked a simple question:

“Was Monday’s rally an oversold bounce or the return of the “bull market?”

As I stated then, the short-term oversold condition of the market set the stage for a rally. I updated the analysis on Saturday discussing the two possible paths of the market this week.

“As expected the market did rally last week. As I noted it would be the success or failure of the rally attempt which would dictate what happens next. 

  1. “If the market can reverse course next week, and move back above the 50-dma AND break the declining price trend from the March highs, then an attempt at all time highs is quite likely. (Probability Guess = 30%)
  2. However, a rally back to the 50-dma that fails will likely result in a continuation of the correction to the 200-dma as seen previously. From current levels that would suggest a roughly -5% drawdown. However, as shown below, those drawdowns under similar conditions could approach -15%. (Probability Guess = 70%)”

As of Friday, the market failed at resistance closing below the 50-dma for the week. As denoted by the red dashed lines, the current price action of the market being compressed within a downtrend.

A “breakout” will likely occur next week which will fulfill one of the two potential outcomes noted above. “

Chart updated through Tuesday’s open.

As noted the “breakout” did occur which sent the markets pushing back above both the 50-dma and the previous downtrend resistance from the March highs. The “short covering” surge following the French elections now puts a retest of old highs within reach. As noted last week, the oversold condition is the “fuel supply” for the rally.

“The chart below is the ratio between the 3-Month Volatility Index and the Volatility Index (VIX). As shown, when this ratio declines to 1.00, or less, it has generally coincided with short-term bottoms in the market.”

Importantly, for the roughly one-percent rally on Monday, there was a significant reduction in the “fear” of the market suggesting that while we may indeed get an attempt at old highs, it may well not be much more than that. Also, the 14-period Wm%R indicator has already swung from extreme oversold to extreme overbought with Monday’s move as well. Again, the “fuel” for the rally is being quickly absorbed which suggests a rather limited advance heading into the seasonally “weak” period of the year.

On an intermediate term basis, the market cleared the overall downtrend currently as shown below. The good news is the rally on Monday has kept the secondary “sell” signal, bottom of chart, from being registered. If the secondary signal is registered it would suggest a more cautionary approach to portfolio allocations, however, for now that is not the case. As shown below, during previous periods where both signals were in play, vertical dashed red lines, it coincided with deeper corrections, if not immediately, in the near future.  

Clearly, the bullish trend on both a daily and weekly basis remains intact. This keeps portfolio allocations on the long side for now.

Sector By Sector

With that bit of analysis in place, let’s review the market environment for risks and opportunities.


The OPEC oil cut has likely run the majority of its course and with Permian Basin production on the rise, the pressure on oil prices from supply/demand imbalances remains an issue.

However, the recent test of $48/bbl support provides a support level currently, but a break of that level will likely see oil sliding back to the low 40’s. While energy-related earnings have helped the overall S&P 500 earnings rebound over the last quarter, it is likely transient and forward earnings estimates will likely have to be ratcheted down rather sharply for the rest of the year. 

Currently, the energy sector remains in a negative trend and suggests a further decline in oil prices will likely lead the sector substantially lower. Importantly, while the sector is oversold enough for a bounce in the short-term, it is not unprecedented for the sector to remain oversold during a continued decline as the highlighted green area shows. 


The outperformance of the Health Care sector has slowed in recent weeks particularly as the risks related to the Affordable Care Act replacement continues to rise.

Current holdings should be reduced to market-weight for now with a stop-loss at $73. A correction to $71-72 would provide an entry point while maintaining a stop at $69.


As the “Trump Trade” has faltered in recent weeks, Financials have weakened. However, the recent test of support at$23 provides a tradeable entry point with a stop at that level. The sector is currently oversold on a short-term basis, and the upside is limited to $25/share at the moment.

Risk is rising in the sector as loan delinquencies are increasing and loan demand is falling. Caution is advised.


Industrials, like Financials, has seen relative performance lagging as of late as concerns over the viability of the “Make America Great Again” infrastructure plan has come into question. Importantly, this sector is directly affected by the broader economic cycle which continues to remain weak so the risk of disappointment is very high if “hope” doesn’t become reality soon.

The sector is currently overbought with little upside currently. Stops on existing holdings should be placed at $64 and reduced back to portfolio weight for now.


As with Industrials, the same message holds for Basic Materials, which are also a beneficiary of the dividend / “Make America Great Again” chase. This sector should also be reduced back to portfolio weight for now with stops set at the lower support lines $51.00.


Back in January, I discussed the “rotation” trade into Utilities and Staples. That performance shift has played out nicely and the sector is now extremely overbought.

Currently, on a risk/reward basis, stops should be placed at $50 on existing positions. Look for a correction to $48.50-$49.50 for potentially adding new positions.


Staples, have recovered as of late and are now back to extreme overbought, along with every other sector of the market. As with Utilities, set stops on existing positions at $54.50 while rebalancing current holdings back to portfolio weights.

Look for a correction to $52 to $53 before adding exposure to the sector.


Discretionary has been running up in hopes the pick-up in consumer confidence will translate into more sales. There is little evidence of that occurring currently as retail stores are rapidly losing sales and fighting the “retail apocalypse.”. However, with discretionary stocks at highs, profits should be harvested.

Trim portfolio weightings should back to portfolio weight with stops set at $86. With many signs the consumer is weakening, caution is advised and stops should be closely monitored and honored.


The Technology sector has been the “obfuscatory” sector over the past couple of months. Due to the large weightings of Apple, Google, Facebook, and Amazon, the sector kept the S&P index from turning in a worse performance than should have been expected prior to the election and are now elevating it post election.

The so-called FANG stocks (FB, AMZN/AAPL, NFLX, GOOG) continue to push higher, and due to their large weightings in the index, push the index up as well. 

The sector is extremely overbought and stops should be moved up to $52 where the bullish trendline currently intersects with the previous corrective bottom. Weighting should be revised back to portfolio weight.


Emerging markets have had a very strong performance and have now run into the top of a long-term downtrend live. The strengthening of the US Dollar will weigh on the sector and will only get worse the longer it lasts. With the sector overbought, the majority of the gains in the sector have likely been achieved. Profits should be harvested and the sector under-weighted in portfolios. Long-term underperformance of the sector relative to domestic stocks continues to keep emerging markets unfavored in allocation models for now.


As with Emerging Markets, International sectors also remain extremely overbought and unfavored in models due to the long-term underperformance. With the international sector now trading 3-standard deviations above the long-term mean, take profits and rebalance to portfolio weightings for now. 


As stated above, the S&P 500 is extremely overbought, extended and exuberant. However, with a “sell signal” currently in place, there is a reason for some near-term caution. The French Election sparked a massive short-covering rally, the big question now will be the ability for follow through. The market will need to break out to new highs to end the current consolidation process. 

Caution is advised for now.


Small cap stocks went from underperforming the broader market to exploding following the Trump election. However, as of late, that performance has stalled and the sector has lagged the broader S&P 500 index. 

Importantly, small capitalization stocks are THE most susceptible to weakening economic underpinnings which are being reflected in the indices rapidly declining earnings outlook. This deterioration should not be dismissed as it tends to be a “canary in the coal mine.” 

Currently, small caps are back to an overbought condition which suggests the current advance may be somewhat limited. Stops should be placed at $820, a break of which would suggest a much deeper reversion is in process. Reduce exposure back to portfolio weight for now.


As with small cap stocks above, mid-capitalization companies had a rush of exuberance following the election as well. However, Mid-caps are currently overbought and remain below resistance. With the risk/reward setup currently unfavorable, reduce exposure back to portfolio weight for now and carry a stop at $1675.


REIT’s have performed well despite the Fed’s ongoing rate hiking campaign. With rates now very overbought, as discussed below, take profits in REIT’s short-term and look for a pullback to trend-line support around $81 to add new positions. A stop should be placed at $80.


As expected a couple of months ago, rates fell as the economic underpinnings failed to come to fruition. However, with rates now oversold, bonds are now overbought. Look for a pullback to support on the index to $120 to add bond holdings back into portfolios. There is no reasonable stop currently for bond trading positions so caution is advised. 


As we wrap up the month of April, we now begin the march into the seasonally weaker period of the year. Therefore, there is a higher probability the current rally could fail given the ongoing debates in Washington over the debt ceiling, tax cut and infrastructure spending plans.

As noted by Nautilus Research, the markets tend to get choppy over the next couple of months.

With the understanding, we are currently on intermediate term sell-signal and overbought, the current short-term rally should likely be used for portfolio repositioning and rebalancing. However, such a statement does NOT mean “cashing out” of the market as the bull market trend remains intact. Maintain, appropriate portfolio “risk” exposure for now, but cash raised from rebalancing should remain on the sidelines until a better risk/reward opportunity presents itself.

Caution remains advised.


Just recently, I hosted the 2017-Economic & Investment Summit in Houston to discuss the markets, economy, the Fed, and the outlook ahead.

It was a great event and I very much appreciated my friends pitching in and helping me out.

  • Michael Lebowitz – 720 Global Research
  • Danielle DiMartino-Booth – Money Strong and Author of “Fed Up!”
  • Dave Collum – Professor at Columbia University
  • Greg Morris – Author of “Investing With The Trend”

The video presentations are below along with the appropriate slide presentations for viewing.

I hope you enjoy and find the information helpful and we look forward to next year as we continue to expand the line up and the information and topics covered. We hope you will consider attending if you missed this year.


Welcome, Intro & Opening Presentation On Economics, Market Cycles & Interest Rates

Slide Deck

Lance Roberts – Economic & Investment Summit 2017 Opening Presentation

Michael Lebowitz

The Virtuous Cycle & Why Valuations Matter

Slide Deck

Lebowitz – Valuations Matter & The Virtuous Cycle by streettalk700 on Scribd

Dave Collum – Professor, Cornell University

The Snowflake Generation

Panel Discussion

Left To Right: Michael Lebowitz, Lance Roberts, Danielle DiMartino-Booth, Dave Collum and Richard Rosso (Moderator)

Greg Morris

Questionable Practices

Slide Deck

Greg Morris – 2017 Economic & Investment Summit Presentation – Questionable Practices by streettalk700 on Scribd

Danielle DiMartino-Booth

Fed-Up: A Look At The Inner Workings Of The Federal Reserve

Many thanks to all of my friends for helping make the entire event a huge success. I hope you enjoy the presentations and will plan to attend next year.


I have been in the “money game” for a long time starting with a bank just prior to the crash of 1987. I make this point only to say that I have seen several full market cycles in my life, and my perspectives are based on experience rather than theory.

In 1999, there was a media personality who berated investors for paying fees to investment advisors/stock brokers when it was clear that ETF’s were the only way to go. His mantra was simply:

“Why pay someone to underperform the indexes?”

After the “Dot.com” crash in 2000, he was no longer on the air.

By the time the markets began to soar in 2007, there was a whole universe of ETF’s from which to choose. Once again, the mainstream media pounced on indexing and that “buy and hold” strategies were the only logical way for individuals to invest.

“Why pay someone to underperform the indexes?”

Then came the crash in 2008.

Today, we are once again becoming inundated with articles as to why it is “apparent” that individuals should only be using low-cost indexing strategies and holding for the “long term.” To wit:

When it comes to investing, it’s a losing proposition to try and be anything better than average.

