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I was recently watching a movie about the FBI trying to bring down a terrorist cell in the U.S. During their investigation, their evidence board became more and more cluttered with people, evidence, and locations as they attempted to track down the “cell.” At first, the clues were disparate, and they didn’t provide a clear path to the end goal. But as more clues were obtained, the bigger picture emerged eventually leading to the successful ending of the terrorist threat.

It got me to thinking about what is currently happening in the markets. As stocks rang new highs last week, there were several disparate stories that caught my attention. Individually, each story is nothing to be overly concerned about, and are regularly dismissed by investors. However, when you begin linking these stories, a picture is beginning to emerge that suggests investors may be ignoring the evidence at their own peril.

Story 1: CPI Remains Weak

Despite three hurricanes and wildfires over the last couple of months, core CPI (ex-aircraft) failed to register much inflationary pressure. One would have expected given the surge in demand for goods and services needed to rebuild destroyed communities.

However, despite the Fed’s hopes for a surge in inflationary pressures to justify further hikes in interest rates, inflationary pressures have been on the decline for the last several months.

Story 2: Real Wage Growth Slumps Along With Employment

Of course, the lack of inflation leads through to a decline in inflation-adjusted wages. While the chart below only goes back to 2008, wage growth has been non-existent since 1998. (For more detail read this.)

But as I discussed previously, even those wage numbers are skewed by the top 20% of income earners versus the bottom 80% which continue to see wages decline.

Story 3: Auto Originations Crash

As Wells Fargo announced this past week, the decline in auto loan originations continued tumbling 47% Y/Y to only $4.3 billion, the lowest print since the bank started disclosing this item back in 2013.

The problem is that it is not just Wells having this problem, but all banks. As shown in the chart below the number of banks reporting strong auto loan demand has been in decline for quite some time.

Story 4: Retail Sales Continue To Lag

It isn’t just auto either. Retail sales account for roughly 40% of personal consumption expenditures which makes up 70% of the economy. With wages stagnant, and the real cost of living on the rise, it is not surprising that with roughly 80% of Americans living paycheck-to-paycheck that retail sales continue to wane. 

The chart below is the annual percent change in the 12-month average of “control purchases.” These are the items that consumers buy with regularity and shows why retail struggles aren’t just related to the “Amazon effect.” 

Story 5: Pay-Tv Customers Decline 

While “cutting the cord” may be a “thing,” this is much more a story about consumers being faced with a choice between making their mortgage payment or paying for cable. With budgets strained, consumers are actively seeking choices where they can get access to programming at much cheaper costs. From Bloomberg last week:

Barring a major fourth-quarter comeback, 2017 is on course to be the worst year for conventional pay-TV subscriber losses in history, surpassing last year’s 1.7 million, according to Bloomberg Intelligence. That figure doesn’t include online services like DirecTV Now. Even including those digital plans, the five biggest TV providers are projected to have lost 469,000 customers in the third quarter.”


At least all the “low budget” films are getting a shot at a whole new audience. So sit back, grab some popcorn and take in “Galaxina” or “Cannibal Women From The Avocado Jungle.” 

Story 6: Banks Ramp Up Loan Loss Reserves

In another interesting note this week, Citi, JP Morgan and BofA all boosted their “loan loss reserves” by the most in 4-years. Banks don’t boost reserves unless there is a rising risk of defaults on the horizon. From Zerohedge:

“Four months ago, when looking at the latest S&P/Experian data, we first reported that credit card defaults had surged the most since June 2013, a troubling development which ran fully counter to the narrative that the economy was recovering and the US consumer’s balance sheet was improving.

The troubling deterioration prompted Moody’s to pen its own report titled ‘Spike in Charge-off Rates Indicates a Slide in Underwriting Standards’ and as Moody’s analyst Warren Kornfelf wrote, the steep increase in credit card charge-off rates in 1Q’17 and 4Q’16 was the largest since 2009, and indicates that ‘strong underwriting standards in place since the financial crisis have deteriorated, potentially rapidly.'”

Of course, the following chart might just suggest why they are doing that.

Story 7: Millennials Are Delaying Marriage Because Men Aren’t Earning Enough

As reported by The Hill this past week, more Americans are living alone today has risen sharply.

“The number of Americans living with a spouse or partner has fallen notably in the last decade, driven in part by decisions to delay marriage in the wake of a recession that hit new entrants into the workforce especially hard.

Forty-two percent of Americans live without a spouse or partner, up from 39 percent in 2007, according to the Pew Research Center’s analysis of U.S. Census Bureau figures. For those under the age of 35 years old, 61 percent live without a spouse or partner, up 5 percentage points from a decade ago.”

With more multi-generational families living together, the aging of the baby-boomer generation and a significant fall-off in birth rates, the huge demographic headwind is gaining momentum. The economic ramifications, as well as for the financial markets, is going to be extremely problematic. (Read this.)

Tying It All Together

As more clues become available, the risk to the financial markets becomes clearer.

All of these stories have a common thread – the consumer. While stocks continue to ratchet to all-time highs on expectations of tax cuts and reforms leading to stronger economic growth, the stories here all suggest something much more telling is happening beneath the surface.

Yes, household net worth has recently reached historically high levels. However, The majority of the increase over the last several years has come from increasing real estate values and the rise in various stock-market linked financial assets like corporate equities, mutual and pension funds.

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

As the Federal Reserve just recently reported, while the mainstream media continues to tout that the economy is on the mend, real (inflation-adjusted) median net worth suggests this is not the case overall. As stated, the recovery in net worth has been heavily skewed to the top 10% of income earners.

Of course, this explains why the largest number of the population over the age of 65 is still employed as they simply can’t afford to retire. The multi-generational households are on the rise, not by choice but by necessity. These are long-term headwinds that suggest economic growth will remain weak, and the rise in delinquencies, slow-down in auto demand, and weak retail sales all suggest consumers may have reached the limits of the debt-driven consumption cycle for now.

In other words, individuals are ratcheting up debt, not to buy more stuff, but just to maintain their current “standard of living.” 

The disconnect between the stock market and real economic growth can certainly continue for now. Exuberance and confidence are at the highest levels on record, but the underlying stories are beginning to weave a tale of an economy that is very late in the current cycle.

Importantly, these are not short-term stories either. The long-term picture for the economy and the markets from the three biggest factors (Debt, Deflation, and Demographics) continues to build. These factors will continue to weigh on economic growth, and market returns, during the next generation as the massive wave a baby-boomers shift from supporters to dependents of the financial and welfare system. 

As an investor, it is important to pay attention to the clues and the weight of the evidence. The success, or failure, of catching the end of the current bull market and economic cycle will have important implications to your long-term financial goals.

As the stock market continues to press new highs, the level of optimism climbs with it. I discussed yesterday Richard Thaler’s, a recent recipient of the Nobel Price in Economics, comments about not understanding the current “irrationality of investors relating to their investing behavior.”

What is interesting is that Thaler’s received his Nobel Prize for his pioneering work in establishing that people are predictably irrational — that they consistently behave in ways that defy economic theory. For example, people will refuse to pay more for an umbrella during a rainstorm; they will use the savings from lower gas prices to buy premium gasoline; they will offer to buy a coffee mug for $3 and refuse to sell it for $6.

The fact that a man who studies the “irrationality of individuals” is stumped by current investor behavior should be alarming at the least.

But as earnings season gets underway we once again return to quarterly Wall Street “beat the estimate game,” in which companies are rewarded by beating continually lowered estimates. Of course, the primary catalyst used to beat those estimates was not a rise in actual revenue, or even reported earnings, but rather ongoing accounting gimmickry and stock buybacks. As shown below, through the second quarter of this year, reported EPS, which includes “all the bad stuff,” actually declined in the latest quarter and has remained virtually unchanged since 2014. (But, even that is an illusion as shares have been aggressively bought back in order to sustain that same level of EPS.)

The difference between reported earnings with and without the benefit of share repurchases is substantial. The chart below shows the net difference between gross reported earnings with and without the buyback impact. Importantly, the net effect of buybacks is having less impact which, as was the case in 2007, was a precursor to the crash. 

Ralph Nader just recently did an in-depth expose on the problems with share repurchases. To wit:

The monster of economic waste—over $7 trillion of dictated stock buybacks since 2003 by the self-enriching CEOs of large corporations—started with a little-noticed change in 1982 by the Securities and Exchange Commission (SEC) under President Ronald Reagan. That was when SEC Chairman John Shad, a former Wall Street CEO, redefined unlawful ‘stock manipulation’ to exclude stock buybacks.”

Yep, stock buybacks used to be considered stock manipulation, yet today, it is widely accepted by investors as “just the right measure to boost earnings in the ongoing “beat the estimate” game.

As Ralph Nader points out – there is a problem.

“The stock buyback mania was unleashed. Its core was not to benefit shareholders (other than perhaps hedge fund speculators) by improving the earnings per share ratio. Its real motivation was to increase CEO pay no matter how badly such burning out of shareholder dollars hurt the company, its workers and the overall pace of economic growth.

The bottom line is that while companies take trillions of dollars and buyback shares, it only benefits the executives of the company at the expense of both workers and, ultimately, shareholders as companies with excessive stock buybacks experience a declining market value.

The interview is worth watching, and read the article, and think about it.

Here’s your reading list to for the weekend.

Trump, Economy & Fed


Research / Interesting Reads

“Making it, and keeping it, are two different things.Anonymous

Questions, comments, suggestions – please email me.

Dear reader, if you are overcome with fear of missing out on the next stock market move; if you feel like you have to own stocks no matter the cost; if you tell yourself, “Stocks are expensive, but I am a long-term investor”; then consider this article a public service announcement written just for you.

Before we jump into the stock discussion, let’s quickly scan the global economic environment. The health of the European Union did not improve in 2016, and Brexit only increased the possibility of other “exits” as the structural issues that render this union dysfunctional went unfixed.

Japan’s population has not gotten any younger since the last time I wrote about it — it is still the oldest in the world. Japan’s debt pile got bigger, and it remains the most indebted developed nation (though, in all fairness, other countries are desperately trying to take that title away from it). Despite the growing debt, Japanese five-year government bonds are “paying” an interest rate of –0.10 percent. Imagine what will happen to its government’s budget when Japan has to start actually paying to borrow money commensurate with its debtor profile.

Regarding China, there is little I can say that I have not said before. The bulk of Chinese growth is coming from debt, which is growing at a much faster pace than the economy. This camel has consumed a tremendous quantity of steroids over the years, which have weakened its back — we just don’t know which straw will break it.

S&P 500 earnings have stagnated since 2013, but this has not stopped analysts from launching their forecasts every year with expectations of 10–20 percent earnings growth . . . before they gradually take them down to near zero as the year progresses. The explanation for the stagnation is surprisingly simple: Corporate profitability overall has been stretched to an extreme and is unlikely to improve much, as profit margins are close to all-time highs (corporations have squeezed about as much juice out of their operations as they can). And interest rates are still low, while corporate and government indebtedness is very high — a recipe for higher interest rates and significant inflation down the road, which will pressure corporate margins even further.