If there’s no point in trying to beat the market through ‘active’ investing – using mutual funds that managers run, selecting what they hope are market-beating investments – what is the best way to invest? Through “passive” investing, which accepts average market returns ­(this means index funds, which track market benchmarks)”

Of course, with the market seemingly impervious to any type of serious downturn, individuals are indeed listening. Via CNBC:

“Flows out of actively managed U.S. equity mutual funds leaped to $264.5 billion in 2016, while flows into passive index funds and ETFs were $236.1 billion, according to data provided by the Vanguard Group and Morningstar. That was the greatest calendar-year asset change in the last decade, during which more than $1 trillion has shifted from active to passive U.S. equity funds.”

Of course, the next crash hasn’t happened…yet.

But therein is the point.

It is effectively the final evolution of “bull market psychology” as investors capitulate to the “if you can’t beat’em, join ’em” mentality.

But it is just that. The final evolution of investor psychology that always leads the “sheep to the slaughter.”

The Inherent Costs Of “Low Costs”

There is a “cost” to chasing “low costs” and “being average.” I do NOT disagree that costs are an important component of long-term returns; however there are two missing ingredients of “buy and hold” index investing are ignoring: 1) time; and, 2) psychology.

As I have discussed previously, the most important commodity to all investors is “time.” It is the one thing we can not manufacture more of. There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.

Individuals who experienced either one, or both, of the last two bear markets, now understand the importance of “time” relating to their investment goals. Individuals that were close to retirement in either 2000, or 2007, and failed to navigate the subsequent market drawdowns have had to postpone their retirement plans, potentially indefinitely.

While the media cheers the rise of the markets to new all-time highs, the reality is that most investors have still not financially recovered due to the second point of “psychology.”

Despite the logic of mainstream arguments that “buy and hold” investing will work, given a long enough time frame, the reality is that investors generally don’t invest “logically.” All investors are driven by “psychology” in their decision-making which results in the age-old pattern of “buying high” and “selling low.”

The biggest problem for individuals, and the culprit of the great “ETF buying panic,” is the “herding effect” as investors rush to chase market returns. The coming problem will be “loss aversion,” as the herding effect runs in reverse in the rush to get out.

The Passive Indexing Trap

Let me just clarify the record – “There is no such thing as passive investing.”  

While you may be invested in an “index,” when the next bear market correction begins, and the pain of loss becomes large enough, “passive indexing” will turn into “active panic.” 

Not surprisingly, as markets have risen, individuals begin to rationalize the current price trend will continue indefinitely. The longer the rising trend lasts, the more ingrained the belief becomes until the last of “holdouts” finally “buy in.”

We can see this in the surge of ETF flows. As the “bull market” continues to run, the more rampant the increase in flows have become. (Note – they same thing was occurring in 2005-2007.)

Of course, while it is believed that ETF investors have become “passive,” the reality is they have simply become “active” investors in a different form. As the markets decline, there will be a slow realization “this decline” is something more than a “buy the dip” opportunity. As losses mount, the anxiety of those “losses” mounts until individuals seek to “avert further loss” by selling.

There are two problems forming.

The first is leverage. 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.

However, it isn’t just margin debt which has hit record highs as of late, but “shadow margin” as well. Via Wolf Richter:

So how much margin debt is out there? We know only the $528 billion reported by NYSE. Then there are companies like Wealthfront. But it’s just small fry. Big players have been doing this for a long time. These securities-based loans (SBLs) are called ‘shadow margin,’ and no one knows how much of it is out there. But it’s a lot.

However, several advisers surveyed by The Post estimated there is between $100 billion and $250 billion in outstanding SBLs among all brokerages.

Morgan Stanley is one of the few firms that says how much in SBLs it’s sold – $36 billion, as of Dec. 31, a 26-percent increase from the year before.

Other major sellers of the loans are UBS, Bank of America, Wells Fargo, Raymond James, and Stifel Nicolaus, sources said.

If this “shadow margin” is $250 billion, it would bring total margin debt to $778 billion. That would make for a lot of forced selling.”

The second, which will be greatly impacted by the leverage issue, is liquidity of these instruments.

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?” 

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

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

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. 

If you are paying an investment advisor to index your portfolio with a “buy and hold” strategy, then “yes” you should absolutely opt for buying a portfolio of low-cost ETF’s and improve your performance by the delta of the fees. But you are paying for what you will get, both now and in the future.

However, the real goal of any investment advisor is not to “beat the index” on the way up, but rather to protect capital on the “way down.” It is capital destruction that leads to poor investment decision making, emotionally based financial mistakes and destruction of financial goals. It is also what advisors should be hired for, evaluated on, and ultimately paid for, as their real job should be keeping you out of “the trap.” 

On Tuesday, I discussed the issuance of the “weekly sell” signal and the implications for the markets over the intermediate term. However, I also stated the markets could well have a reflexive, oversold, bounce in the short-term with two potential outcomes. To wit:

By the time weekly signals are issued on an intermediate-term basis, the market is generally oversold, with ‘bearish’ sentiment increasing, on a short-term (daily) basis. Given those short-term conditions, it is quite likely the markets will rally next week.”

Chart updated through Thursday.

Of course, it is the success or failure of that rally attempt that will dictate what happens next but with the markets currently oversold, I fully expect the markets to rally in the short-term given even the most modest of positive news. For example, as what drove the spike yesterday as news filtered into the market a deal on the ACA repeal may be forming. Via HuffPo:

“GOP moderates and conservatives are nearing a deal on health care that in theory could get the Republican alternative to the Affordable Care Act out of the House and over to the Senate.”

And Steve Mnuchin’s comments on CNBC about the potential of tax reform.

“The Trump administration is close to bringing forward major tax reform, and will unveil a plan very soon.”

While the markets continue to buy into the “jawboning” for now, the economic and political realities are becoming a real risk for the markets. Furthermore, the potential for successful tax reform will be much more difficult than most are currently expecting.

Then there is the “debt ceiling” debate.

When Congress resumes next week, they will immediately pass a “One-Week Continuing Resolution” in order to buy time needed to negotiate a “CR” for the rest of the 2017 fiscal year through August. However, this negotiation will likely come at a “cost” of funding previous ACA requirements and “Planned Parenthood” which many Congressional Republicans strongly oppose.

Again, this is going to further delay “tax reform and cuts” which is what has been the driver of the market rally since last November. Therefore, the question remains:

“How much time does the Administration have to make good on its promises?”

While I do suspect there is a reasonable opportunity for the market rally to continue in the short-term, even potentially setting new highs, there are numerous issues stacking up which could lead to a market stumble this summer.

Which, historically speaking, is likely what the “weekly sell signal” in the markets is currently predicting. 

As I stated last week: Pay attention….things are getting interesting.

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



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.

Doug Kass wrote a very interesting piece this week on the bond market:

“As overvalued as I believe the U.S. stock market may be, fixed-income instruments may be even more overvalued.

Yesterday the 10-year note was yielding 2.21% — the lowest yield since last Nov. 11 — and the long bond’s yield is down to 2.88% after weak core consumer price index (CPI) and retail sales were released on Good Friday, when the markets were closed.

This decline in yield and rise in bond prices may be the last opportunity for a generation to sell fixed-income positions. Indeed, bonds may now represent the single most overvalued asset class extant.”

Before I start getting a bunch of “hate mail,” let me state that I greatly respect Doug’s opinion. In this case, however, I simply have a differing view.

Both Doug and I agree that stocks are indeed overvalued. Since investors pay a price for what they believe will be the future value of cash flows from the company, it is possible that investors can misjudge that value and pay too much. Currently, with valuations trading at the second highest level in history, it is not difficult to imagine that investors have once again overestimated the future earnings and cash flows they might receive from their invested capital.

However, bonds are a different story.

Unlike stocks, bonds have a finite value. At maturity, the principal is returned to the holder along with the final interest payment. Therefore, bond buyers are very coherent of the price they pay today, for the return they will get tomorrow. Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer is not going to pay a price that yields a negative return in the future. (This is assuming a holding period until maturity. A negative yield might be purchased on a trading basis if benchmark rates are expected to decline further and/or in a deflationary environment.) 

Given that bonds are loans to borrowers, the interest rate of a bond, at the time of issuance, is tied to prevailing interest rate environment. In this discussion, we are primarily addressing the 10-year Treasury rate often referred to as the “risk-free” rate.

However, the price of an existing bond, traded on the secondary market, is determined by the difference between the coupon rate and the prevailing interest rate for the type of obligation being considered. The benchmark rate acts as the baseline. Let’s use a very basic example.

Bond A:

  • $1000 bond bought at 100.00 (par) with a 5% coupon and matures in 12-months.
  • At the end of 12-months Bond A matures. $1000 is returned with $50 in interest or $1050 for a 5% yield.

Benchmark Interest Rate Falls To 4%

  • What is the “fair value” of Bond A in a 4% rate environment?
  • Since the coupon of 5% cannot be changed, the price must be altered to adjust the “yield at maturity.”
  • In this case, the price of the Bond A would need to rise from $100 to $101.
  • At maturity of Bond A, the principal value of $1000 is returned along with $50 in interest to the holder.
  • Since the new owner paid $1010 for the bond, there is a loss of $10 in value ($1010 – $1000) which equates to a net return of $1000 +($50 in interest – $10 loss in principal = $40) = $1040 or a 4% yield.

Got it?

The chart below shows the 10-year Treasury yield as compared to BBB to AA Corporate Bond rates. Not surprisingly, as the credit rating declines the spreads between the “risk-free” rate and the “risk” rate increases. However, with the exception of the bond market freeze during the “financial crisis,” the ebb and flow of yields primarily track the ebb and flow of the “risk-free” benchmark rate.

Since rates are generally tied to a primary benchmark, for bonds to become overvalued the benchmark rate would have to become detached from the underlying metrics that drive the level of borrowing costs.

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 and inflation. Since wage growth is what allows individuals to consume, which makes up roughly 70% of economic growth, the level of demand for borrowing is directly tied to the demand from consumption. As demand increases, businesses then demand credit for increases in capital expenditures or production. The interest rates of loans are driven by demand from borrowers. Currently, as shown below, the level of demand is consistent with the interest rates currently being charged. (Also: note the sharp drop in activity over the last several months which has been previously consistent with recessionary onsets)

Since “borrowing costs” are directly tied to the underlying economic factors that drive the NEED for credit, interest rates, and therefore bond values, can not be overvalued. Furthermore, since bonds have a finite value at maturity, there is little ability for an overvaluation in the “price paid” for a bond as compared to its future “finite value” at maturity.

As I discussed previously, the primary argument that rates must go up, is simply because rates are currently so low. That is not necessarily true. Take a look at the long-term chart of 10-year equivalent Treasury rates below. (The dashed black line is the median interest rate during the entire period.)

(Note: Notice that a period of sustained low interest rates below the long-term median, as shown in the chart above, averaged roughly 40 years during both previous periods. We are only currently 7-years into the current secular period of sub-median interest rates.)

As shown, there have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was at the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed. But that was just the start of it as innovations leaped forward as all eyes turned toward the moon.

Today, the U.S. is no longer the manufacturing epicenter of the world.  Labor and capital flows to the lowest cost providers so that inflation is effectively exported from the U.S. and deflation can be imported. Technology and productivity gains ultimately suppress labor and wage growth rates over time and debt continues to usurp capital from productive investments and savings. The chart below shows this dynamic change which begins in 1980. A surge in consumer debt was the offset between lower rates of economic growth and incomes in order to maintain the “American lifestyle.”

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. Even the Fed’s own “long run” economic growth rates currently run below 2%. Given this environment, the current level of interest rates are currently “fairly valued” based on those conclusions.