I am acutely aware that all of the above sounds like a broken record. It absolutely does, but that doesn’t make it any less true; it just makes me sound boring and repetitive. We are in one of the last innings (if only I knew more about baseball) of the eight-year-old bull market, which in the past few years has been fueled not by great fundamentals but by a lack of good investment alternatives.

Starved for yield, investors are forced to pick investments by matching current yields with income needs, while ignoring riskiness and overvaluation. Why wouldn’t they? After all, over the past eight years we have observed only steady if unimpressive returns and very little realized risk. However, just as in dating, decisions that are made due to a “lack of alternatives” are rarely good decisions, as new alternatives will eventually emerge — it’s just a matter of time.

The average stock out there (that is, the market) is very, very expensive. At this point it almost doesn’t matter which valuation metric you use: price to ten-year trailing earnings; stock market capitalization (market value of all stocks) as a percentage of GDP (sales of the whole economy); enterprise value (market value of stocks less cash plus debt) to EBITDA (earnings before interest, taxes, depreciation, and amortization) — they all point to this: Stocks were more expensive than they are today only once in the past century, that is, during the dot-com bubble.

In reference to this fact, my friend and brilliant short-seller Jim Chanos said with a chuckle,

“I am buying stocks here, because once they went higher . . . for a year.”

Investors who are stampeding into expensive stocks through passive index funds are buying what has worked — and is likely to stop working. But mutual funds are not much better. When I meet new clients, I get a chance to look at their mutual fund holdings. Even value mutual funds, which in theory are supposed to be scraping equities from the bottom of the stock market barrel, are full of pricey companies. Cash (which is another way of saying, “I’m not buying overvalued stocks”) is not a viable option for most equity mutual fund managers. Thus this market has turned professional investors into buyers not of what they like but of what they hate the least (which reminds me of our political climate).

In 2016, less than 10 percent of actively managed funds outperformed their benchmarks (their respective index funds) on a five-year trailing basis. Unfortunately, the last time this happened was 1999, during the dot-com bubble, and we know how that story ended.

To summarize the requirements for investing in an environment where decisions are made not based on fundamentals but due to a lack of alternatives, we are going to paraphrase Mark Twain:

“All you need in this life [read: lack-of-alternatives stock market] is ignorance and confidence, and then success is sure.”

To succeed in the market that lies ahead of us, one will need to have a lot of confidence in his ignorance and exercise caution and prudence, which will often mean taking the path that is far less traveled.

There is a wide disconnect between the current market’s focus on short-term influences and the long-term and worrisome trends in pension obligations, spiraling debt, the wealth/income gap and the Fed’s ability to extricate itself from its large balance sheet.

“I’d say get it while you can, yeah
Honey, get it while you can, yeah
Hey hey, get it while you can
Don’t you turn your back on love, no, no

Don’t you know when you’re loving anybody, baby
You’re taking a gamble on a little sorrow
But then who cares, baby
‘Cause we may not be here tomorrow, no.”

–Janis Joplin, “Get It While You Can

We live in a not-so-brave world in which time frames have been increasingly compressed, owing in part to the impact of technology on human behavior. It is as if almost everyone these days has ADHD, or attention-deficit hyperactivity disorder.

This short-term behavior permeates our society as physical human interaction is diminished in a world of Twitter, Instagram and Snapchat.

Even politics is subverted to the short term. For example, politicians are elected and almost the next day they have begun to campaign and raise money for their next election. Another example of the short-term orientation and subversion of longer-term thinking is seen in President Trump’s impulsive, possibly dangerous and seat-of-the-pants tweeting, which is now being “normalized,” as an expression of delivering policy that in the past has been conducted in a far more contemplative way. Or even in Anthony Weiner’s sexting!

Nowhere is the compression of time frames more apparent than in the investment business, where it seems that everyone has become a day trader.

As it is said, market opinions are like noses — everyone has one!

The business media spends most of their time asking the talking heads questions that are likely to be responded to without much rigor because it’s easier looking at a price chart or monitoring “unusual call activity” in making short-term trading decisions than employing fundamental analysis that is time-consumptive and laborious.

Among the usual questions:

  • Where are interest rates going by year-end?
  • What is the next 50-handle move in the S&P Index?
  • How will XYZ Co.’s shares respond to this afternoon’s earnings report?
  • What is the next move in the U.S. dollar, the price of oil, in soybeans or in the emerging market space?

The limited discussion and consideration of intermediate to longer-term prospects — such as whether we are pulling investment returns forward — may be a technologically influenced event or may be the desire, as Janis Joplin reminded us all, of “getting it while we can.”

Or it might be the byproduct of the continuing eight-year bull market in which dips are ever bought.

Regardless, current prices always must be measured and judged not only by the next near-term variable (such as interest rates, earnings and the price of oil), but also by the assessment of the intermediate to longer term.

And it is the longer term that to me and to some others is where the greatest concerns lie for investors today.

These longer-term concerns seem to have been ignored by most market participants and by the machines, algorithms and ETFs, which have been fueled by large inflows that have translated into the virtuous market cycle I recently wrote about in “Active vs. Passive Conflict, and Why All Dips Are Bought.”

Stated simply, passive investing is agnostic to long-term fundamentals such as private market value and secular earnings growth projections. One can spend weeks discussing these profound headwinds and challenges, and I will follow up on them in the time ahead by expanding on my non short-term concerns. However, here are the four leading issues as seen in my eyes with a big, big assist from my friend, Outside the Box’s rigorous John Mauldin (the first two issues):

* Uncle Sam’s Unfunded Promises: The Trump administration’s tax plan is not a plan. It is a melange of ideas put forth without precision or arithmetic. Any possible supply-side benefits of the tax proposal must be weighed against the dampening impact of future deficits on economic growth

* Pension Storm Warning 

* The Screwflation of the Middle Class: A longstanding concern of mine, the continued income and wealth gap and the likely continued failure of “trickle-down economics,” holds important and adverse social, political and economic ramifications.

* The Fed’s Role and Its Effect on the Markets The bullish cabal is taking an incredible leap of faith that the Fed’s tightening cycle is going to be without hiccup and essentially have been brainwashed by not just the Fed but by the actions of all central banks in believing that every slip-up will be fully rectified. The central banks believe they have cured the diseases called “bear market” and recession and convinced us that we are in a new paradigm. I would argue that this is likely a big mistake, as evidenced by the numerous policy boners by the Fed in the last one to two decades.

Bottom Line

“A bull market is like sex. It feels best just before it ends.” Warren Buffett

We live in a world of instant gratification.

Basing investments on short-term influences and worshiping at the altar of price momentum can be profitable, but it obscures our attention from long-term trends, many of which are potentially quite adverse.

The long term can be seen as a collection of short terms; the long term is little discussed as the investment debate principally is governed by questions regarding near-term market and price movements, in which market participants try to “get it while they can.”

There is a wide disconnect between the current market’s high valuations and focus on short-term influences and the long-term and worrisome trends in pension obligations, spiraling debt, the wealth/income gap and the Fed’s ability to extricate itself from its large balance sheet.

During my morning reading, I ran across a couple of very interesting articles that tied a common theme relating to the current risks in the financial markets.

Via Zerohedge:

88-year-old investing icon John “Jack” Bogle, founder of the Vanguard Group, said:

“The valuations of stocks are, by my standards, rather high, but my standards, however, are high.

When considering stock valuations, Bogle’s method differs from Wall Street’s. For his price-to-earnings multiple, Bogle uses the past 12 months of reported earnings by corporations, GAAP earnings, which include ‘all of the bad stuff,’ to get a multiple of about 25 or 26 times earnings.

‘Wall Street will have none of that. They look ahead to the earnings for the next 12 months and we don’t really know what they are so it’s a little gamble.’

He also noted that Wall Street analysts look at operating earnings, ‘earnings without all that bad stuff,’ and come up with a price-to-earnings multiple of something in the range of 17 or 18.

‘If you believe the way we look at it, much more realistically I think, the P/E is relatively high,’

‘I believe strongly that [investors] should be realizing valuations are fairly full, and if they are nervous they could easily sell off a portion of their stocks.'”

This, of course, from the father of “buy and hold” investing with whom millions of Americans have pumped roughly $4.7 Trillion into a whole smörgåsbord of indexed based ETF’s provided by Vanguard to meet investor appetites.

Think about that for a moment while you read the following snippet from Bloomberg:

“A buoyant and complacent stock market is worrying Richard H. Thaler, the University of Chicago professor who this week won the Nobel Prize in economics.

‘We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.

I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked. Nothing seems to spook the market, and if the gains are based on tax-reform expectations, surely investors should have lost confidence that tax reform is going to happen.'”

These two points drive to the heart of the recent concerns I have expressed in both how companies continue to use accounting gimmickry to win the beat the estimate game” each quarter and the risk of disappointment surrounding tax reform legislation.

But since markets have continued to advance due to the ongoing flood of liquidity from global Central Banks, no one is really paying attention to such “silly” things. However, while market analysts continue to come up with a variety of rationalizations to justify high valuations, none of them hold up under real scrutiny. The problem is the Central Bank interventions boost asset prices in the short-term, in the long-term, there is an inherently negative impact on economic growth. As such, it leads to the repetitive cycle of monetary policy.

  1. Using monetary policy to drag forward future consumption leaves a larger void in the future that must be continually refilled.
  2. Monetary policy does not create self-sustaining economic growth and therefore requires ever larger amounts of monetary policy to maintain the same level of activity.
  3. The filling of the “gap” between fundamentals and reality leads to consumer contraction and ultimately a recession as economic activity recedes.
  4. Job losses rise, wealth effect diminishes and real wealth is destroyed. 
  5. Middle class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption. 
  7. Wash, Rinse, Repeat.

If you don’t believe me, here is the evidence.

The stock market has returned more than 60% since 2007 peak, which is more than three times the growth in corporate sales growth and 30% more than GDP. The all-time highs in the stock market have been driven by the $4.5 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, PE expansion, and ZIRP.

It is critical to remember the stock market is NOT the economy. The stock market should be reflective of underlying economic growth which drives actual revenue growth. Furthermore, GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40).

However, in the meantime, the promise of a continued bull market is very enticing as the “fear of missing out” overrides the “fear of loss.”

Valuations Are Expensive

This brings us back to Jack Bogle and the importance of valuations which are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are HORRIBLE predictors of 12-month returns should not be used in any strategy that has such a focus. However, in the longer term, valuations are strong predictors of expected returns.

I have adjusted Bogle’s measure of valuations to a 24-month, versus 12-month, measure to smooth out the enormous spike in valuations due to the earnings collapse in 2008. The end valuation result is the same but peaks, and troughs, in valuations are more clearly shown.

At 26.81, Bogle is clearly correct that valuations have reached expensive levels. More importantly, outside of the peak in 1999, stocks are more highly valued today than at any other point in history. (The two points during bear market troughs are excluded as those valuations were due to earnings collapsing faster than prices due to recessionary conditions.)

Bogle’s view is also confirmed by other measures as well. The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-ratio. Again, valuations only appear cheap when compared to the peak in 2000. Outside of that exception, the financial markets are now more expensive than at any other single point in history.

I have also previously modified Shiller’s CAPE to make it more sensitive to current market dynamics.

“The need to smooth earnings volatility is necessary to get a better understanding of what the underlying trend of valuations actually is. For investor’s, periods of ‘valuation expansion’ are where the bulk of the gains in the financial markets have been made over the last 116 years. History shows, that during periods of ‘valuation compression’ returns are more muted and volatile.

Therefore, in order to compensate for the potential ‘duration mismatch’ of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.”

To get a better understanding of where valuations are currently relative to past history, we can look at the deviation between current valuation levels and the long-term average going back to 1900.

With a 63.62% deviation from the long-term mean, a reversion will be quite damaging to investors when it occurs. As you will notice, reversions have NEVER resulted in a “sideways” consolidation but rather much more serious, and sharp, declines. These rapid “maulings” of investors is why declines are aptly named “bear markets.” 

Lastly, even Warren Buffett’s favorite valuation measure is screaming valuation issues. The following measure is the price of the Wilshire 5000 market capitalization level divided by GDP. Again, as noted above, asset prices should be reflective of underlying economic growth rather than the “irrational exuberance” of investors.

Of course, it’s Buffett’s own axiom that best sums up all of the famous valuation measures noted above.

“Price is what you pay, valuation is what you get.” 

Maybe Not Today

Bogle, Buffett, Shiller, and Tobin are right about valuations.

Maybe not today.

Next month.

Or even next year.

But as Vitaliy Katsenelson just recently penned:

Our goal is to win a war, and to do that we may need to lose a few battles in the interim.

Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions.

We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.”

With that point, I clearly agree.

The most fundamental basis for economics is human decision-making. Satisfying needs and wants creates demand. Engaging in a vocation to provide a good or service of value to others generates supply. The intersection of the two is a market.

This week we introduce the unique insight of Mark McElroy. Mark is a friend of 720Global who often provides valuable input on our article concepts, their structure and occasionally challenges their validity. Now, with some minor arm-twisting, he challenges the status quo of economics – the profession, the pedigrees and their intentions. 

In Saying It Slowly Doesn’t Help, he doesn’t challenge the PhD economists so much as he takes the rest of us to task. If human decisions are the basis for economics then aren’t we all obligated to be economists at some level? His casual but intentional arms-length observer status poses the question: why is economics so difficult?

Saying It Slowly Doesn’t Help

“The quality of ideas seems to play a minor role in mass movement leadership. What counts is the arrogant gesture, the complete disregard of the opinion of others, the singlehanded defiance of the world.”Eric Hoffer, The True Believer

To communicate about economics is to describe the mirror as if it were a commodity. Economics is a tricky subject. It schemes and dodges—just try to sneak up on a mirror. For all the numbers, parentheses, red and black, boxes and columns, economics is mostly narrative. The digits and bytes of the trade are stand-ins for our resources or assets that are stand-ins for our fears, hopes, memories, hungers and regrets.  Economics is the overly eager attempt to hold at arms-length what we don’t want to see up close. Quantifying the narrative is like measuring a joke. But, it must be done.  It should be done.  Honestly, it needs to be done because no one is alone.

If such twaddle seems impractical, you’re in large company. I get it. That doesn’t necessarily mean you should be off the hook for thinking practically (critically) regarding how we talk about ourselves, our resources, and our guiding principles–economics.  Our collective want for information about economics is huge. Really huge. Cable, Twitter, whatever offers a 24/7 stream of info about economics to more and more people.  Evidently being in a flood doesn’t make one a hydrologist (that was weak, I apologize).  For all the volume of economic info/data available, one would expect we could be fairly proficient in discussing/communicating the basics of economics. Given the rise of six year financing plans for Toyota Corollas, I’m gonna go out on a limb and call BS on the notion that we know how to talk about it effectively. Clearly. Honestly.

If you fancy yourself an economist (and everyone should), it may be of comfort to realize economists are not the only ones in this “we have much to say and struggle to be understood” syndrome.  Scientists find themselves there, too. Scientists are studying themselves and the scientific assumptions regarding how to communicate about science. Tired of being picked last for kickball in the public square, scientists are aiming their magnified gaze upon themselves and are coming around to a counter-intuitive notion.  The more scientists try to correct and inform the public discourse, the less impact they have.  Saying it (you know, smart stuff) with more detail and credentials not only doesn’t work, it makes things worse. Tim Requarth in Slate wrote it like this:

[T]he way most scientists think about science communication—that just explaining the real science better will help—is plain wrong. In fact, it’s so wrong that it may have the opposite effect of what they’re trying to achieve.

I think he meant this:

[T]he way most scientists economists think about science economic communication—that just explaining the real science economics better will help—is plain wrong. In fact, it’s so wrong that it may have the opposite effect of what they’re trying to achieve.

Okay, he clearly did not mean that, but it would have been great if he did. Go read his article in full and play this parlor game. Every time you see “science” or some version of it, replace it with “economics” or some version of it.  It pretty much holds up.

Economics should be natural for us to communicate, but it isn’t. Who doesn’t know what a mirror looks like?  Economics is discussed ad nauseam as if it were an elusive concept that only a few have glimpsed (yep, just like Bigfoot) when it should be as natural as falling off a bike. Why is that?

I have a guess. Something as simple and natural as discussing the priorities and principles around which we value and exchange our assets has been made complex, confusing, and somehow has justified cable news panels with snooty people using phrases I can’t spell (of which there are many)—all this is the handiwork of a cottage industry (institution) committed to sustaining the confusion for profit, prestige, or because they miss satisfaction of taking names in third grade.

SIDEBAR: I am in a sustained lover’s quarrel with an institution that now spans 30+ years. Institutions of all flavors are the same in that their original spark, purpose or mission always becomes overwhelmed by its desire for self-perpetuation. To be clear, when I refer to the cottage industry proliferating the confusion regarding economics as an “institution,” it is meant as no compliment. If you have finished watching the paint dry and are intrigued by the whole institution thing, check out the work of Eric Hoffer, The True Believer: Thoughts on the Nature of Mass Movements.  SIDEBAR CLOSED

If economics remains confusing for me (as is religion and healthcare), I am less likely to experience contentment (or faith or health). Admittedly, though, the institutions that keep economics (and other matters) an ivory tower topic have a willing accomplice in me.  It is a co-dependence. Somewhere deep down I need as a way coping for that topic to be at arms-length.  At arms-length, I can see economics as a collection of digits, theories, and fractional transactions en masse. I am then spared the need to contemplate the basics of economics: stewardship, community, contentment, and charity.

Honestly, it needs to be done because no one is alone.

Mark McElroy, PhD @B40MKM is a writer, farmer, and management consultant with leadership roles in nonprofit and technology/information companies.





 “I think we’re doing the right things with money, but we feel sub-optimized.”

Twenty-eight years guiding others through financial challenges, thousands of words, and oddly I experienced personal angst over this one – “sub-optimized.”

It’s rare the word arises, if at all. There was something about it that captured my ear and mind. I wondered about the obstacles that create what I call “dollar drag,” whereby the highest and best use of our money is overlooked or ignored.

Sub-optimization is an equal opportunity offender. We all are afflicted, even if our track record of handling money is better than average. There can be great intentions, even respectable core money habits and yet sub-optimization thrives because we’re human.

As in the case of this forty-something couple: Six-figure wage earners, ambitious savers who set aside 20% of income for retirement, well-funded 529 plans for young children and saddled with dangerous credit card debt levels due to a failed real estate venture.

Overall, I give them high marks when it comes to handing their money however a simple solution to reduce the high-interest debt was clearly in front of them and they couldn’t see it. They couldn’t wrap their minds around their financial condition in its entirety.

There was a mental barrier between the personal and business debt even though they were the business. In other words, the burdensome interest charges affected their household net worth.

As a financial professional I realize nobody can avoid some degree of sub-optimization or dollar drag. Much of it stems from a failure in our logic called mental accounting.

See, we like to compartmentalize money: We create mental walls that prevent us from considering how each dollar may flow freely through and across various goals to the final and best destinations on our household balance sheets.

Dan Ariely, professor of behavioral economics at Duke University and New York Times best-selling author helped me understand how to position “highest and best use” in my mind. He said

“Every financial decision has an opportunity cost. You cannot make the best money choices in a vacuum.”

You must revolve around each decision and control where your money lands.

So, how can you make better financial choices and think full circle?

6-Steps To Optimization

1) Break it down and look around.

Don’t perceive every financial challenge as a straight edge with a beginning and conclusion. It leads to narrow thinking and sub-optimization at the point of action.

Round out your thought process. Go where you never been before. When presented with a financial decision, break down the walls, goals, compartments and picture how all your dollars can flow free from their different types of accounts and work together to achieve the greatest impact to your bottom line.

When performing this exercise with my fiscally responsible couple, we concluded that utilizing an existing home equity line of credit at less than 4% interest, to pay off the credit card with 21% interest rate, was an optimum conclusion.

It was a major improvement never considered because the mental barriers were thick between business and personal accounts. Once those barriers were removed, a solution was obvious.

2) Grab every opportunity to assess the opportunity (cost).

I’ve gone overboard with this one. I take lessons seriously from influences like Dan Ariely and share them with anyone who will listen. I now examine the “full circle” of every money choice. I’m obsessed with dollar drag.

During a recent evening out, before ordering at an iconic Texas barbecue place, I stepped back and thought of what else I could do with the money.  Was this the “highest and best use” for my $28 bucks?

I took away the walls and permitted the money to flow through other options including eating at home. I had to weigh the opportunity cost until I either returned full circle to the current choice, or stopped on a better solution. Better doesn’t always mean cheaper, either. When it comes to opportunity cost you need to input much into the calculation including what your time is worth and qualitative factors.

If anything, this type of exercise will allow you to pause before making a purchase and create awareness about other options that may bring greater satisfaction and value.

And yes, I went for the pork ribs and fixings.

3) Think rooftop, not basement.

When you bust down the walls between dollars, you begin to think bigger (and smarter). You’re up on the roof looking out and over the landscape of your finances. You begin to see how fungible money is.

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

For example, when gasoline prices were shy of 4 dollars a gallon, I was inundated with inquiries about trading in paid-off automobiles for new gas-efficient options. In other words, I was being asked whether spending $32,000 was worth the saving of $600 a year at the gas pump.

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

4) Hire a navigator.

The navigators are out there. The best financial advisers are sensitive to their own emotional biases and can help others navigate through theirs. There’s a synergy and greater satisfaction when a financial partner can help reduce barriers and encourage breakthrough or “a-ha” moments.