Will the “bond bull” market eventually come to an end?  Yes, eventually. However, the catalysts needed to create the type of economic growth required to drive interest rates substantially higher, as we saw prior to 1980, are simply not available today. This will likely be the case for many years to come as the Fed, and the administration, come to the inevitable conclusion that we are now caught in a “liquidity trap” along with the bulk of developed countries.

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.

Almost a year ago, we stumbled upon a topic that is currently generating much discussion in the financial media. In Mm Mm Good, published August 2016, we highlighted the Campbell Soup Company (CPB) and the utility sector to show how yield-starved investors were chasing dividend stocks to dangerously high valuations. The following quote from the article highlights the risk inherent in CPB’s valuation:

“This concept of a no-growth company with soaring valuations is alarming. The price of CPB would have to drop 30% to return to its post-recession average P/E. If that were to occur, it would take 16 years’ worth of dividend payments to recoup the price loss, assuming dividends remain stable”.

When writing that article, we assumed that a hunger for yield was the primary driver of excessive valuations in those relatively safer sectors. We did acknowledge, however, that there were other factors. Unbeknownst to us at the time, the shift from active to passive investing was one such factor playing a growing role in creating valuation divergences.

We followed up the article in November of 2016 with Passive Negligence. This sequel, of sorts, discussed valuation divergences and economic inefficiencies occurring as a result of the growing popularity in passive investing and the related decline in value/active management strategies. The following quote summed up a concern we had then and one that is even more troubling today: Typically, market index changes are the result of the movement in underlying constituents. Today, market index changes are the driver of the underlying constituents”.

Valuation Regulator

Passive index funds can play an important role in portfolio management. However, when such passive styles of investing grow in popularity to the point that they are overly influential in setting prices, problems tend to arise. In fact, the ongoing massive shift of capital toward passive strategies argues that the healthy process of price discovery is being destroyed.

Value/active managers are vital for efficient asset pricing in the long run. By simply buying what they believe to be cheap and selling what they think is expensive, they help keep valuations and fundamentals in sync over the long run. When their role is diminished, as is frequently seen in bubble manias like today, these investors lose their ability provide the market with necessary checks and balances. For example, in the late 1990’s value/active investors were eschewed in favor of those chasing technology stocks to record-breaking valuation peaks. This type of passive management created absurd pricing distortions that eventually resolved themselves when investors broadly re-awakened to the reality of fundamentals. As the bubble burst in the year 2000, the popularity of value/active investors spiked and valuations normalized.

According to Bloomberg, Vanguard, primarily a passive fund manager, saw net inflows of $2 billion a day in the first quarter of 2017. In the same quarter they raised $121 billion of new cash, beating the prior quarterly record by almost 50%. Vanguard is just one of many passive managers exhibiting massive growth. This growth is coming largely at the expense of value/active managers, the regulators of valuation.

Toilet Paper

The implications of this dynamic may be illustrated through a simple example:

Imagine walking down the paper goods aisle in your local grocery store in search of toilet paper. Instead of picking out your preferred choice you just blindly take the first one you see. This act on its own would not be meaningful, but imagine if most shoppers chose toilet paper in a similar manner. Manufacturers that produced higher quality product could lose the advantage of differentiation and their additional cost of providing a higher quality product would be wasted. In fact, the quality of the product would be irrelevant to the shopper as compared to the ease in which the product can be grabbed from shelf. Without consumers making thoughtful trade-offs between price and value, the price of all brands of toilet paper would converge, rising and falling depending only on how easy it is to grab off the shelf!

As we began the process of writing a sequel to Passive Negligence we watched a video that masterfully explains the effects of the soaring popularity of passive investing. Therefore, we decided that instead of reinventing the wheel, our readers would be best served by providing them links for the video and chart book from Steven Bregman’s presentation at Grant’s Fall 2016 Conference.

The video is courtesy Steven Bregman and Horizon Kinetics. The chart book is courtesy Steven Bregman and Horizon Kinetics as well as Grants Financial Publishing.


This topic is important if one is to understand why valuations continue to rise despite a fundamental backdrop that has historically been poor for stocks. Watching money flows to and from passive managers may very well help provide valuable insight into how much higher valuations can rise and may offer hints as to when they might begin to normalize.

Based upon the prevailing money flows, it appears few investors realize the benefit that value/active investing provides. When their role is diminished by indiscriminate buying based only on the market cap or float of a security, as is the case in passive investing, value/active investors have less influence over the price discovery process and asset valuations become broadly exaggerated.

The outperformance of passive investing strategies over active ones is a major reason for the shift in interest and money flows, but there are other reasons as well. By comparison, fees on passive strategy funds are lower than those of active strategy funds and anticipation of the Department of Justice’s Fiduciary Rule is also having an impact on retirement accounts and those who manage them. That said, active managers tend to earn their fees when it matters most to investors – by protecting wealth when it is jeopardized by collapsing markets. Passive investing has no such conscience and will offer no sympathy when the day of reckoning arrives.

Finally, Jesse Felder of The Felder Report clarified the “logic” of such decision-making in simple terms: 

“Embracing passive investing is exactly this sort of ‘cover your eyes and buy’ sort of attitude. Would you embrace the very same price‐insensitive approach in buying a car? A house? Your groceries? Your clothes? Of course not. We are all very price‐sensitive when it comes to these things. So why should investing be any different?”





If you climb a mountain for the first time and die on the descent, is it really a complete first ascent of the mountain? I am rather inclined to think personally that maybe it is quite important, the getting down, and the complete climb of a mountain is reaching the summit and getting safely to the bottom again.” – Mr. Edmund Hillary,

Hillary, a New Zealand mountaineer, was one of the first climbers to reach the summit at Mount Everest – 29,028 feet, the highest point on Earth.

If you’re bold and disciplined enough to take on unfamiliar ground, (unlike more than 200 unfortunate souls who perished, some still missing, others found frozen in a moment that greets adventurers along three rocky plateaus which lead to the dining-room table sized summit of Everest,) the retirement adventure can be one of accomplishment, self-re-discovery and spiritual fulfillment.

But there’s a catch.

The first year in retirement, the initial ascent, can change your life. On occasion, not for the better.

Like the robust explorers of Everest, retirement preparation is also crucial. However, all the training in the world, even the best of retirement planning, pales in comparison to living the experience.

So, what should new retirees know about navigating the genesis of retirement? Or let’s call it “the initial ascent.”

Here’s a quick guidebook for first time retirement climbers.

Understand where on the mountain your broker is dropping the portfolio you’re going to need to survive a retirement exploration.

Did you know that Didier Delsalle, a former French fighter pilot beat incredible odds and was the first to land a helicopter on Everest’s summit, the peak?

No kidding.

With gale forces that regularly exceed 186 mph and low atmospheric pressure that can choke off oxygen for pilot and engine, Mr. Delsalle had to employ all his years of flying experience along with acute reflexes to find pockets of downdrafts and updrafts to successfully land his aircraft on snow over rock and ice.

Frankly, only the most skillful of navigators could accomplish such a feat. And never discount good luck. That day and time found skies crystal clear and winds unusually light.

Unfortunately, there have been helicopter crashes and associated fatalities on Everest. In 2003, two people perished and several injured on a descent into Everest’s Nepal Base Camp.

At 17,598 feet above sea level, Base Camp is merely a frozen tundra pitted by a makeshift tent metropolis. A haphazard patchwork of pitched, thick fabrics provides minimal shelter against harsh conditions.

These simple structures comprised of rainbow-colored canvas and aluminum posts, bend, wave and snap, mercilessly to the elements that absorb them and yet hold steadfast like the adventurers they embrace.

This respite, one of two camps available on Everest, is also permanent home to a roomy teahouse tent where weary trekkers gather and share warmth that emanates from not only body but piping hot water steeped with fruit-flavored powders or lemon, orange and ginger for nervous stomachs.

Some travelers are restless in anticipation of the journey closer to where only Boeing’s greatest aircraft engines slice through part troposphere, part stratosphere. Others are not going to make it farther than the dreams that got them this far. A few will die in place, under ledges, quiescent, in tight fetal positions.

Most will ponder if they’ll return to their once-ordinary lives at ground level because you see, getting to the top is only half the journey and many perish on the descent, per the opening comment by Mr. Hillary.

So, if your broker decides today to land a static retirement asset allocation on the summit or a peak of price/earnings which now stands at a majestic 28.85X earnings based on the Shiller P/E Ratio, then the stock segment of the investable assets you require to survive, holds a greater probability of dying before you do, especially if entering a portfolio withdrawal stage.

In other words, the descent from that height could be a killer if you don’t consider re-adjusting your portfolio altitude to match the current cycle you’re going to be breathing through.

The first year in retirement or sooner is the time to brace the portfolio against the elements by decreasing risk, until overvalued conditions or skies, improve. And that may take years. That’s why you’ll require a financial Sherpa to help you navigate retirement mountain through year one and beyond.

You see, like massive, jagged formations of the Mahalangur Range which includes Mount Everest and its summit that bridges the international border of China and Nepal, stock market cycles are vast and span decades.

Chasms of time compress; especially when you take the span of human existence into consideration and position them atop market summits.

It’s only then does one realize how small and short human lives truly are.

As a novice retiree and feeling most exposed to harsh conditions, is when one also begins to comprehend how devastating a wealth avalanche from a peak can be to future financial health.

The first year in retirement especially, is best suited for small adventures. Think level plains over big peaks and valleys which is why, if this is the first year in or you’re two years closer to the goal, that it’s time to review or create a game plan to tackle the Everest of all life events: Retirement.

It’s normal to freeze spending but don’t let it die.

Even the finest of savers, investors and long-term planners are going to freeze up when it comes to spending during the initial stage of retirement. It’s normal. Frankly, I think it’s healthy to be overwhelmingly guarded and aware of your daily financial moxygen (money oxygen) intake and outflow.

With the assistance of a qualified professional or certified financial planner, one should enter retirement fully aware of spending guidelines and under specific conditions may they be altered.

To help retirees keep track or become fully engaged with their cash flow terrain, especially through the first year, I have newbies establish online fiscal ‘base camps’ with FDIC-insured virtual banking institutions like Ally or Synchrony and then create an electronic ‘lifeline’ connection to their brick and mortar institutions.

Fixed-dollar portfolio withdrawals are set for monthly and each quarter excess funds (and there always seems to be excess the first year) above expenses, are electronically swept into base camp bank accounts.

At the end of the year, the base camp surplus is totaled and future withdrawals fine-tuned for the ongoing quest. The base camp cash serves as a perfect buffer for unanticipated expenditures in year two.

You’ll never be completely ready until you step on to the terrain and begin the journey.

When British explorer and mountaineer extraordinaire George Mallory was asked in the early 1920s why he sought to climb Everest.

He said, simply – “because it is there.”

The rest is history.

Well, sadly, it’s unclear whether George and his partner climber Andrew “Sandy” Irvine, made it to the Summit. George’s body had been missing for over 75 years and finally discovered face down, preserved rope around his exposed, bleached white Plasticine-like torso during a May 1999 expedition.

Naturally, you should undertake formal financial planning to make certain you’re ready for retirement but that’s only part of the challenge.

The sound of your biological retirement clock will grow too loud to ignore.

In other words, the “because it’s there,” that ticks internally will gnaw at you.

I’ve witnessed the willingness to take the first step in as much as a nuance or passing thought.

For example, pre-retirees seem to sense when their employers’ plans are headed in a different direction than they are. Those I counsel often reference turbulence at work they no longer find appealing or willing to accommodate. They seek to take shelter or remove themselves from the adventure.

Stressful projects, new bosses. Changes that were easy to overcome in the past, begin to become intolerable.