You always appreciate the highest and best use of a navigator. Ostensibly, your net worth should be affected positively, too.

5) Live your retirement plan optimization. Most people I encounter have a retirement strategy. Unfortunately, it exists in their heads, but not in writing.

Those who have a formal, written plan tend to weigh opportunity costs or are at the least, sensitive to the implications of their financial choices.  Since plans take into account your entire financial picture they re-direct focus on the big picture. Hey, the portfolio is important, but it isn’t everything.

Eventually, emotional walls crumble; you can easily think full circle and assess how every decision made today affects your retirement start date.

6) How sub-optimized are your relationships? As you grow as an individual, a force, you must consistently optimize your relationships to determine who is worthy of your inner circle. All the others must be cast away. They’re weights tied to your spirit and they will hold you down.  Surround yourself with those who are smarter than you (not just book smart, but also will expose you to learning experiences outside your comfort zones). Also, people who make you laugh inspire optimization.


Now that you’re in the mood to bust boundaries around money, keep in mind that any account can be a retirement account. Just because it’s not held with your employer or doesn’t have “IRA” in the title, doesn’t mean the dollars you save aren’t applicable to retirement. Society, to a degree, has encouraged mental accounting by sanctioning retirement vs. non-retirement accounts.

As part of your change in thinking, consider all money in one pool. You decide how it flows to its most honorable (and hopefully lucrative) conclusion.

Sub-optimization optimized my thinking; I hope it’s sparked a new perspective for you.

This past weekend, I discussed what appears to be the markets ongoing melt-up toward its inevitable conclusion. Of course, that move is supported by the last of the “holdouts” that finally capitulate and take the plunge back into a market that “can seemingly never go down.” But therein lies the danger. To wit:

“However, it should be noted that despite the ‘hope’ of fiscal support for the markets, longer-term conditions are currently present that have led to rather sharp market reversions in the past.”

“Regardless, the market is currently ignoring such realities as the belief ‘this time is different’ has become overwhelming pervasive.”

The other problem on a short-term basis is the market is pushing very elevated levels currently. As shown below, with RSI (14) now above 70, the market 3-standard deviations above the 50-dma, and the MACD over 13, in both previous cases over the last year a short-term reversal followed.

A similar outcome would not be surprising this time either, so some caution is advised.

Positioning Review

The COT (Commitment Of Traders) data, which is exceptionally important, is the sole source of the actual holdings of the three key commodity-trading groups, namely:

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

The data we are interested in is the second group of Non-Commercial Traders.

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

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

Volatility Extreme

The extreme net-short positioning on the volatility index suggests there will be a rapid unwinding of positions given the right catalyst. As you will note, reversals of net-short VIX positioning has previously resulted in short to intermediate-term declines. With the largest short-positioning in volatility on record, the rush to unwind that positioning could lead to a much sharper pickup in volatility than most investors can currently imagine.

Crude Oil Extreme

The recent attempt by crude oil to get back to $50/bbl coincided with a “mad rush” by traders to be long the commodity. For investors, it is also worth noting that crude oil positioning is also highly correlated to overall movements of the S&P 500 index. With crude traders currently extremely “long,” a reversal will likely coincide with both a reversal in the S&P 500 and oil prices being pushed back towards $40/bbl. 

While oil prices could certainly fall below $40/bbl for a variety of reasons, the recent bottoming of oil prices around that level will provide some support. Given the extreme long positioning on oil, a reversion of that trade will likely coincide with a “risk off” move in the energy sector specifically. If you are overweighted energy currently, the data suggests a rebalancing of the risk is likely advisable.

US Dollar Extreme

Recent weakness in the dollar has been used as a rallying call for the bulls. However, a reversal of US Dollar positioning has been extremely sharp and has led to a net-short position.

As shown above, and below, such negative net-short positions have generally marked both a short to intermediate-term low for the dollar as well as struggles for the S&P 500 as a stronger dollar begins to weigh on exports and earnings estimates.

It is also worth watching the net-short positioning the Euro-dollar as well which has also begun to reverse in recent weeks. Historically, the reversal of the net-short to net-long positioning on the Eurodollar has often been reflected in struggling financial markets.

Interest Rate Extreme

One of the biggest conundrums for the financial market “experts” is why interest rates fail to rise. Apparently, traders in the bond market failed to get the “memo.” With the net positioning in bonds at some of the highest levels since the financial crisis, there is little reason to believe the “bond bull” market is over. Look for a reversal of the current positioning to push bond yields lower over the next few months.

Smart Vs. Dumb Money Extreme

While we have been looking at solely the large non-commercial traders above, they are not the only ones playing in the future markets. We can also dig down into the overall net exposure of retail investors (considered the “dumb money”) versus that of the major institutional players (“smart money”)

The first chart below shows the 3-month moving average of both smart and dumb-money players as compared to the S&P 500 index. With dumb-money running close to the highest levels on record, it has generally led to outcomes that have not been favorable in the short-term.

We can simplify the index above by taking the net-difference between the two measures. Not surprisingly, the message remains the same. With the confidence of retail investors running near historic peaks, outcomes have been less favorable.

None of this analysis suggests that a market “crash” is about to occur tomorrow. However, with complacency high, and investors scrambling to find excuses why markets can only go higher, suggests that extremes in positioning have likely been reached. 

This was a point made by Macquarie’s Viktor Shvetz, the bank’s head of global equity strategy, yesterday:

Investors seem to be residing in a world without any notable perceived risks. It is an extraordinary and unprecedented situation, particularly given unresolved issues of over-leveraging and associated over-capacity as well as profound disruption of business and economic models, which are not just depressing inflation but also causing extreme political and electoral outcomes while feeding Maslowian-type disappointments across labor markets.

What can explain such lack of concern regarding potential risks?

In our view, the only answer is one of investors’ perception that, as we discussed in our preview of 2H’17, ‘slaves must remain slaves’ and hence, neither Central Banks nor other public institutions can afford to step aside but need to continue to guarantee asset price inflation. In its turn, this can only be achieved by ensuring that volatilities are contained (as they are the deadliest enemy of an ongoing leveraging) and liquidity is expanding at a sufficient pace to accommodate nominal demand.

We remain constructive on financial assets (both equities and bonds), not because we expect a return to self-sustaining private sector-led recovery and growth but because we believe that an ongoing financialization is the only politically and socially acceptable answer.

In our view, therefore, the greatest risk is one of policy.”

The complete disregard for “risk” has never worked out well for investors in the past and is unlikely to be different this time either. But remember, in the short-term, the markets can remain irrational longer than logic would predict and they always “feel” their best at the peak.

The rise in the market has seemed unstoppable. Despite the Federal Reserve continuing to hike interest rates and tightening monetary policy, geopolitical risks from North Korea to Iran, mass shootings, failure of legislative agenda and weak economic growth – the market’s rise has continued unabated.

Much of the recent rise, as discussed last week, has been based upon faulty assumptions about the effect of tax cuts and reforms. However, in the short-term, it is always the exuberance of market participants chasing returns as the “fear of missing out,” or FOMO, overrides the logic of fundamentals.

The problem for investors is that since fundamentals take an exceedingly long time to play out, as prices become detached “reality,” it becomes believed that somehow “this time is different.” 

Unfortunately, it never is.

Our chart of the day is a long-term view of price measures of the market. The S&P 500 is derived from Dr. Robert Shiller’s inflation adjusted price data and is plotted on a QUARTERLY basis. From that quarterly data I have calculated:

  • The 12-period (3-year) Relative Strength Index (RSI),
  • Bollinger Bands (2 and 3 standard deviations of the 3-year average),
  • CAPE Ratio, and;
  • The percentage deviation above and below the 3-year moving average. 
  • The vertical RED lines denote points where all measures have aligned

Over the next several weeks, or even months, the markets can certainly extend the current deviations from long-term mean even further. But that is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market “holdouts” back into the markets.

As Vitaliy Katsenelson penned last week:

Our goal is to win a war, and to do that we may need to lose a few battles in the interim. Yes, we want to make money, but it is even more important not to lose it. 

We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.”

I wholeheartedly agree with that statement which is why we remain invested, but hedged, within our portfolios currently. Unfortunately, for most investors, they are currently playing with a losing hand.

As the chart clearly shows, “prices are bound by the laws of physics.” While prices can certainly seem to defy the law of gravity in the short-term, the subsequent reversion from extremes has repeatedly led to catastrophic losses for investors who disregard the risk.

With sentiment currently at very high levels, combined with low volatility and excess margin debt, all the ingredients necessary for a sharp market reversion are currently present. Am I sounding an “alarm bell” and calling for the end of the known world? Should you be buying ammo and food? Of course, not.

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desired end result you have been promised.

As I stated above, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered “bearish” to point out the potential “risks” that could lead to rapid capital destruction; then I guess you can call me a “bear.” However, just make sure you understand that I am an “almost fully invested bear”…for now.

But such can, and will, rapidly as the market dictates.

(Follow up read on how to approach the market: The 80/20 Rule Of Investing)

Just remember, in the market there really isn’t such a thing as “bulls” or “bears.” There are only those that “succeed” in reaching their investing goals and those that “fail.” 

With the market recently breaking above 2500, there seems to be nothing to dampen the bullish exuberance. The recent run, which has largely been focused on areas in the market with the most sensitivity to tax cuts, has exploded over the last two weeks to record highs. That explosion has also lead to a surge in the Market Greed/Fear Gauge which comprises different measures of market complacency and bullishness.

But the rush to chase performance can be clearly seen in the chart below of the S&P 600 index (small cap) which is now 4-standard deviations above the 6-month moving average.

Then there is the widely viewed CNN Fear/Greed Index.

Of course, not surprisingly, with investors as optimistic and bullish as they can be equity to money market ratios are at extremes.

And “Dumb Money” is continuing to pile into markets as “Smart Money” is willing to sell positions to them.

After 9-years of a bull market, and pushing a 270% gain from the lows, investors have now decided it is now time to get back into the market. But that is the nature of a bull market, and particularly one that has entered into the final stages of long-term cyclical advance, where the last of the “holdouts” are sucked back into the game.

As we enter into earnings season, we once again enter into the “beat the estimates game,” where analysts act surprised that companies “beat” lowered estimates. In the short-term, these “beat rates” will provide support for the bullish case, but in the long-term, it is valuations and actual revenue growth that matters.

I agree with Doug’s sentiment yesterday:

  •  Massive injections of liquidity from the world’s central bankers
  • Passive investing (quants and ETFs) are now dominating markets (at nearly 40%) at the margin
  • Machines and algorithms, as well as many individual investors, are behaving differently as they are now programmed and conditioned to buy the dips.
  • 17% of the listed shares outstanding have been retired in corporate stock repurchases since the Generational Low in March, 2009.
  • More than half of the listed companies on the exchanges have disappeared over the last eight years

“We have a Bull Market in Complacency.” – Doug Kass


Here’s your reading list to for the weekend.