If you plan accordingly for retirement, you’ll be able to control your ascent, maintain focus on an exit. You’ll be motivated to tackle the big one. There will be a sense of urgency to depart.

For example, a client who retired from a large corporation turned in his resignation one day before the executive suite announced the sale of the finance unit he had worked in for 16 years.

That’s the uncanny sixth sense I’m talking about. Be open to the message. But you need to listen and pay heed to the emotional fortitude that once compelled a young English adventurer to take on a monumental endeavor.

“Because it is there.” 

So, if or when asked – How did you know you were ready to retire?” And you readily respond yet slowly, “because I knew I was ready.”

That’s all you’ll require. Simple as that. 

Solid finances may be the finest of equipment for the journey, but without the guts to utilize that equipment, retirement is not a life warmly lived but a prolonged period of freeze and inertia.

However, it’s acceptable to be fervently cautious the first year into the retirement voyage to avoid a possibly impetuous reach to accomplish everything on the bucket list.

Perhaps George was a bit too ambitious and he suffered a frozen fate for it.

The first year of retirement can feel as emotionally challenging to overcome as a great mountain.

And to think the peak of Mount Everest was once the bottom of the ancient Tethys Sea. As subcontinental and continental plates collided 30-50 million years ago, the surface rose and became the highest point on Earth.

Emotionally, financially, possibly spiritually, you were there too. So many years ago.

Down below then, now high above.

You’re ready to harvest the zenith of hard work and discipline.

Go for it.

“It is not the mountain we conquer, but ourselves.”  – George Mallory. 

“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.

In this past weekend’s missive, “Markets Go On Alert,” I stated that due to the oversold condition of the market on a very short-term basis, a rally was due this week. To wit:

IMPORTANT: By the time weekly signals are issued on an intermediate-term basis, the market is generally oversold, with ‘bearish’ sentiment increasing, on a short-term (daily) basis. Given those short-term conditions, it is quite likely the markets will rally next week.”

Chart updated through Monday’s close.

“IMPORTANT: It is the success or failure of that rally attempt that will dictate what happens next.

  1. If the market can reverse course next week, and move back above the 50-dma AND break the declining price trend from the March highs, then an attempt at all time highs is quite likely. (Probability Guess = 30%)

  2. However, a rally back to the 50-dma that fails will likely result in a continuation of the correction to the 200-dma as seen previously. From current levels that would suggest a roughly -5% drawdown. However, as shown below, those drawdowns under similar conditions could approach -15%. (Probability Guess = 70%)”

I have denoted both setups in the chart above. The downtrend resistance from the March highs is quite evident as well as the 50-dma resistance at 2353 currently. Furthermore, as noted, the oversold condition has provided the “fuel” for a reflexive, “oversold,” bounce.

The chart below is the ratio between the 3-Month Volatility Index and the Volatility Index (VIX). As shown, when this ratio declines to 1.00, or less, it has generally coincided with short-term bottoms in the market.

It is worth noting that in several cases, these “oversold” conditions were generally precursors to a future decline.

But how can we tell the difference?

This is where we have to step away from a very short-term view and move to an intermediate-term perspective. The chart below is essentially the same as above but the data is weekly, versus daily, which reduces some of the “noise.”

As shown, when the volatility ratio has hit low levels previously, the determination of whether the subsequent rally failed or succeeded was dependent upon how “overbought or oversold” the market was at the time of the volatility ratio low. If the volatility low was hit with the market still primarily overbought, a subsequent decline in the markets tended to follow. The best buying opportunity came when the volatility low coincided with an oversold condition in the market on a weekly basis. Such is not the case today. 

Does this mean the market is about to crash? No.

However, it does suggest that as we wrap up the “seasonally strong” period of the year, the markets may run into some trouble this summer given the recent rise in uncertainty in both the geopolitical and fiscal policy backdrop.

As I noted in my recent presentation at the 2017 Economic and Investment Summit, the main support for stocks has been the hopes of tax reform, tax cuts, and infrastructure spending. Given the current problems in Washington D.C. in getting legislative agenda agreed to by Congressional Republicans, delays should be expected. 


The question, of course, is just how much time the markets will give Washington to make progress on legislative agenda? As noted above, the estimates currently driving stocks were based on tax cuts being brought through to boost bottom line profitability. If those cuts don’t happen soon, earnings disappointments may bite investors. 

A look at the weekly internals of the market shows some notable deterioration in both the advancing-declining issues and volume. With a weekly “sell” signal in place for the NYSE Advance-Decline line, it suggests more weakness ahead.

Importantly, given these are weekly signals, it does NOT MEAN stocks can’t rally in the short-term. It simply suggests there is selling pressure on stocks the path of least resistance currently is lower.

If we apply a Fibonacci retracement to a weekly chart, shown below, a correction to the first retracement level would take the market back to 2208. While the Williams %R at the top, and the Full Stochastics at the bottom, are effectively the same measure, they tell us two things.

  1. The market, on a weekly basis, is very overbought.
  2. The weekly “sell” signal combined with the overbought condition suggests a move to the first retracement level is possible over the course of the next few weeks.

Again, while a short-term bounce in likely given the recent sell-off, it will require a move to new highs to reverse the currently more “bearish” dynamics at work in the market. 

Bulls Still In Charge

The good news for the bulls is that on a long-term, monthly basis, the ongoing bull market remains intact for now. As noted below by the vertical blue dashed line, the monthly “buy signal” that was registered at the end of 2010, as the market moved above the long-term supportive trend line going back to 1965, remains for now. However, given the current extension of the market, and the deviation between the current price and long-term average, a reversion to the mean could be quite painful while the market remains within the “confines” of a bullish trend. 

More importantly, as denoted by the red circles, the market is currently trading 3-standard deviations above the long-term average. This has only happened a few times in history and has generally preceded a rather sharp correction in the not too distant future.

Conclusion & Suggestions

With the seasonally strong period of the market coming to its inevitable conclusion, geopolitical tensions rising, economic data trending weak and fiscal policy in a bit of a disarray – it may be time for investors to rethink levels of risk exposure in their portfolios currently.

As I stated at the beginning of March, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios back in January as well. (I update our portfolio strategy in the weekly newsletter.)

Given the weekly “sell” signals currently in place, the recommendation to rebalance portfolio risks remains. Here are the guidelines I recommended previously:

Step 1) Clean Up Your Portfolio

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have been big winners
  3. Sell laggards and losers
  4. Raise cash and rebalance portfolios to target weightings.

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas requiring new or increased exposure.
  2. Determine how many shares need to be purchased to fill allocation requirements.
  3. Determine cash requirements to make purchases.
  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
  5. Determine entry price levels for each new position.
  6. Determine “stop loss” levels for each position.
  7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are looking for a rally to reduce the oversold condition of the market and allow for a better opportunity to rebalance equity risk.

As noted in yesterday’s missive on 10-Investment Wisdoms:

“The absolute best buying opportunities come when asset holders are forced to sell.” – Howard Marks

But you can’t buy low, if you didn’t sell high to raise the cash, first.

Stay alert…things are finally getting a lot more interesting.


Throughout history, investors have repeatedly made the same investment mistakes. Whether it was selling at the bottom of major market corrections, or buying near the peaks of the next cyclical bull market, the results have, for the most part, been generally the same.

I have written many articles previously on 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.

One of the biggest problems with “buy and hold” investment advice is what I call a “duration mismatch.” The issue that arises is individuals do not necessarily have the “time” to achieve the long-term average returns of the market.

“Most have been led believe that investing in the financial markets is their only option for retiring. Unfortunately, they have fallen into the same trap as most pension funds which is hoping market performance will make up for a ‘savings’ shortfall.

However, the real world damage that market declines inflict on investors, and pension funds, hoping to garner annualized 8% returns to make up for that lack of savings is all too real and virtually impossible to recover from. When investors lose money, it is possible to regain the lost principal given enough time, however, what can never be recovered is the “time”  lost between today and retirement. “Time” is extremely finite and the most precious commodity that investors have.

In the end – yes, emotional decision making is very bad for your portfolio in the long run.

Emotions and investment decisions are very poor bedfellows. Unfortunately, the majority of investors make emotional decisions because, in reality, very FEW actually have a well-thought-out investment plan including the advisors they work with. Retail investors generally buy an off-the-shelf portfolio allocation model that is heavily weighted in equities under the illusion that over a long enough period of time they will somehow make money. Unfortunately, history has been a brutal teacher about the value of risk management.”

Importantly, I am NOT ADVOCATING, and never have, “market timing” which is being “all in” or “all out” of the market. Such portfolio management can not be successfully replicated over time.

What I am suggesting is that individuals CAN MANAGE THE RISK in their portfolios to minimize the destruction of capital during market downturns. 

It is important to remember that we are not investors. We do not control the direction of the company, their management decisions or their sales process. We are simply speculators placing bets on the direction of the price of an electronic share that is heavily influenced by the “herd” that makes up the markets.

More importantly, we are speculating, more commonly known as gambling, with our “savings.” We are told by Wall Street that we “must” invest into the financial markets to keep those hard-earned savings adjusted for inflation over time. Unfortunately, due to repeated investment mistakes, the average individual has failed in achieving this goal.

With this in mind, this is an excellent time to review 10 investment lessons from some of the investing legends of our time. These time-tested rules about “risk” are what have repeatedly separated successful investors from everyone else. (Quote source: 25IQ Blog)

1) Jeffrey Gundlach, DoubleLine

“The trick is not only to take risks and be paid for taking those risks, but to take a diversified basket of risks in a portfolio.”

This is a common theme that you will see throughout this post. Great investors focus on “risk management” because “risk” is not a function of how much money you will make, but how much you will lose when you are wrong. In investing, or gambling, you can only play as long as you have capital. If you lose too much capital but taking on excessive risk, you can no longer play the game.

Be greedy when others are fearful and fearful when others are greedy. One of the best times to invest is when uncertainty is the greatest and fear is the highest.

2) Ray Dalio, Bridgewater Associates

The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.”

Nothing good or bad goes on forever. The mistake that investors repeatedly make is thinking “this time is different.” The reality is that despite Central Bank interventions, or other artificial inputs, business and economic cycles cannot be repealed. Ultimately, what goes up, must and will come down.

Wall Street wants you to be fully invested “all the time” because that is how they generate fees. However, as an investor, it is crucially important to remember that “price is what you pay and value is what you get.” Eventually, great companies will trade at an attractive price. Until then, wait.

3) Seth Klarman, Baupost

“Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”

Investor behavior, driven by cognitive biases, is the biggest risk in investing. “Greed and fear” dominate the investment cycle of investors which leads ultimately to “buying high and selling low.”

4) Jeremy Grantham, GMO

“You don’t get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it.”

Successful investors avoid “risk” at all costs, even it means underperforming in the short-term. The reason is that while the media and Wall Street have you focused on chasing market returns in the short-term, ultimately the excess “risk” built into your portfolio will lead to extremely poor long-term returns. Like Wyle E. Coyote, chasing financial markets higher will eventually lead you over the edge of the cliff.

5) Jesse Livermore, Speculator

“The speculator’s deadly enemies are: ignorance, greed, fear and hope. All the statute books in the world and all the rule books on all the Exchanges of the earth cannot eliminate these from the human animal….”

Allowing emotions to rule your investment strategy is, and always has been, a recipe for disaster. All great investors follow a strict diet of discipline, strategy, and risk management. The emotional mistakes show up in the returns of individuals portfolios over every time period. (Source: Dalbar)

6) Howard Marks, Oaktree Capital Management

“Rule No. 1: Most things will prove to be cyclical.

Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.”

As with Ray Dalio, the realization that nothing lasts forever is critically important to long-term investing. In order to “buy low,” one must have first “sold high.” Understanding that all things are cyclical suggests that after long price increases, investments become more prone to declines than further advances.

7) James Montier, GMO

“There is a simple, although not easy alternative [to forecasting]… Buy when an asset is cheap, and sell when an asset gets expensive…. Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance.”

“Cheap” is when an asset is selling for less than its intrinsic value. “Cheap” is not a low price per share. Most of the time when a stock has a very low price, it is priced there for a reason. However, a very high priced stock CAN be cheap. Price per share is only part of the valuation determination, not the measure of value itself.

8) George Soros, Soros Capital Management

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

Back to risk management, being right and making money is great when markets are rising. However, rising markets tend to mask investment risk that is quickly revealed during market declines. If you fail to manage the risk in your portfolio, and give up all of your previous gains and then some, then you lose the investment game.

9) Jason Zweig, Wall Street Journal

“Regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”

The chart below is the 6-year annualized inflation-adjusted rate of change of the S&P 500 index going back to 1900. The power of regression is clearly seen. Historically, when returns breached 133% it was not long before returns started falling and reverted below 0%. 

10) Howard Marks, Oaktree Capital Management

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.

The biggest driver of long-term investment returns is the minimization of psychological investment mistakes. As Baron Rothschild once stated: “Buy when there is blood in the streets.” This simply means that when investors are “panic selling,” you want to be the one that they are selling to at deeply discounted prices. The opposite is also true. As Howard Marks opined:

“The absolute best buying opportunities come when asset holders are forced to sell.”

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 to manage the inherent risk.

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

As I stated at the beginning of this missive, “Market Timing” is not an effective method of managing your money. However, as you will note, every great investor throughout history has had one core philosophy in common; the management of the inherent risk of investing to conserve and preserve investment capital.

“If you run out of chips, you are out of the game.”



In my money management process, portfolio “risk” is “ratcheted” up and down based on a series of signals which tend to indicate when market dynamics are either more, or less, favorable for having capital exposed to the market. This model is published each week in the Real Investment Report as shown below:

As you will notice, portfolios NEVER reach 100% cash levels. The reason is purely psychological. Once individuals go to 100% cash, it is extremely hard to re-enter back into the markets. I learned this lesson in February 2009 when I wrote the article “8-Reasons For A Bull Market” which stated:

“Any weakness next week will most likely warrant a push down to 800 for first support and then the November lows of 750.   We believe that these lows will hold although we are aware that if the market doesn’t get ‘it’ together soon further weakness could show itself. 

We are cautious here and still holding on to a lot of cash waiting for some signal that the market is making a turn for the short term to the better. March, April, and May tend to be fairly strong months for the market and any ‘real’ assistance next week for homeowners could push the markets higher. A move above 900 will be a signal for a move higher in the markets.

Of course, the market bottomed on March 9th at 666 and never looked back as over $33 Trillion in various bailouts, workouts, subsidies, and QE followed.

However, when the markets bounced above 900, suggesting it was time to re-enter the market, I faced extremely tough resistance from clients. I learned maintaining a small slug of exposure, which can be completely hedged, it becomes far easier to add to an existing position as improvement can already be seen. 

So, why do I bring this up?

Because the market has now tripped the first signal as shown above, and below, sending a warning that further weakness could ensue. With the first signal registered, combined with a break of the 50-dma, it puts us on “a signal-1 alert.”

With portfolios already hedged, as we added a lot of bond and interest rate sensitive holdings back in January, there is no action to take currently. This is why, for now, it is only an “alert” that something more important is developing.

The bullish trend remains intact, and the two primary signals (2 & 3), which would initiate further equity reductions, remain on “buy signals” currently.

With the markets getting oversold and “bearish” sentiment increasing on a short-term basis, it is quite likely the markets will rally next week. It is the success or failure of that rally attempt that will dictate what happens next. However, as noted by the “red vertical” lines above, previous weekly “sell” signals have typically devolved into more substantial declines.

Pay attention….things are getting interesting.

In the meantime, here are some things to read over the long Easter weekend.


Illusion Of Liquidity


Point-Counter Point

Research / Interesting Reads

“Knowledge of financial history is critical to successful investing” – Larry Swedroe

Questions, comments, suggestions – please email me.

I thought the following quote from Janet Yellen’s Q&A at the University Of Michigan this week was interesting regarding the lessons I thought were learned from the financial crisis.

“First, we supervise banking organizations and some other financial enterprises to make sure that they operate in a safe and sound fashion. Second, we monitor potential threats to financial stability. We certainly don’t want to have another financial crisis and we want to redress threats in the environment that could lead to one. We had a system in which banking organizations were not monitoring and controlling risk appropriately. They had too much capital and were overleveraged.”

Silly me.

While talk is cheap, the reality is the Federal Reserve fostered another surge in leverage by promoting and maintaining “accommodative” policies for far too long. The chart below is the aggregate of corporate, consumer, margin and banking debt in billions. I have excluded governmental debt so we can focus on the leverage in the economy. I have added GDP for comparative purposes.

It is worth noting that from 1959 to 1983, it required roughly $1 of debt to create $1 of economic activity. However, as I have discussed previously, the deregulation of the financial sector, combined with falling interest rates, led to a debt explosion. As shown below this debt explosion, which allowed for an excessive standard of living, has led to the long-term deterioration in economic growth rates.

If we add governmental debt, student loan debt, and entitlements into the equation, the problem gets far worse. 

However, the point I want to address here is the level of debt in the system which has once again reached new records since the financial crisis.

What could possibly go wrong this time?

There is an inherent belief that corporate and bank balance sheets are in much better shape today than they were in 2007. While I will not argue that banks are indeed on better footing, the repeal of FASB Rule 157 allowed banks to “mark assets to fantasy,” which vastly improved their balance sheet health.

The question that should be asked of Ms. Yellen is simply:

“After trillions in various bailouts of the financial system, and claims the ‘health’ of the financial system is good, why does FASB Rule 157 still remain repealed?”

The answer is simple.  The “health” of the financial system may not be as strong as advertised.

But I digress.

As debt levels increase, the servicing of that debt diverts capital from productive investment. Furthermore, the use of debt as it relates to “current” consumption, which is 70% of economic growth, is “future” consumption denied.

In other words, individuals use debt to pull “forward” consumption which leaves a “void” in the future. However, since “debt accumulation” is “finite,” there is a point to where excess debt is resolved through default, write off, or bankruptcy as witnessed during the “financial crisis.”

It is this accumulation of debt which has provided a dangerous illusion of liquidity. 

But it may be showing signs of coming to an end.

The chart below shows bank loans and leases as well as bank reserves held at the Fed. The precipitous drop is somewhat concerning. Commercial bank reserves held at the Fed have dropped by -20% from the peak of $2.79 trillion in 2014 to $2.23 trillion currently. Also, as shown, the drops in reserve balances has also corresponded to declines in 10-year rates as well. The recent drop in rates from 2.6% a month ago to 2.3% on Tuesday will likely see reserve balances decline in the next data update.

Furthermore, the year over year change in Commercial Bank loans and leases has dropped by almost half from the narrow range of 7.6% to 8.0% that prevailed from Jan. 2015 to Sept. 2016 to the current level of 3.8% currently which is at the level that preceded the past two recessions.  Also, the annual change in Commercial Bank Deposits held at the Fed has dropped by more than one-half from the recent high of 10.3% in 2012 to 4.8% currently.

As my “Canadian economist” (I know, two strikes already) friend, Gerry O’Brien, pointed out:

“The deteriorating trends in Commercial Banking activity is important, especially when combined with the Fed’s indication from their recent FOMC minutes they are considering plans to begin reducing their balance sheet this year. Their ongoing march to hike rates, and now potentially reduce liquidity, suggests a rapid reduction in liquidity which will hit stocks and interest rates this year.”

Don’t dismiss the importance of that statement.

When looking at the Fed balance sheet from a long-term view it only APPEARS to have flattened compared to the massive increases that were taking place previously. Of course, given the recent spike in the market since the election, many have assumed the liquidity push by the Fed has been replaced by stronger earnings and economic growth expectations.

Not so fast.

If we zoom in we can see the reinvestment process taking place by the Fed which continues to provide support for assets prices though continued injections of liquidity into the system, albeit at a much lower pace.

To be clear, I am not suggesting this is the ONLY catalyst to the rise in the market since the election. Clearly, the return of “exuberance” due to the “expectations” of tax cuts, repatriation, and infrastructure have led to a surge in optimism along with numerous other factors like an extremely warm winter and a restocking cycle driven by a coming increase in logistic rates. However, “expectations” have gone unfulfilled and the restocking cycle to beat a price hike has likely come to an end. This puts the Fed in a precarious position of tightening monetary policy without a fiscal policy offset.

Of course, it is not just the Fed slowing the rate of liquidity but also the Central Banks of England and China.

With the Bank of Japan and the European Central Bank recently hinting at they may also begin to “taper” their respective liquidity driven operations, all of this suggests the illusion of liquidity may be starting to evaporate.

Rates Below 1% As Stocks Get Hit

The illusion of liquidity has a dangerous side effect. The process of the previous two debt-deleveraging cycles led to rather sharp market reversions as margin calls, and the subsequent unwinding of margin debt fueled a liquidation cycle in financial assets. The resultant loss of the “wealth effect” weighed on consumption pushing the economy into recession which then impacted corporate and household debt leading to defaults, write-offs, and bankruptcies.

With the push lower in interest rates, the assumed “riskiness” of piling on leverage was removed. However, while the cost of sustaining higher debt levels is lower, the consequences of excess leverage in the system remains the same.

Outside of other events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. which all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. Given the current low level of interest rates, the next recessionary bout in the economy will very likely see rates approaching zero.

Furthermore, given rates are already near zero in many parts of the world, which will likely go negative during a global recessionary environment, near zero yields will still remain more attractive to foreign investors. This will be from both a potential capital appreciation perspective (expectations of negative rates in the U.S.) and the perceived safety and liquidity of the U.S. Treasury market. 

Lastly, my recent points on current levels of volatility, and the expectation of a reversal, also support the idea of lower interest rates. As I stated:

“In my opinion, there seems to be a higher than normal probability that volatility will take a turn higher sooner rather than later. As such as I have added a net long position in portfolio betting on a rise to hedge against the coincident decline in my net long equity holdings at the current time.” 

Not surprisingly, increasing rates of volatility that coincide with declines in asset prices have also coincided with declines in interest rates.

The chart below shows the historical correlation between bonds and stocks. Since the turn of the century, the “risk on/off” trade can be clearly seen. However, beginning with QE3 in 2013, that historical correlation was broken but now looks like to be returning back to historical norms. With volatility low and the stock/bond ratio at historically high levels, the reversion of those two indicators has historically led to substantially lower yields. 

Here is the point, while the punditry continues to push a narrative that “stocks are the only game in town,” this will likely turn out to be poor advice. But such is the nature of a media driven analysis with a lack of historical experience or perspective.

From many perspectives, the real risk of the heavy equity exposure in portfolios is outweighed by the potential for further reward. The realization of “risk,” when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.

In other words, I get paid to hedge risk, lower portfolio volatility and protect capital. Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.

In the short-term, the market could surely rise. This is a point I will not argue as investors are historically prone to chase returns until the very end. But over the intermediate to longer-term time frame, the consequences are entirely negative.

As my mom used to say:

“It’s all fun and games until someone gets their eye put out.” 