Trump Tax Cuts…


Research / Interesting Reads

“In a bear market all stocks go down and in a bull market they go up.Jesse Livermore

Questions, comments, suggestions – please email me.

“At this time 85 years ago, Yale economist Irving Fisher was jubilant. ‘Stock prices have reached what looks like a permanently high plateau,’ he rejoiced in the pages of The New York Times. That dry pronunciation would go on to be one of his most frequently quoted predictions — but only because history would record his declaration as one of the wrongest market readings of all time.” -Time Magazine, “The Worst Stock Tip In History

In Jim “El Capitan” Cramer’s opening missive today he analytically addresses the active vs. passive conflict, which helps explain the market’s steady bullish action. As Jim writes:

“The answer is that there are two kinds of sellers in this market: hedge fund sellers, who react off of research, and portfolio shufflers, who buy and sell ETFs and index funds.

The former jump on anything, right or wrong, as long as it is actionable. Sure, if PepsiCo (PEP) has an organic growth shortfall, as we said could happen in our Action Alerts PLUS bulletins last week about PEP, it could get hammered. That’s a change in the margin of a bad group. But most of the  ‘valuation’ calls analysts make, shy of catalysts, only produce hedge fund jumps.

The latter, the index funds and ETF traders, rarely jump although they may press down harder on a bedraggled ETF, like one that includes the consumer products group.

But there are two kinds of buyers. The opportunistic buyers and the index buyers. The opportunists think that the downgrades are noise and give them a chance to buy high quality stocks with the money that comes in over the transom.

The index and ETF buyers? Well, they just buy.

The dichotomy explains a lot of the bullish action, and isn’t talked about enough. You see the sellers off those research calls? They were either shorts, or people who hadn’t done their homework, because nothing really happened to justify their actions.

But the buyers?

They lurk and wait and pounce.”

I am in basic agreement with Jim but would differ a bit in my interpretation of why dips are bought and how sustainable that buying is.

ETFs and index funds, when faced with a constant and large inflow of funds, are always rebalancing and buying, which is why all dips are purchased. But sizable net inflows may not be seen over time as a constant state, because at some point there will be outflows and that steady dip buying and demand for stocks could disappear almost immediately. To be sure, attempts to give reasons why investor sentiment, now buoyant (see the latest CNN Fear & Greed Index), may erode have fallen on deaf ears this year. But ebbs and flows are a more natural condition of the markets, and as sure as night follows day, the outflows at some point will return. And if ETFs sell, who will be left to buy?

Second, another source of dip buying, as mentioned below (and not covered by Jimmy), are the quant funds that are influenced by a conditioning in the algorithms to buy weakness. That buying has nothing to do with fundamentals, as machines are agnostic to the value — or lack of value — inherent in the income statement, balance sheets and replacement values of the constituent stocks. And, of course, traders who worship at the altar of price momentum are now following the dip buying of quant funds.

Third, money is coming out of active managers in favor of passive investing (i.e., ETFs and quants). Many high-profile and successful managers have closed. Hedge funds — the catalyst for fundamental-based selling that Jim describes — no longer hold the sort of influence that they have in the past.

The Virtuous Circle

The dominance and impact of these three constituents — inflows into ETFs, an expansion in quants’ influence and the contraction taking place in hedge funds — explain a lot about the dip buying that has existed over the last year and the current virtuous circle of demand versus supply.

I recently added up some other reasons for the dip buying.

From my perch, stocks continue to be buoyed by some of the following conditions:

* Massive injections of liquidity from the world’s central bankers

* Passive investing (quants and ETFs) are now dominating markets (at nearly 40%) at the margin

* Machines and algorithms, as well as many individual investors, are behaving differently as they are now programmed and conditioned to buy the dips

* 17% of the listed shares outstanding have been retired in corporate stock repurchases since the Generational Low in March, 2009.

* More than half of the listed companies on the exchanges have disappeared over the last eight years

* We have a Bull Market in Complacency

–Kass Diary, “A Bull Market in Complacency”

We are having a hard time finding high-quality companies at attractive valuations.

For us, this is not an academic frustration. We are constantly looking for new stocks by running stock screens, endlessly reading (blogs, research, magazines, newspapers), looking at holdings of investors we respect, talking to our large network of professional investors, attending conferences, scouring through ideas published on value investor networks, and finally, looking with frustration at our large (and growing) watch list of companies we’d like to buy at a significant margin of safety. The median stock on our watch list has to decline by about 35-40% to be an attractive buy.

But maybe we’re too subjective. Instead of just asking you to take our word for it, in this letter we’ll show you a few charts that not only demonstrate our point but also show the magnitude of the stock market’s overvaluation and, more importantly, put it into historical context.

Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: the average stock is overvalued somewhere between tremendously and enormously. If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry, we don’t know either. But this is our point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.

Let’s demonstrate this point by looking at a few charts.

The first chart shows price-to-earnings of the S&P 500 in relation to its historical average. The average stock today is trading at 73% above its historical average valuation. There are only two other times in history that stocks were more expensive than they are today: just before the Great Depression hit and in the1999 run-up to the dotcom bubble burst.

We know how the history played in both cases – consequently stocks declined, a lot. Based on over a century of history, we are fairly sure that, this time too, stock valuations will at some point mean revert and stock markets will decline. After all, price-to-earnings behaves like a pendulum that swings around the mean, and today that pendulum has swung far above the mean.

What we don’t know is how this journey will look in the interim. Before the inevitable decline, will price-to-earnings revisit the pre-Great Depression level of 95% above average, or will it maybe say hello to the pre-dotcom crash level of 164% above average? Or will another injection of QE steroids send stocks valuations to new, never-before-seen highs? Nobody knows.

One chart is not enough. Let’s take a look at another one, called the Buffett Indicator. Apparently, Warren Buffett likes to use it to take the temperature of market valuations. Think of this chart as a price-to-sales ratio for the whole economy, that is, the market value of all equities divided by GDP. The higher the price-to-sales ratio, the more expensive stocks are.

This chart tells a similar story to the first one. Though neither Mike nor Vitaliy were around in 1929, we can imagine there were a lot of bulls celebrating and cheerleading every day as the market marched higher in 1927, 1928, and the first eleven months of 1929. The cheerleaders probably made a lot of intelligent, well-reasoned arguments, which could be put into two buckets: first, “This time is different” (it never is), and second, “Yes, stocks are overvalued, but we are still in the bull market.” (And they were right about this until they lost their shirts.)

Both Mike and Vitaliy were investing during the 1999 bubble. (Mike has lived through a lot of more bubbles, but a gentleman never tells). We both vividly remember the “This time is different” argument of 1999. It was the new vs. the old economy; the internet was supposed to change or at least modify the rules of economic gravity – the economy was now supposed to grow at a new, much faster rate. But economic growth over the last twenty years has not been any different than in the previous twenty years – no, let us take this back: it has actually been lower. From 1980 to 2000 real economic growth was about 3% a year, while from 2000 to today it has been about 2% a year.

Finally, let’s look at a Tobin’s Q chart. Don’t let the name intimidate you – this chart simply shows the market value of equities in relation to their replacement cost. If you are a dentist, and dental practices are sold for a million dollars while the cost of opening a new practice (phone system, chairs, drills, x-ray equipment, etc.) is $500,000, then Tobin’s Q is 2. The higher the ratio the more expensive stocks are. Again, this one tells the same story as the other two charts: Stocks are very expensive and were more expensive only twice in the last hundred-plus years.

What will make the market roll over? It’s hard to say, though we promise you the answer will be obvious in hindsight. Expensive markets collapse by their own weight, pricked by an exogenous event. What made the dotcom bubble burst in 1999? Valuations got too high; P/Es stopped expanding. As stock prices started their decline, dotcoms that were losing money couldn’t finance their losses by issuing new stock. Did the stock market decline cause the recession, or did the recession cause the stock market decline? We are not sure of the answer, and in the practical sense the answer is not that important, because we cannot predict either a recession or a stock market decline.

In December 2007, Vitaliy was one of the speakers at the Colorado CFA Society Forecast Dinner. A large event, with a few hundred attendees. One of the questions posed was “When are we going into a recession?” Vitaliy gave his usual, unimpressive “I don’t know” answer. The rest of the panel, who were well-respected, seasoned investment professionals with impressive pedigrees, offered their well-reasoned views that foresaw a recession in anywhere from six months to eighteen months. Ironically, as we discovered a year later through revised economic data, at the time of our discussion the US economy was already in a recession.

We spend little time trying to predict the next recession, and we don’t try to figure out what prick will cause this market to roll over. Our ability to forecast is very poor and is thus not worth the effort.

An argument can be made that stocks, even at high valuations, are not expensive in context of the current incredibly low interest rates. This argument sounds so true and logical, but – and this is a huge “but” – there is a crucial embedded assumption that interest rates will stay at these levels for a decade or two.

Hopefully by this point you are convinced of our ignorance, at least when it comes to predicting the future. As you can imagine, we don’t know when interest rates will go up or by how much (nobody does). When interest rates rise, then stocks’ appearance of cheapness will dissipate as mist on the breeze.

And there is another twist: If interest rates remain where they are today, or even decline, this will be a sign that the economy has big, deflationary (Japan-like) problems. A zero interest rate did not protect the valuations of Japanese stocks from the horrors of deflation – Japanese P/Es contracted despite the decline in rates. America maybe an exceptional nation, but the laws of economic gravity work here just as effectively as in any other country.

Finally, buying overvalued stocks because bonds are even more overvalued has the feel of choosing a less painful poison. How about being patient and not taking the poison at all?

You may ask, how do we invest in an environment when the stock market is very expensive? The key word is invest. Merely buying expensive stocks hoping that they’ll go even higher is not investing, it’s gambling. We don’t do that and won’t do that.

Not to get too dramatic here, but here’s how we look at it: Our goal is to win a war, and to do that we may need to lose a few battles in the interim.

Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions.

We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.

However, valuing companies is not random. In the long run stocks revert to their fair value. If we assemble a portfolio of high-quality companies that are significantly undervalued, then we should do well in the long run. However, in the short run we have very little control over how the market will price our stocks.

Our focus in 2016 was to improve the overall quality of the portfolio – and we did. We will stubbornly continue to build a portfolio of high-quality companies that are undervalued.

The market doesn’t need to collapse for us to buy new stocks. The market falls in love and out of love with specific sectors and stocks all the time. In 2014 and 2015 healthcare stocks were in vogue, but in 2016 that love was replaced by a raging hatred. We bought a lot of healthcare stocks in 2016. In the first quarter, REITs as a group were decimated and we bought Medical Properties Trust (MPW) at less than 10 times earnings and a near 8% dividend yield – more on that later. We also spend a lot of time looking for stocks outside the US, in countries that have a free market system and the rule of law.

The point we want to stress is this: We don’t own the market. Though the market may be overvalued, our portfolio is not.