Real Investment Advice welcomes Ben Masters to our growing list of contributors. Benjamin Masters is the creator, designer, and writer for Third Wave Finance, With over ten years of experience working as a lead Portfolio Analyst, Ben brings additional insights into the discussion of economics, markets and portfolio management.

One of the common side effects of debt-fueled speculation/spending is financialization, and one should immediately look to the growth and prominence of the financial industry (since the 1980s) with alarm, hesitation and concern; how and why is it that an industry that produces no physical product has grown to its current size?  After all, the financial industry exists as a non-production-utility — its very purpose is to properly allocate capital and resources to desirable (in-demand) industries; it’s an industry whose very existence relies on the success of other industries. If the financial industry is able to properly allocate capital/resources to desirable industries, it’s rewarded and is able to grow along with those other fundamental industries; and if a misallocation occurs, capital/resources are allocated to (and used up by) unsuccessful industries — those industries then shrink, along with the finance industry and economic growth.

The concern then is that if a general “hollowing out” of production occurs in a country — something that is rarely disputed these days when addressing U.S. industry — this would typically result in a smaller financial industry, not a larger one; yet the explosion of growth in the finance industry since the 1980s has been in stark contrast.  Why is this?  Put simply, debt-fueled investment speculation and debt-based spending has exploded since the 1980s.

Debt-fueled investment speculation can be seen in this visual of the three instances of the 21st century where long-term returns for stocks have been reduced — each peak fueled by different forms of speculation that ensure low future returns:

Tradable securities far outpacing economic growth…

The three speculative episodes of the 21st century, and dangerous transition periods…

Each of these speculative episodes have been addressed in The Orchestration of Debt-Based Expansions; and the topic of debt-based spending (pursued since the 1980s) has been written about as well, and includes government debt and consumer debt (mortgages, credit cards, student loans, car loans, borrowing to supplement falling incomes, etc.): see Debt LevelsWhy does college cost so much?Why doesn’t anyone earn anything in a bank account anymore?, and Income Stagnation.

The dilemma is that debt temporarily inflates the price of desirable assets (until the point in time where that debt needs to be paid back), and if a majority of the economy has debt that needs to be paid back economic growth is constrained — at some point in time those individuals are paying back loans instead of boosting economic growth through spending.  And if the majority of the economy has unproductive debt (debt that has not created an income stream to repay the principal amount borrowed and interest on the debt) then defaults, write-downs, etc. have a punishing affect on the economy and financial system.

For many, that punishing affect is a destruction of investments (which are not the same as wealth… see Fundamental Wealth).  Their “assets” evaporate, prices plunge, and they don’t know why…  The reason that assets vanish in a market crisis is because debt is always considered an asset by the issuer, yet in reality debt isn’t always an asset for the issuer; there are improper claims of assets — assets that don’t exist (loans that won’t be able to be paid back).  In effect, there are claims of assets (and securities issued on those “assets”) that outnumber the actual underlying assets.

It’s the financialization due to debt/leverage/speculation — the adding of layers and complexities — that can lead to a weakening of the market structure; one need only look to Charles Kindleberger’s work Manias, Panics, and Crashes to see how this process has unfolded over and over throughout history.

“Speculative manias gather speed through expansion of money and credit. . .there are many more economic expansions than there are manias.  But every mania has been associated with the expansion of credit.  In the last hundred or so years the expansion of credit has been almost exclusively through the banks and the financial system.

In boom, entropy in regulation and supervision builds up danger spots that burst into view when the boom levels off.” – Charles Kindleberger

And so financialization — the prominence of the finance industry and the growing dominance of obscure types of investments (many of which are simply more expensive packages of existing investments) — is made plain and clear: since the 1980s, it has grown due to temporary debt-based investment speculation and debt-based spending.  And although financialization is temporary (debt constraints eventually cause a readjustment), the real danger is that the temporary misallocation-of-wealth that occurs rewards the financial industry in a boom/bust cycle; wealth and capital that would have been used in other in-demand industries (had productive debt been pursued) is instead concentrated and used up in the financial industry, and when coupled with the ability to influence politics this temporary reward/misallocation can cause a further entrenchment of the undeservedly rewarded industry — a further misallocation of wealth.

Said in 2009 by Jeremy Grantham, co-founder and chief investment strategist of Grantham, Mayo, & Van Otterloo — one of the largest investment companies in the world…

“I’d like to challenge the usefulness — not just of new instruments — but of large tracts of the whole financial industry, much of which is a net drag.  Let’s start with the investment management business, because I think intuitively, obviously, you can see that we collectively add nothing.  We produce no “widgets”, we shuffle the existing value of all corporations and bonds around, in a cosmic poker game.  At the end of each year, the investment community is down by one percent (cough)…the individual is down by two, and aggregate fees have steadily grown.  As we grew by ten times from ’89 to ’99 huge economies of scale were existing, but the fees-per-dollar-managed grows — no fee competition at all, contrary to theory.  Why?  Agency problems, asymmetry of information, the client can’t tell talent from luck or risk taking, and as we add new products (options, futures, CDOs, hedge funds, private equity) aggregate fees rise as a percentage of assets; there becomes a layer of fees and another layer of agents and fees — the more complicated and opaque, the more the client need us. . .

As fees go up by half-a-percent, we reach into the client’s balance sheet, snatch the half-a-percent, and turn it into income; it’s almost magic — capital into income… but we lower the savings rate of our clients (savings and investment rate) by half-a-percent as our fees go up, so we get short term GDP kick from our income, at the expense of lower long-term growth on the part of the system.  Similarly with the whole financial system… let us say by 1965 (the best decade we ever had, the ’60s) there was a very financial financial-service arrangement — enough banking, enough letters of credit, to get the job done.  

Adequate tools are vital — that’s not the issue.  We’re talking the razzmatazz of the last ten or fifteen years…  The financial system was 3% of GDP in 1965 — it’s now 7 1/2; this is an extra 4% load that the real economy carries.  The financial system overfeeds and slows down the real economy.  The first hundred years, up to 1965, the economy was like a battleship, growing at 3.5% a year.  Even the great depression bounced off it.  After 1965 the GDP (ex-financials) grew at 3.2; after 1982, at 3.1; after 2000, at 2.3; all of these to the end of ’07 (not including the current problems).  From society’s point of view this 4% works like looting, or an earthquake — both increase GDP short term, but chew up capital.  They might as well be retirees or children — all these extra people in the financial business— but they are much, much more, expensive.  

Economists have not studied the optimal size for finance — indeed, a learned journal recently rejected a paper on the grounds that finance does not comment on social utility; that is perhaps why the risks are little.  

The underlying problem recently has been touching faith in capitalism, this faith was based on 50 years of a dominant economic theory that was shockingly not based on facts but on unestablished, unprovable, assumptions: “rational expectations” — this has given us efficient markets. So why regulate new instruments, if capitalism and markets are efficient?  Or why regulate anything?  So Greenspan, Rubens, Summers, and the SEC, happily beat back Brooksley Borne trying to regulate new instruments. But as Keynes knew in 1934, markets are behavioral jungles, racked by changing animal spirits, and by agency problems.  Efficient markets assume symmetry of data on all sides.  In real life, agents have all the data and the principal clients know little. It’s like taking candy from babies, the more opaque and complicated the new instruments, the easier the ripoff.  There is now — at LSE [London School of Economics] — a Centre for the Study of Capital Market Dysfunctionality, started by my former colleague, Paul Woolley, that is even now, attempting an academese, to establish that in the real world condition, agents in finance tend towards getting everything.” — Jeremy Grantham, 5:33 mark of 2009 Buttonwood Gathering

July 10, 1877: How can there be so much blood? John knew what he was seeing wasn’t good. Blood this dark meant something serious; something arterial hit by the bullet. Heavy twill pants went saturated so quickly they might as well have been made of cheap linen. 

A shaken, ashen-faced 30 year-old John Hardeman tried to remain calm.

He falsely assured his brother all would be well as William Hardeman bled to death in the gravel of a red-dust main street. The ground was so parched William’s life liquid didn’t soak in, it pooled in a warm bubble underneath him.

Nowhere to go, it rose and spread, beaded over the grit – light red, then dark to black.

Like Texas crude rising from below.

“Get that dyin’ man out of the street, it’s bad for business!” bellowed “Rowdy Joe” Lowe who operated the only gambling house in town…

Allegedly the shooting was over an unpaid gambling debt. Justice swiftly rendered.

For decades, the dusty mecca of Luling, Texas (pop. 5,500) has celebrated all that is cold, wet and sweet through its annual watermelon thump. Once coined the “toughest town in Texas,” Luling was initially known as a center-point rest-and-rambunctious stop for cattle drivers along the Chisholm Trail.

It’s sort of odd it would become associated with anything as sweet and refreshing as ripe watermelon but so it goes in Texas.

An acrid odor arises from oil pumps, punches the stillness, (I’m told it’s gas) and irritates the nostrils. The faint aroma of metal grind on metal as the railroad, along with an ear-piercing whistle, rolls through frequently and mixes with the fragrance of barbecue that rises and suspends in smoke-filled gossamer ribbons.

Luling’s era as a hub for heavy commerce and cattle are long gone. Yet warm shadows of the past embrace the inevitable invasion of the present. They cast vigilant shade. Progress is allowable only to a point, never enough to shut out the light of what was.

Current residents are far from back woods. There’s a clothesline here and there with large overalls hanging, I’ll give you that.

Most dwellings are not much to view. They’re worn from constant heat. Need work. Sun-faded remnants of outdoor plastic toys litter front and back yards.

A tattered couch on a porch catches the eye.

There exist old majestic structures that gleam white and border the center of town beautifully preserved. The history in the walls is nurtured. Artistry lives in the wood, expansive porches, columns that guard grand entrances halls.

Ordinary episodes of daily life strain through a time warp – polite words travel along bands of narrow streets within this close-knit town webbed to a rail line. When trains run, a round sound of train whistle sepia tones the sky.

Clouds halt above. The current year fades in decade drips.

The signs of enlightenment are there for those open enough to accept them. The teachings carry strong on the smell of industry, the local smoked cuisine and in the sweetness of carnival caramel corn. White-hot brick walls and penetrating sunlight can’t stop history from fading. And for this I’m grateful.

True: Folks are comfortable with rusted memories of accomplishments long ago although they seem fine to allow the past to co-exist. In fact, they relish and celebrate the idea, especially when the thump raises Luling’s map dot even if it’s for only for a few days.

Otherwise, not much happens. And I’m being polite. I mean nothing absolutely happens here. Just living and dying in a small town. Naturally, football pride (Friday Night Lights) is strong like most places in Texas. Oil and gas exploration is experiencing a renaissance in this area, too.

A slight claim to fame was the 2006 movie “The Return,” a horror/supernatural thriller starring Sarah Michelle Gellar who portrayed a young woman haunted by psychic visions of a murder that happened years back in the character’s hometown of, that’s right, Luling.

Then there’s the watermelon. Lots of watermelon.

Every year, homage is paid to a produce-induced vision of a school principal from way back. Another world in fact: 1954.

Carnival festivities and watermelon-themed events like seed spitting (not as gross as it sounds) are bathed in ropes of colorful party lights for four fun-filled days.

A warm breeze carries a pungent wave from a teeter-tottering arm of an aged oil pump and bounces it across and through what seems like endless strings of tiny white lights. The lights flicker so much I can’t tell whether watermelon is a fruit or a vegetable in the ebb and flow of reflection. This is a big controversy on the internet by the way. I stick with watermelon as a fruit. I don’t like my vegetables sweet. That’s how I roll.