Last week, I did a fairly extensive analysis on the release of the 9-page “Trump Tax Cut” plan. 

The most important aspect of that discussion was the difference between 1982, the last time there was permanent tax reform, as compared to today.

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


The differences between today’s economic and market environment could not be starker. The tailwinds provided by initial deregulation, consumer leveraging and declining interest rates and inflation provided huge tailwinds for corporate profitability growth.

Most importantly, when tax cuts were implemented in the mid-80’s, the U.S. economy was just coming out of back-to-back recession versus being in the third longest economic expansion on record to date.

However, besides the fact the economic backdrop is diametrically opposed to what is was during the “Reagan years,” we also need to look at the backdrop of who actually pays taxes to begin with.

Who Pays Taxes

While the current tax plan has not defined actual income levels as of yet, we can make some assumptions from previous iterations of proposals. The entire premise behind the tax cuts is that it will unleash economic growth, generate millions of jobs, bring back manufacturing to America and lead to higher wage growth.

However, given that roughly 70% of economy is driven by personal consumption, the tax cuts will need to increase the amount of disposable incomes available to individuals to expand consumption further, thereby increasing overall economic growth.

So, here is the issue of tax cuts for the middle class. The chart below shows “who pays what in Federal taxes.”

Look at that chart closely.

  • 50% of ALL taxes are paid by the top 10% of income earners.
  • The other 50% of ALL taxes are paid by remaining 90%.
  • The BOTTOM 80% only pay 36% of ALL taxes.

But it is even more glaring when we look at the taxes paid by just the top 20% of income earners.

Given that roughly 2/3rds of income taxes are paid by the top 20%, the reality is that tax cuts will have their greatest impact in reducing the tax burden of those individuals.

The picture gets worse when you look at just INDIVIDUAL tax liabilities. The bottom 80% currently pay only about 18% of individual taxes with top 20% paying the rest. Furthermore, the bottom 40% currently have a NEGATIVE tax liability, and with the new tax plan cutting many of the deductions currently available for those in the bottom 40%, it could be the difference between a tax refund and actually paying taxes. 

Of course, those in the top 20% of income earners are likely already consuming at a level with which they are satisfied. Therefore, a tax cut which delivers a few extra dollars to their bottom line, will likely have a negligible impact on their current levels of consumption.

The problem, as I have detailed previously, is that the vast majority of Americans are living paycheck to paycheck. According to CNN, almost six out of every ten Americans do not have enough money saved to even cover a $500 emergency expense. That lack of savings can be directly contributed to the lack of income growth as noted recently by Bloomberg:

“Newly released income and wealth data from the Federal Reserve Board’s triennial Survey of Consumer Finances show that America’s richest families enjoyed gains in income and net worth over the last decade. Not part of the top 10 percent? Then your income probably fell. The data show that families ranked in the highest percentile saw an income gain of $16,300 from 2007 to 2016. Those below are still making less money.”

So, with 80% of Americans living paycheck-to-paycheck, the need to supplant debt to maintain the standard of living has led to interest payments consuming a bulk of actual disposable income. The chart below shows that debt has exceeded personal consumption expenditures. Therefore, any tax relief will most likely evaporate into the maintaining the current cost of living and debt service which will have an extremely limited, if any, impact on fostering a higher level of consumption in the economy.

But again, there is a vast difference between the level of indebtedness (per household) for those in the bottom 80% versus those in the top 20%.

But Corporate Tax Cuts Are The Key, Right?

Yes, corporate tax cuts will immediately drop to the bottom lines of corporate income statements. When that earnings boost is combined with any repatriated dollars to buy back shares, there will be an earnings expansion for the first year. (You didn’t REALLY think they would use repatriated dollars to expand production and hire workers did you?)

Importantly, while there is a boost to bottom line earnings, there was NO increase in top-line revenues.

However, from an economic perspective, tax cuts for corporations will have only a minor impact in reality. The first chart below shows total federal tax revenue by source.

As you can see, corporate taxes are less than 10% of the total taxes collected by the Government.

But more importantly, it is the promise of cutting the corporate tax rate from 35% to 20% that has gotten the financial markets all excited.

There’s just one problem. Roughly 80% of all corporations already pay rates far lower than 20% and any reduction in deductions for corporations will actually lead to higher taxes being paid. As shown below, 90% of all corporations currently have a tax rate below 10%.

It is a myth that the U.S. has the highest corporate tax rate in the world. We simply don’t.

This was also an observation made by Dr. John Hussman this week:

“I’ll add that another feature of Wall Street’s blissful delusion is the notion that ‘U.S. corporate taxes are the highest in the world.’ It’s striking how disingenuous this claim is. The fact is that among all OECD countries, the U.S. is also the only country that does not levy any tax at all on corporate value-added in the production of goods and services.”

“The main point is this. The argument that U.S. taxes on corporate profits are somehow oppressive relative to other countries is an apples-to-oranges comparison. It wholly ignores that the U.S. levies no value-added tax on corporations at all, whereas the value-added tax is the principal revenue source for most other countries. The rhetoric on corporate taxes here is unfiltered effluvium.

The chart below presents a clearer picture of U.S. corporate profits taxation. Actual taxes paid by U.S. companies, as a share of pre-tax profits, have never been lower, outside of the depths of the global financial crisis.”

Again, as with individual taxes, today ain’t 1982 or 1986.

The effective outcome of tax cuts at this juncture will result in:

  • Only a minimal impact to economic growth, if any at all. 
  • An expansion of the debt of between $2-5 Trillion depending on next recessionary drag.
  • A ballooning of the budget deficit as entitlements rise with the expansion of child tax credits. 
  • A further divide in the “wealth gap” between those in the top 10% and the bottom 90%. 

This issue of whether tax cuts lead to economic growth was examined in a 2014 study by William Gale and Andrew Samwick:

“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

Again, the timing is not advantageous, the economic dynamics are not supportive and the structure of the tax cut itself is not self-supporting.

As Hussman concludes:

“The potential effect of even a substantial percentage reduction in statutory rates for several years is quite small when the present value of the tax reduction is compared with existing equity market capitalization. The likely cumulative impact comes to just a few percent of stock market value.

Against that, consider that the most reliable market valuation measures we identify (as measured by their correlation with actual subsequent S&P 500 total returns in market cycles across history) are currently between 2.5 and 2.7 times their historical norms (that is, 150% to 170% above those norms).

Put simply, it seems misguided to imagine that ‘tax reform’ will somehow make the most obscene speculative bubble in U.S. history something other than the most obscene speculative bubble in U.S. history.”

Put simply, you can’t solve a debt-problem with tax cuts.

The following article was published for premium subscribers of 720Global’s The Unseen on July 28, 2017. 720Global is sharing it exclusively with readers of Real Investment Advice.  Despite being two months “seasoned”, the rationale for hedging equity market exposures are even more relevant today. For more information on The Unseen please contact

Protecting your Blind Side

The price of protecting quarterbacks was driven by the same forces that drove the price of other kinds of insurance: it rose with the value of the asset insured, with the risk posed to that asset.”  -Michael Lewis, The Blind Side

Counter-intuitively, that is often not the case in the capital markets. The more asset valuations and risk rise, the more implied volatility tends to drop and therefore the cost of insuring financial assets typically fall. As the S&P 500 index nears the sumptuously round number of 2500 and valuations surpass levels preceding the Great Depression, the price of options to protect investors is deeply discounted.  Provide valuable insight

The lead quote from Michael Lewis is in reference to NFL Hall of Famer Lawrence Taylor, otherwise known as LT, a defensive end for the New York Giants. LT was an exceptional player who not only threatened an opposing team’s offensive prowess but more importantly, the health of their quarterback. The Blind Side, by Michael Lewis, documented how teams were forced to pay dearly for insurance against this threat. The insurance came in the form of soaring salaries for strong left tackles who protect right handed quarterbacks from the so called “blind side” from which players like LT were attacking. The sacrifices teams made to shield their most valuable asset, the quarterback, limited the salaries that could be spent on players to boost their offensive fire power. LT taught general managers an important lesson -protecting your most important asset is vital in the quest for success.

Growing your wealth through good times and preserving it in bad times are the key objectives of wealth management. At times when the markets present “LT”-like threats, prudence argues for both a conservative posture and protection of assets.

While many investors continue to ignore the lopsided risk/return proposition offered by the equity markets, we cannot. Sitting on one’s hands and avoiding the equity market is certainly an option and one which we believe might look better over time than most analysts think. That said, it is not always a viable option for many professional and individual investors. Some investors have a mandate to remain invested in various asset classes to minimum required levels. In other cases, investors need to earn acceptable returns to help themselves or their clients adhere to their financial goals. Accordingly, the question we address in this article is how an investor can run with the bulls and take measures to avoid the horns of a major correction.

Risk vs. Reward

There are two divergent facts that make investing in today’s market extremely difficult.

  1. The market trend by every measure is clearly Any novice technician with a ruler projected at 45 degrees can see the trend and extrapolate ad infinitum.
  2. Markets are extremely overvalued. Intellectually honest market analysts know that returns produced in valuation circumstances like those observed today have always been short-lived when the inevitable correction finally arrives.

In The Deck is Stacked we presented a graph that showed expected five-year average returns and the maximum drawdowns corresponding with varying levels of Cyclically-Adjusted Price-to-Earnings (CAPE) ratios since 1958. We alter the aforementioned graph, as shown below, to incorporate the odds of a 20% drawdown occurring within the next five years.

Over the next five years we should expect the following:

  1. Annualized returns of -.34% (green line)
  2. A drawdown of 27.10% from current levels (red line)
  3. 76% odds of a 20% or greater correction (yellow bars)

In a recent article, 13D Research raised an excellent point quoting Steve Bregman of Horizon Kinetics:

There is no factor in the algorithm for valuation. No analyst at the ETF organizer—or at the Pension Fund that might be investing—is concerned about it; it’s not in the job description. There is, really, no price discovery. And if there’s no price discovery, is there really a market?”

If, as Bregman states, the market is awash with investors, traders and algorithmic robots that do not care about fundamentals or value, is there any reason to think the market cannot continue to ignore fundamentals and run higher? While such a condition can easily endure and propel prices to even loftier valuations, the precedent of prior bubbles dictates this does not end well. At some point, the reality of economic fundamentals which underlie prices reassert themselves. Accordingly, in the following section, we present a few hedging strategies that allow one to profit if the market keeps charging ahead and at the same time limit losses and/or profit if financial gravity reasserts itself.


There are an infinite number of options strategies that one can deploy to serve all kinds of purposes. Even when narrowing down the list to purely hedging strategies one is left with an enormous number of possibilities. In this section, we discuss three strategies that involve hedging exposure to the S&P 500. The purpose is to give you a sense of the financial cost, opportunity cost, and loss mitigation benefits that can be attained via options.

Option details in the examples below are based on pricing as of July 24, 2017.