Activities kick off on a Thursday evening with the crowning of “Watermelon Queen,” selected from a small group of junior-high and high-school young ladies. Sponsored by community services and local businesses, the girls, dressed in formal best, gather at an outdoor aged wooden structure called the “pavilion” and sit nervously awaiting the judges’ decision. The “fresh-picked” Queen holds the primary responsibility of representing the town at upcoming statewide events and local school and business functions until the next thump and new royalty is crowned.

For eight consecutive years, my daughter and I have honored the tradition and at the same time, created a strange one of our own by sweltering in the Texas humidity.

Partaking with gusto in all that small-town hospitality has to offer.

For temporary relief at least, watermelon is plentiful. Icy-cold that stings the gums (two slices two dollars). Miles of funnel cake and food specialties are savory high-caloric backups.

I’ve visited at least a dozen times (for savory barbeque served on butcher-brown paper at the iconic City Market), and came to know business owners and residents at least on cordial speaking terms.

I’m viewed as sort of odd man out and been laughingly called a Yankee a time or two, however hospitality runs strong in these parts and no matter how out of place I appear, I am treated as warmly as a native (after light jabbing).

A fascination with Texas history rolled me down Interstate 10. I have remained intrigued as those I encounter manage to survive, even thrive on modest financial resources (a per-capita income of roughly $13,000 a year).

I‘ve been a respectful observer. Under the radar. A speck on painted oil pump.

My window of observation is usually limited due to the July blast-furnace Texas heat.  Surprisingly weather conditions were different this year. The late afternoon brought with it a front of cooler air which pushed out humidity, broke the heat and exposed a pinkish-blue Technicolor sky against a busy Ferris wheel dripping in colorful carnival lights.

Over the years, I’ve compiled notes of the best of lessons money and otherwise, from the residents of Luling.

Here are seven of the most memorable:

“I don’t eat the whole chicken all at once, just a piece at a time.” You can’t make this stuff up! Those who seek immediate satisfaction or look to get rich quick are going to suffer from incredible financial indigestion or worse. Growing wealth isn’t magic – it begins with a financial awareness of cash flow, consistently spending less than household income, managing debt and a saving and/or investment plan for specific life benchmarks like retirement.

Many feel the tasks too overwhelming. Why bother?

Well, listen to Luling: Take a baby step: If you’re not saving, start. Even if it’s an additional $50 a month to bolster an emergency cash stash. Increase your 401(k) or retirement plan contributions by one percent next week.

Apply as much as you can to get credit card bills paid off quickly. Take the action now. Worry about the repercussions on the budget later. Take a step forward. Find a way to make it work.

“Don’t owe nothin’ to nobody.” Appears those with smarts in Caldwell County, mostly the “senior folk,” abhor debt. The gentlemen who blurted this insight at me had a mouth full of ribs and a face devoid of several teeth (meat falls right off the bone at City Market).

Wisdom happens even if those providing it are all gums. U.S. households are slowly getting their balance sheets in order and that requires reducing debt and working to aggressively increase savings. Be proud of the eventual independence that comes from becoming debt free.

Principal, interest, taxes and insurance doesn’t exceed 25 percent of gross monthly income. Standard rule of thumb is 28 percent; my advice is to come in below as the rule is antiquated like many of the downtown Luling facades.

I have been disciplined enough to follow a “20 percent of gross” mantra. But then I’ve never perceived a house as an investment – just a place to hang the hat.

Side note: City Market only takes cash – no credit cards, no checks. You can enjoy melt-in-your-mouth brisket without taking on additional debt. The establishment is eternally smoky and there’s no air conditioning. Spicy sauce makes the experience hotter. Don’t worry. As the sweating kicks in you feel cooler. 

“You can fool yourself but the pigs’ll still laugh at you.” I needed to think outside the box with this one. Emotion is the greatest enemy of investment and financial success. Individual investors are constantly plagued by overconfidence (you didn’t beat the market, I’m sorry-you didn’t).

You consistently sell low and buy high, hold on to losers too long, sell winners prematurely and create trends in your head where none exist. Understand your limitations and emotional biases and you’ll be much more successful. You’ll deny this at first.

Your performance should be gauged against specific goals you have for money, not an index like the S&P 500. Your performance should be compared on an absolute basis, to the return you require to hit the gusher (Texas talk). I consider it “financial life benchmarking.”

Financial life benchmarks are those specific milestones you create, accomplish and check off. They move you ahead, keep you focused and ostensibly bolster your household balance sheet.

There’s a point, a law of diminishing returns (or financial wheel-spinning) where you’ll take on more risk and not receive a commensurate amount of return. The problem is a bell doesn’t ring or an alarm doesn’t go off once you approach or breach the danger zone whereby additional risk is not complimentary but greatly detrimental to future results.

When you’re focused on beating the market, you will lose sight of the risk and wind up like poor William Hardeman as your net worth bleeds away.

FLB helps you understand clearly the returns you require to get to where you want to be – It’s about you, not a market index. It’s your life, your attitude towards money, what’s important to you about having the money to meet lifestyle goals all wrapped together in a functional action plan. It’s your town and the roads are unlike any others.

By the way, those I’ve encountered with impressive success in markets rarely brag about it. Look in the mirror and understand how the stock market will humble you today.

Always perceive markets as ornery as “Rowdy Joe.”

The heat won’t kill ya until it does.” I needed to sit a spell after hearing this Lone Star nugget of wisdom. What the heck did it mean? Then I realized-in Texas you respect the heat and understand the danger of oppressive weather conditions on your health. Ignore the heat and deal with the consequences. The famous quote by Albert Einstein comes to mind: “Insanity: Doing the same thing over and over again and expecting different results.” 

If your current relationship with money or yourself is subpar, it isn’t going to change itself. Overextending on credit, not saving for retirement or at least forming a strategy, a lack of an emergency cash buffer, using spending as a substitute for happiness, not taking care of your body physically/mentally, failing to continue to learn will burn you to a crisp.

Start a personally heated change wave. It doesn’t need to be huge. A habit takes repetition to become second nature. Soon a healthier and wealthier routine will be yours but it doesn’t happen by accident.

“Hay is gold.” An unprecedented drought and elongated period of record heat, and hay becomes a valuable commodity in Texas. All of life comes down to supply and demand. Right now there’s a greater supply of you and little demand. Just look inside the unemployment rate or employment numbers..

What makes you unique?

It’s a tough reality. The skills you had, or even the career you thrived on have a greater chance of being sour permanently since the Great Recession. That doesn’t mean you don’t possess several core strengths to expand upon. Confidence in your personal skills and abilities has been shaken more than any other time in history outside the Great Depression. Take control.

“I’ll take small quality over big a big stack of nothin’.” I admit it. I overheard this one. Yes, everything is bigger in Texas. Texans also respect and appreciate quality and pureness of heart over size. It’s a good time to go smaller. How much you need anyway?

Luling is home to an interesting business: Tiny Texas Houses. Each house is made of 99 percent salvaged materials. No structure is bigger than 12’ x 28’ with a loft. How much square footage you need? Get yourself two dogs (they’re loyal), two acres and possibly a person to keep you company once in a while and you’ll be styling.

I’ve been preachin’ this two dogs, two-acre sentiment for years because it seems right to me. Feels like true independence.

Peace of mind comes from taking in more than you need to meet expenses. I’ve been told that too, in Luling. I’ve seen it.

“The past has a place but shouldn’t interfere too much with the present.” The new owners and staff of the Francis-Ainsworth Bed & Breakfast are in the process of restoring the historic structure for a new generation of guests to enjoy.

I feel history tap me on the shoulder here.

It’s a presence which lightly beckons, lowers its head in deference as I enter, and invites me to never forget to respect what’s come before me. I’m merely passing through.

With that I learn how I must deeply preserve those in my inner circle, swiftly cut out negative presences, continue my understanding of the human condition and work to assist, respect my teachers.

In August, 1922 another shaken, ashen-faced man watched as black bled into dirt. The flow of the liquid was so strong it cut a trail into sunbaked earth for over a mile.

The discovery of oil by Edgar B. Davis changed Luling’s landscape dramatically in 1922. He mortgaged everything he owned and was about to throw in the towel when Rafael Rios #1 became a gusher.

Edgar Davis’ creation of the Luling Oil Field promoted rapid growth as the town population grew to 6,000 and 100 new businesses were created by 1928.

At its peak, the oil field produced 11,134,000 barrels.

One 100 degree-plus day in 2015 as I stood outside of Blake’s Restaurant on Main Street, a hot breeze overtook me.

I could barely breathe.

With it came the odor from nearby operating oil pump jacks. I crinkled my nose – who wouldn’t?

An elderly local walking by tipped his white cowboy hat at me, stopped and politely said:

“I wouldn’t do that son, that’s the smell of money.”

It was another trip. The same trip. But it was different.

The heat was cathartic.

The watermelon was sweeter.

The lessons were timely.

And the train kept going on through.

Until next year.

The whistle blows.

Knifing through the humidity of what now is past.

“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.

Prior to the election last year, I penned an article entitled “2400 or Bust” which discussed the potential for a market “melt-up” at that time. To wit:

“As shown below, the current price action continues to consolidate in a very tight range which will resolve itself in very short order. A breakout to the upside will clear the markets for a further advance. However, while the technicals suggest a move to 2400, it is quite possible it could be much less. Notice in the bottom section of the chart below. Turning the current ‘sell signal’ back into a ‘buy signal’ at such a high level does not give the markets a tremendous amount of runway.”


Of course, since then the market has completed the majority of that advance. I have updated that chart below through Tuesday’s open.

Despite rising geopolitical tensions in the Middle East, the deployment of the USS Carl Vinson strike group off the coast of the Korean peninsula, or the looming potential of a Government shutdown over a “debt ceiling” fight, nothing seems to concern the markets much.

The market remains in a bullish trend and short-term moving averages continue to provide support against a deeper correction. At the same time, complacency remains high leading to Wall Street pushing estimates ever higher. In fact, you don’t have to go far to find the bullish case now being made for S&P 2700-3000 as per Morgan Stanley:

“The cyclical upturn that began a year ago has less to do with President Trump and more to do with the global business cycle that bottomed in 1Q-2016. Trump simply ‘turbocharged’ the cycle and stoked animal spirits on Wall and Main Street, with tangible effects on the real economy and markets. The title of our year-ahead outlook as CIO for Morgan Stanley Wealth Management on January 1st was ‘Are You Ready for Euphoria?’– based on Sir John Templeton’s four stages of the investment cycle:

‘Bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria.’

The end of the cycle is often the best. Think 1999 or 2006-07. In a low-return world, investors cannot afford to miss it.”

The chart below projects the move to 2700 from current levels as “euphoria” takes hold. (A move to 3000, as suggested, would only exacerbate the deviation.) The data in the orange box is an extrapolated price advance using historical market data. The dashed black line is the 50-week moving average (because #BlackLinesMatter) and the bar chart is the deviation of the markets from price average.

Here’s the problem.

As I discussed recently, the predicted surge in earnings was based upon corporate tax reform which would boost bottom lines earnings per share.

“The expectations of a $1.31 boost to earnings for each percentage point of reduction in tax rates is also a bit ‘squishy.’ The premise WAS based on the expected earnings in 2017 of $131.00 for the entirety of the S&P 500. The $1.31 increase is simply 1% of $131.00 in total operating earnings.

Since actual earnings for 2016 was $94.54/share, this implies a $0.9454 increase per point, or an earnings boost of $18.91 (.9454 * 20) at best which would bring total 2017 estimates to $113.45. This is $5.38 less than what is currently estimated for 2017 and brings into serious question of 2018 estimates of $130.03.  