Elementary Put Hedge

This first option strategy is the simplest option hedge one can employ. A put provides its holder a right to sell a security at a given price. For instance, if you own the S&P 500 ETF (SPY) at a price of 100 and want to limit your downside to -10% you can buy a put with a strike price of 90. If SPY drops below 90, the value of the put will rise in line, dollar-for-dollar with the loss on SPY, thus nullifying net losses beyond 10%. Devising a similar strategy to manage a basket of stocks, ETF’s or mutual funds is more complicated but similar.

To help visualize what a return spectrum might look like on a portfolio hedged in this manner consider a simple scenario in which one owns the S&P 500 (SPY) and hedges with SPY options.  The following assumptions are used:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase SPY put options with a strike price of $230, expiration of 9/21/2018 and a cost of $9.15 per share and total cost of $915 per option. (Each option is equal to 100 shares)

The graph below provides the return profile of the long SPY position (black) and three hedged portfolios for a given range of SPY prices. The example provides three different hedging options to show what under-hedged (2 options), perfectly-hedged (4 options) and over-hedged (8 options) outcomes might look like.

Note the breakeven point (yellow circle) on the hedged portfolios occurs if SPY were to decline 10% to $221 per share. The cost of the options in percentage terms is shown on the right side of the breakeven point. It is the difference in returns between the black line and the dotted lines. Conversely, the benefit of the options strategies appears in the percentage return differentials to the left of the breakeven point. (Additional cost/benefit analysis of these strategies is shown further in the article) In this example, we assume the options are held to the expiration date. Changes in other factors such as time to expiration, rising or falling volatility, and intrinsic value will produce results that do not correspond perfectly with the results above at any point in time other than at the expiration date.


The elementary option strategy was straightforward as it only involved buying a one-year put option. Like the first strategy, a collar entails holding a security and buying a put to hedge the downside risk. However, to reduce the cost of the put option a collar trade requires one to also sell (write) a call option. A call option entitles the buyer/owner to purchase the security at the agreed upon strike price and the seller/writer of the option to sell it to them at the agreed upon strike price. Because the investor is selling/writing an option, he is receiving payment for selling the option. Incorporating the call option sale in a collar strategy reduces the net cost of the hedge but at the expense of upside returns.

To help visualize what the return spectrum might look like with a collared portfolio that owns the S&P 500 (SPY) and hedges with SPY options, consider the following assumptions:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase SPY put options with a strike price of $230, expiration of 9/21/2018 at the cost of $9.15 per share and total cost of $3,660. (Each option is equal to 100 shares)
  • Sell/write SPY call options with a strike price of $270, expiration of 9/21/2018 at the cost of $3.75 per share and total benefit of $1,550.

As diagramed below, a collar strategy literally puts a collar or limit around gains and losses.

Writing the call option reduces the net hedging cost by $1,550, limits losses to 9% but caps the ability to profit if the market increases at 7.21%.

Bloomberg created an index that replicates a collar strategy. Bloomberg’s collar index (CLL) assumes that an investor holds the stocks in the S&P 500 index and concurrently buys 3-month S&P 500 put options to protect against market declines and sells 1-month S&P 500 call options to help finance the cost of the puts. As options expire new options are purchased. The percentage returns of the S&P 500 and CLL indexes from 2007 and 2008 are graphed below.

Data Courtesy: Bloomberg

Note that the CLL and SPY returns were well correlated until the latter part of 2008. At this point, when volatility spiked and the markets headed sharply lower, the benefits of the collar were visible.

**Bloomberg assumes a different collar structure than we modeled and described above.

Sptiznagel’s Tail Strategy

Mark Spitznagel is a highly successful hedge fund manager and the author of a book we highly recommend called “The Dao of Capital.” Spitznagel uses Austrian school economic principles and extensive historical data to describe his unique perspectives on investing. In pages 244-248 of the book, he presents an options strategy that served him well in periods like today when valuations foreshadowed significant changes in market risk. The goal of the strategy is not to hedge against small or even moderate losses, as in the first two examples, but to protect and profit from severe tail risk that can destroy wealth like the recent experiences of 2000 and 2008.

Sptiznagel’s strategy hedges a market long position with put options expiring in two months. On a monthly basis, he sells the put options and buys new options expiring in two months. The strike price on his options are 30% below current prices. To replicate his strategy and compare it to the ones above we assume the following:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase 82 SPY put options (equivalent to .50% of the portfolio value) with a strike price of $175 (30% out of the money), expiration of 9/15/2017 (2 months) at a cost of $.06 per share and total cost of $492. (Each option is equal to 100 shares)
  • For purposes of this example, new options are purchased when the current options mature every two months (Spitznagel sells and buys new options on a monthly basis).
  • We also assume this hedge was already in place for a year resulting in an accrued trade cost of $2,952 (6 *$492) to date.

The graph below highlights the cost benefit analysis.

The strategy graphed above looks appealing given the dazzling reward potential, but we stress that the breakeven point on the trade is approximately 30% lower than current prices. While the cost difference to the right of the breakeven point looks relatively small, the axis’s on the graph have a wide range of prices and returns which visually minimizes the approximate 6% annual cost. Similar strategies can be developed whereby one gives up some gains in a severe drawdown in exchange for a lower cost profile.

Cost/Benefit Table

The tables below compare the strategies detailed above to give a sense of returns and a cost/benefit analysis across a wide range of SPY returns.

The option strategies in this article are designed for the initial stages of a decline. Pricing of options can rise rapidly as volatility, a key component of options prices, increases. The data shown above could be vastly different in a distressed market environment. These options strategies and many others can be customized to meet investor’s needs.


We insure our cars, houses, health and our lives. Why is the idea of hedging ones wealth rarely considered especially considering the cost of that protection actually falls as the market becomes more vulnerable? Given current market valuations along with a 76% chance of a 20%+ drawdown, we urge clients to consider implementing a defensive strategy of insuring your portfolio.  Although option strategies compress returns, they serve to “defend the perimeter” in the event of a severe market correction. These strategies and many others like them yield peace of mind and the ability to respond clinically in the event of turmoil as opposed to reacting emotionally.

The rather simple examples in this article were created to give you a sample of the costs and benefits of hedging. When devising a hedging strategy, it often helps to draw a picture of an ideal but realistic return spectrum. From that point, a spreadsheet model can be used to try to create the desired return profile using available options.

In addition to options strategies, there are other means of hedging a long portfolio such as structured notes, volatility funds, and short funds. Portfolio construction is also an important natural means of mitigating exposure to losses. While the topic for future Unseen articles, they are ideas worth exploring and comparing to options strategies.  Hedging and options analysis is a complex field limited only by imagination and market liquidity. If you have questions, feel free to reach out to us to explore these or other ideas that may be better suited for you.





Autumn is the period of transition from summer to winter; a time of harvest.

Use the season to breathe fresh perspective into your finances and prepare for a prosperous 2018.

8-Steps To Get “Fiscally Fit”

#1: A thorough portfolio review with an objective financial partner is timely.

Most likely your long-term asset allocation or the mix of stocks, bonds and cash you maintain or add to on a regular basis, has been ignored. With most of the major stock indices higher by double-digits year-to-date through October 2, 2017, it’s possible your personal allocation to stocks has grown disconnected from your tolerance for risk.

Consider complacency the emotional foible du jour. After all, it appears easy to ride out an aggressive allocation at present since every market dip appears to be an opportunity to buy. With volatility in September as measured by the VIX, at the lowest it’s ever been historically, investors are growing increasingly overconfident in future market gains.

A financial professional, preferably a fiduciary, can help make sense of how the risk profile of your portfolio has changed, provide input on how to rebalance or sell back to targets, and ground your allocation for what could be a different 2018.

Read: 4 Warnings for the Bull Market.

#2: Sell your weak links (losers), trim winners.

Tax harvesting where stock losses are realized (you may always purchase the position back in 31 days,) and taking profits taken from winners is the ultimate cool fall-harvest portfolio moves. Going against the grain when the herd is chasing performance takes intestinal fortitude and an investment acumen with a more appetizing scent than pumpkin spice!

Candidly, tax-harvesting isn’t such a benefit if you examine its effects on overall portfolio performance. However, the action of disposing of dead weight is emotionally empowering and if gains from trimming winners can offset them, then even better.

Per financial planning thought-leader Michael Kitces in a thorough analysis, the economic benefit of tax-loss harvesting is best through tax-bracket arbitrage with the most favorable scenario being harvesting a short-term loss and offsetting with a short-term gain (which would usually be taxed at ordinary income rates).

#3: Fire your stodgy brick & mortar bank.

Let’s face it: Brick & mortar banks are financial dinosaurs. Consider how many occasions you’ve seen the interior of a bank branch. Unfortunately, banks are not in a hurry to increase rates on conservative vehicles like certificates of deposit, savings accounts and money market funds even though the Federal Reserve appears anxious to step up their rate-hike agenda.

Virtual banks like, provide FDIC insurance, don’t charge service fees and offer savings rates well above the national average.

Accounts are easy to establish online and electronically link to your existing saving or checking accounts.

#4: Get an insurance checkup.

It’s possible that weakness exists in your insurance coverage and gaps can mean unwelcomed surprises and consequences for you and the financial health of loved ones.

Risk mitigation and transferring risk through insurance is a crucial element to reduce what I call “financial fragility,” where a life-changing event not properly prepared for creates an overall failure of households to survive financially.

As I regularly review comprehensive financial plans, I discover common insurance pitfalls which include not enough life insurance, especially for stay-at-home parents who provide invaluable service raising children, underinsurance of income in the event of long-term disability, overpaying for home and auto coverage and for high-net worth individuals, a lack of or deficient umbrella liability coverage to help protect against major claims and lawsuits. Renter’s insurance appears to be a second thought if it all however, it must be considered to protect possessions.

You can download an insurance checkup document from It’s a valuable overview and comprehensive education of types of insurance coverage.

Set a meeting this quarter with your insurance professional or a Certified Financial Planner who has extensive knowledge of how insurance fits into your holistic financial situation.

#5: Don’t overlook the value of your employer’s open enrollment period.

Usually in November, you have an opportunity to adjust or add to benefits and insurance coverage provided or subsidized by your employer. The biggest change (shock, surprise), may pertain to future healthcare insurance benefits.

The number of employers moving to high-deductible health care plans for their employees increases every year. In addition, overall, individuals and families are shouldering a greater portion of health care costs, including premiums every year.

According to a survey of 600 U.S. companies by Willis Towers Watsons, a major benefits consultant, by 2018 nearly half of employers will implement high-deductible health plans coupled with Health Savings Accounts.

Health Savings Accounts allow individuals and families to make (and employers to match) tax-deductible contributions up to $3,450 and $6,900, respectively for 2018. Those 55 and older are allowed an additional $1,000 in “catch-up” contributions.

Money invested in a HSA appreciates tax free and is free of taxation if withdrawn and used for qualified medical expenses. Like a company retirement account, a HSA should have several investment options in the form of mutual funds from stock to bond.