Based on this math, forward valuations (assuming prices don’t move from yesterday’s close) would be 20.63x.  This is far more expensive than the 17x earnings expected previously. But unfortunately, the news is already getting worse as estimates have continued to slide just in the last month.”

Here’s the problem.

While Morgan Stanley is suggesting earnings will rocket higher to $142/share in the next 12-months to support the ongoing bullish advance to 2700, the catalyst for that surge has been put “on hold” for now with the “tax plan agenda” scrapped,

While there is little doubt that “bullish hopes” certainly remain, it is worth noting (in the second chart above) the market has issued a weekly “sell signal” from a high level which has previously preceded temporary weakness in the market.  Given the current extension above the longer-term moving average (green dashed line,) a correction to 2250 currently would be consistent with previous corrections following a similar sell signal.  While such a correction would only be roughly -4.4%, it would not only wipe out all of the gains of the year so far, but would also “feel” much worse given the currently high levels of investor complacency. 

Bond Bulls Emerge

The most interesting note as of late has been the quiet death of the “bond bears.”

Back in January, as the 10-year Treasury rate pushed towards 2.6% based on the coming reflationary resurgence of inflation and economic growth from the “Trump Agenda,” Wall Street trumpeted the “death of bonds.”

This is an argument I have continued to debunk since June 2013 but most recently in August of last year.

“There is an assumption that because interest rates are low, that the bond bull market has come to its inevitable conclusion. The problem with this assumption is three-fold:

  1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
  2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largess in the future, the budget deficit is set to swell back to $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
  3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion which will push the 10-year yield towards zero.”

Not surprisingly, as the current administration continues to fumble economic policy agendas, the rotation out of the “Trump Trade” back into “safety” has picked up steam. As shown below, interest rates have now triggered a “weekly sell signal,” or more notably, a “weekly buy signal” for bonds.

A break below support at 2.3%, which will likely coincide with any type of “debt ceiling” showdown, will likely push rates back towards 2% or lower. Importantly, the rotation from the “reflation trade” back into the “risk-off trade” suggests a loss of confidence in the potential for fiscal policy reforms. As noted by John Mason recently:

“More slow economic growth? That is what the bond market seems to be saying about the future growth of the US economy.” 

Of course, with 2016 GDP slipping to just 1.6% annual growth and Q1-2017 targeted to just 0.6% currently, there is little ability for interest rates to move substantially higher. This is particularly the case with consumers currently facing a severe shortfall between wage growth and their current cost of living.

At current levels, even small changes to borrowing rates can have a very quick adverse effect on the 70% of the economy that borrows money to maintain their standard of living.

When Bulls Collide

So, with this backdrop of weakening underpinnings of the “Trump Trade” but exuberant hopes of a continued bull market run comes the potential collision between markets.

It is highly unlikely that bond bulls and stock bulls will both be right.

One thing is true, as shown below, prior to 2012, the direction of rates closely dictated the moves of the equity markets. However, as the BOJ, BOC, BOE, ECB and the FED engaged in massive liquidity programs in an attempt to spark inflation pressures and economic growth, as shown below, the markets became somewhat detached from the message bonds were sending. With the Fed now hiking rates and tightening monetary policy, it is quite likely bonds are once again signaling a warning to stock investors. 

This detachment between fundamentals and monetary policy has also driven the stock/bond ratio to historical heights which has previously not ended well for stock investors. More importantly, the acceleration of the ratio should also raise an alarm.

As noted by GaveKal recently:

“Over short periods of time, the relative performance of stocks and bonds fluctuates around a mean of about zero. When stocks outperform bonds by a large amount over a short period, that period of outperformance reverts back towards zero, either through time or performance. While we can’t possibly predict the performance of either stocks or bonds, what we can fairly confidently deduce is that further stock strength relative to bonds is unlikely over the coming months.”

This is a very good point and my suspicion is that he will be right.

So, while I am still bullish on the markets short-term (few days to weeks), I am becoming much more cautious. Over the longer-term (few weeks to several months), I am much more bearish.

Hedging risk continues to remain a prudent course of action.

Last week, I discussed the primary issue that has led to the “Unavoidable Pension Crisis” in America. To wit:

“Using faulty assumptions is the lynchpin to the inability to meet future obligations. By over-estimating returns, it has artificially inflated future pension values and reduced the required contribution amounts by individuals and governments paying into the pension system.”

This is a critically important point to understand. Why? Because you may well be in the same “quicksand” as pension funds and just don’t realize it.

For years, Wall Street has continued to espouse the “myth of compounded average returns.” This is the same myth which has not only infected pension funds, but has led to the same false sense of future financial security in personal retirement planning nationwide. An article from IBD last week further perpetuates this myth:

“What determines how much savings is enough by a certain age, with a particular income?

J.P. Morgan says ‘enough’ means the nest egg is big enough to have at least an 80% chance of surviving 30 years in retirement.’ So, 20% of the time you’d need to course correct — by boosting something like your savings rate or cutting your retirement spending — to avoid running out of money in the long run. But 80% of the time, you would not need to make any changes to avoid running out of money.’

The financial firm’s number crunchers also assume that, before retirement, you keep kicking in 10% of your income each year to your nest egg. In addition, they assume that your retirement portfolio grows an average of 6% a year before retirement and 5% a year in retirement.

And there it is.  The biggest mistake you are making in your retirement planning by buying into the “myth” that markets “compound returns” over time.

They don’t. They never have. They never will.

I have adjusted the chart I showed you last week to show a compound return rate of 6%, $5000 annual, made monthly, contributions (10% of $50,000 which is roughly the median wage) and using variable rates of return from current valuation levels. (Chart assumes 35 years of age to start saving and expiring at 85)

As you can see, markets do not compound average returns over time.

Most importantly, just as with “pension funds,” the issue of using above average rates of return into the future suggests one can “save less” today because the “growth” will make up for the difference.

Unfortunately, it just doesn’t work that way.

But there is more to this equation that is not being discussed.

The Missing Ingredients

But there is another problem that is overlooked by IBD in their analysis above. The impact of taxes and fees during the drawdown period (not to mention fees.)  

In a report entitled “Retiree’s May Have A Spend Down Problem” I used the follow example:

“For instance, imagine a retiree who has a $1,000,000 balanced portfolio, and wants to plan for a 30-year retirement, where inflation averages 3% and the balanced portfolio averages 8% in the long run. To make the money last for the entire time horizon, the retiree would start out by spending $61,000 initially, and then adjust each subsequent year for inflation, spending down the retirement account balance by the end of the 30th year.”

I have taken that example and adjusted it for a 6% average return and then included scenarios a $50,000 annual withdraw rate adjusted for inflation and taxes.

Unfortunately, once you account for taxes and inflations, the time to depletion accelerates rapidly.

But hold on.  It actually gets worse.

The above example uses the “pension fund” model of 6% compounded annual average returns. Let’s remodel forward returns using the average returns of the markets historically over the subsequent 30-year period from where the index hit 20x valuations. This is shown in the chart below.

If we take the average returns of those years and apply them to our spend down model, as shown above, the depletion rate of retirement savings grows sharply.

The analysis above reveals the important points individuals should consider given current valuation levels and a Fed-driven bull market advance over the last 8-years:

  • 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 rising market years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for retirement income planning. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of plans for variable rates of future returns.

Financial Insecurity – Or, “You Aren’t Saving Enough”

I get it.

Asking people to save “more” really isn’t an option given the recent study published by MarketWatch:

“Some 50% of people is woefully unprepared for a financial emergency, new research finds. Nearly 1 in 5 (19%) Americans have nothing set aside to cover an unexpected emergency, while nearly 1 in 3 (31%) Americans don’t have at least $500 set aside to cover an unexpected emergency expense, according to a survey released Tuesday by HomeServe USA, a home repair service. A separate survey released Monday by insurance company MetLife found that 49% of employees are “concerned, anxious or fearful about their current financial well-being.”

The lack of savings, of course, is directly related to the rising cost of living versus the lack of wage growth over the last 35-years which led to a massive surge in debt to maintain the standard of living.

Fidelity provided some further insights into the savings problem for Generation X’ers and Millennials in a recent publication:

“Generation X is squarely in middle age and beset on all sides by bills. Many in Generation X have dependents at home—84% in the survey said they have at least one. They may also still be paying off their own student debts—just more than one in four survey respondents from Generation X says he or she is still paying for his or her own education. 

There are all kinds of money problems, but the solutions are generally the same: Save more, spend less, or find a higher-paying job—or maybe all three. But this is easier said than done.”

The massive shortfall in “savings” is going to be a problem in the future given the shortfall that currently exists for a large number of Americans.

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

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

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

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

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

Let me suggest a warning.

Two week’s ago, I discussed the failure of Congress to get the Affordable Care Act (ACA) repealed, much less replaced. The problem, of course, is the failure to repeal the ACA leaves in question the ability to pass other agenda based items such as tax reform, border wall construction, repatriation or immigration reform.

“Reaching an agreement on the FY budget resolution will not be easy; in the past, conservatives have demanded a balanced budget within ten years but this would require endorsing spending cuts (in non-binding form) that some centrist Republicans might oppose along with the BAT.

Of course, while Wall Street believes ‘tax reform’ will be a much easier process than repealing health care, the reality is it could be just as tough as government entitlement programs, funding for Planned Parenthood, and other programs central to the Democrats, and some left-leaning Republicans, come under attack.” 

This past week, while Congress still hasn’t made any advance towards solving the current health care debate, Paul Ryan, House Majority Leader, confirmed my discussion on the rising risk of tax reform failure. To wit:

“U.S. House of Representatives Speaker Paul Ryan said on Wednesday that tax reform will take longer to accomplish than repealing and replacing Obamacare would, saying Congress and the White House were initially closer to agreement on healthcare legislation than on tax policy.

The House has a (tax reform) plan but the Senate doesn’t quite have one yet. They’re working on one. The White House hasn’t nailed it down. So even the three entities aren’t on the same page yet on tax reform.’

Just to remind you, the entire catalyst behind the post-election rally has been the “hope” that tax cuts will boost earnings enough to support current market valuations. However, interestingly, while the markets continue to hope for “fiscal policy” reforms, according to the release of the FOMC minutes there is little consideration being given to Trump’s agenda. From the minutes:

“Participants continued to underscore the considerable uncertainty about the timing and nature of potential changes to fiscal policies as well as the size of the effects of such changes on economic activity. However, several participants now anticipated that meaningful fiscal stimulus would likely not begin until 2018. In view of the substantial uncertainty, about half of the participants did not incorporate explicit assumptions about fiscal policy in their projections.”

Furthermore, the FOMC also raised concerns over the level of valuations in the markets.

“Broad US equity price indexes increased over the intermeeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms. A standard measure of the equity risk premium edged lower, declining into the lower quartile of its historical distribution of the previous three decades. Stock prices rose across most industries, and equity prices for financial firms outperformed broader indexes.

Of course, valuations have been a topic of great debate in recent months particularly as they pushed into levels only witnessed prior to the 1929 and 2000 crashes.

This leaves markets with the “hope” trade in peril as Congress continues to trip itself up in moving legislative agenda forward while, at the same time, the Fed has decided accelerated the pace of monetary tightening and sending clear warnings to the markets.

This has “bad” written all over it. 

Just some things I am thinking about this weekend as I catch up on my reading.



Research / Interesting Reads

“There is no training that prepares for trading the last third of a move, whether it’s the end of a bull market, or the end of a bear market.” – Paul Tudor Jones

Questions, comments, suggestions – please email me.