Although Health Savings Accounts provide tax advantages, as an employee you’re now responsible for a larger portion of out-of-pocket costs including meeting much higher insurance deductibles. If you think about it, your comprehensive healthcare benefit has morphed into catastrophic coverage.

No longer can employees afford to visit the doctor for any ailment or it’s going to take a bite out of a household’s cash flow at least until the mountain of a deductible is met.

#6: Check beneficiary designations on all retirement accounts and insurance policies.

It’s a common mishap to forget to add or change primary and contingent beneficiaries. It’s an easily avoidable mistake. Several states like Texas have formal Family Codes which prevent former spouses from receiving proceeds of life insurance policies post-divorce (just in case beneficiaries were not changed), with few exceptions.

Proper beneficiary designations allow non-probate assets to easily transfer to intended parties. Not naming a beneficiary or lack of updating may derail an estate plan as wishes outlined in wills and trusts may be superseded by designations.

#7: Shop for a credit card that better suits your needs.

Listen, it’s perfectly acceptable to utilize credit cards to gain travel points or cash back as long as balances are paid in full every month; so why not find the card that best suits your spending habits and lifestyle?

For example, at, you can check out the best cash-back credit cards.

For those who carry credit card balances and unfortunately, it’s all too common, consider contacting your credit card issue to negotiate a lower, perhaps a balance transfer rate or threaten to take your business (and your balance), elsewhere. Keep in mind, on average an American family maintains more than $8,300 in credit card debt and the national average annual percentage rate is 15.07%.

8#: Prepare for an increase to your contribution rate to retirement accounts and emergency cash reserves.

Start 2018 on the right financial foot by increasing payroll deferrals to your company retirement accounts and bolstering emergency cash reserves. Consider a formidable step, an overall 5% boost and prepare your 2018 household budget now to handle the increase.

You can’t do it? Think again. As the seasons change so can your habits.

You’re Not Saving Enough

Financial media laments pervasively how you aren’t saving enough. Tell us something we don’t already know. From my experience, this message is usually not productive; it fosters a defeatist attitude. People become frustrated, some decide to throw in the towel. They figure the situation is overwhelming and hopeless.

Don’t listen! Well, it’s ok to listen but don’t beat yourself up.

Saving money is personal. Meet with an objective financial adviser and don’t give much relevance to broad-based messages you hear about saving; it’s not one size fits all. Create a personalized savings and budgeting plan with the end result in mind and remain flexible in your approach.

Just the fact you’re saving is important. The action itself is the greatest hurdle. Strive to save an additional 1% each year; it can make a difference.

I know I’m asking you to go further. Dig deeper.


Start with tough questions and honest answers to uncover truth about your past and current saving behavior.

You can go through the grind of daily life and still not comprehend your motivations behind anything, especially money decisions. Ostensibly, it comes down to an inner peace over your current situation, an objective review of resources (financial and otherwise), identification of those factors that prevent you from saving more and creating a plan to improve at a pace that agrees with who you are. A strategy that fits your life and attitude.

The questions you ask yourself should be simple and thought-provoking.

Why aren’t you saving enough? Perhaps you just don’t find joy in saving because you don’t see a purpose or a clear direction for the action. Long-term change begins with a vision for every dollar you set aside. Whether it’s for a daughter’s wedding or a child’s education, saving money is a mental re-adjustment based on a strong desire to meet a personal financial benchmark.

What’s the end game? It’s not saving forever with no end in sight, right? Perceive saving as a way to move closer to accomplishing a milestone, something that will bring you and others happiness or relieve financial stress in case of emergencies. A reason, a goal, a purpose for the dollars. Eventually savings are to be spent or invested.

Last year I read a story in a financial newspaper about a retired janitor who lived like a pauper yet it was discovered upon his death, that he possessed millions. What’s the joy in that? Did this gentleman have an end game? I couldn’t determine from the article whether this hoarding of wealth was a good or bad thing. I believe it’s unhealthy.

Living frugally and dying wealthy doesn’t seem to be a thought-out process or at the least an enjoyable one. The messages drummed in your head from financial services are designed to stress you out; they’re based on generating fear and doubt.  And fear is a horrible reason to save, joy isn’t.

Form an honest and simple philosophy that outlines specific reasons why you need to save or increase savings. Approach it positively, three sentences max to describe your current perspective, why you’re willing to improve (focus on the benefits, the end game) then allow your mind to think freely about how you will fulfill your goals. Don’t listen to others who believe they found a better system. Find your own groove and work it on a regular basis.

The fall is a time to shed the old and prepare for the new.

When it comes to money, we can all learn from the power, beauty and resiliency of Mother Nature. Use the season to gain a fresh perspective and improve your financial health.

Over the weekend, I discussed the market’s breakout to the upside and the increase in equity exposure in client’s portfolios. As I stated:

The short-term analysis of the market remains broadly positive with both the ongoing bullish trend and recent break above 2500 remaining intact through the close on Friday. 

As shown below, the market is pushing a short-term ‘buy’ signal. However, now at 2-standard deviations above the 75-dma, as seen previously, the market likely has limited upside from here.”

“The breakout, of course, was driven by continued hopes of tax cuts/reforms from the White House as details of the latest proposal from the House Ways and Means Committee were released this week.  (Click Here For Details & Analysis)

More importantly, since the March 9th, 2009 lows, the bull market has surged more than 268% with no decline greater than 20% along the way. Importantly, the correction in early 2016, did not violate the trend line from the 2011 lows which keeps the current market defined to a singular bull market.”

Buying Because I Have To. You Don’t.

After discussing that we had increased exposure to portfolios last week due to the breakout, and added new money, I received several emails questioning the move. To wit:

“With the markets clearly overvalued, and as you say, excessively extended and bullish, why are you buying? As you have often stated, the risk of loss outweighs potential return.” 

That is absolutely correct.

However, there is a difference between views of long-term fundamentally driven potential outcomes and short-term emotionally driven realities.

Importantly, as a portfolio manager, I am buying the breakout because I have to. If I don’t, I suffer career risk, plain and simple.

However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the market.

Think about it this way.

As noted in the chart above, the markets have returned more than 260% since the 2009 lows in the second-longest bull market on record. Yes, it is still just one bull market.

Assuming that you were astute enough to buy the “cherry picked” low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals. 

If you went to cash now, the odds are EXTREMELY high that in the years ahead you will far outpace investors who remain invested. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs the decline will destroy most, if not all, of the returns accumulated over the last 9-years.

So, if you buy the “breakout,” do so carefully. Keep stop losses in place and be prepared to sell if things go wrong.

For now, things are certainly weighted towards the bullish camp, however, such will not always be the case.

How To Add Exposure

I have also received quite a few emails asking how to add exposure to the market, particularly if in a large cash position currently. The answer is more in line with the age-old question:

“How do you pick up a porcupine? Carefully.”

Here are some guidelines to follow:

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  1. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move.This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
  1. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tend to lead when markets fall. Like “weeds choking a garden,” pull them.
  1. Add to sectors, or positions, that are performing with, or outperforming, the broader market. (See last week’s analysis for suggestions.)
  1. Move “stop loss” levels up to current breakout levels for each position. Managing a portfolio without “stop loss” levels is like driving with your eyes closed.
  1. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
  1. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

The “Rothschild 80/20” Rule

When discussing portfolio management, it is often suggested that you can’t “time the market.”

That statement is correct.

You can not effectively, and repetitively, get “in” and “out” of the market on a timely fashion. I have never suggested that an investor should try and do this. However, I HAVE discussed managing risk by adjusting market exposure at times when “risk” outweighs the potential for further “reward.”

While I am often tagged as ‘bearish’ due to my analysis of economic and fundamental data for ‘what it is’ rather than ‘what I hope it to be,’ I am actually neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy which focuses on capital preservation and long-term ‘risk-adjusted’ return.”

Here is my point. As a long-term investor, I don’t need to worry about short-term rallies. I only need to worry about the direction of the overall market trends and focus on capturing the positive and avoiding the negative.

As Baron Nathan Rothschild once quipped:

“You can have the top 20% and the bottom 20%, I will take the 80% in the middle.”

This is the basis of the 80/20 investment philosophy and the driver behind the risk management process.


While you may not beat the market from one year to the next, you will never have to suffer the “time loss” required to “get back to even.” In the long run, you will win.

As shown in the table below, a $100,000 investment in the S&P 500 returns a far lower value than the “Rothschild 80/20 Rule” model. This is even if I include a ridiculous 2% management fee.

Here is a chart to illustrate the deviation more effectively. (Capital appreciation only.)

Yes, it’s only a bit more than a hundred thousand dollars worth of difference, but the reduced levels of volatility allowed investors to emotionally “stick” to their discipline over time. Furthermore, by minimizing the drawdowns, assets are allowed to truly “compound” over the long-term.

An easy way to apply this principle is to use a simple moving average crossover. In the chart below, you are long equities which the S&P 500 index is above the 12-month moving average, and you switch to bonds when the S&P 500 falls below the 12-month average.

No, it’s not perfect every time. But no measure of risk management is.

But having a discipline to manage risk is better than not having one at all. 

Get it. Got it. Good.

Cracks In The Bull Market Armor

While we did increase exposure to the market in portfolio last week, as the bullish trend does currently persist, there is growing evidence of “cracks” appearing.

With the Fed now on track to begin reducing support for the market, and a real possibility that “tax reform” will fail to materialize anytime soon, the possibility of a trap getting sprung on unwitting investors is rising.

The current rally is built on a substantially weaker fundamental and economic backdrop. Thereforeit is extremely important to remember that whatever increase in equity risk you take, could very well be reversed in short order due to the following reasons:

  1. We are moving into the latter stages of the bull market.
  2. Economic data continues to remain weak
  3. Earnings are beating continually reduced estimates
  4. Volume is weak
  5. Longer-term technical underpinnings are weakening and extremely stretched.
  6. Complacency is extremely high
  7. Share buybacks are slowing
  8. The yield curve is flattening

It is worth remembering that markets have a very nasty habit of sucking individuals into them when prices become detached from fundamentals. Such is the case currently and has generally not had a positive outcome.

What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case being built to warrant taking some equity risk on a very short-term basis. We will see what happens over the next couple of weeks. 

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

While it is certainly advisable to be more “bullish” currently, like picking up a “porcupine,” do so carefully.

Investing is not a competition.

It is a game of long-term survival. 

As the stock market hits all-time highs in its 2nd longest bull market run in history, the lift of asset prices has surely lifted the economic prosperity of all. Right?

Not really.

New reports from the Hamilton Project and The Federal Reserve show the real problems facing Americans today.

First, the Hamilton Project as noted by Pedro Nicolaci Da Costa last week:

“An expansion that began, believe it or not, more than seven years ago has extended a longer-run trend of wage stagnation for the average US worker, despite a sharp drop in the official unemployment rate to 4.4% from an October 2009 peak of 10%.

No wonder the recovery seems so lopsided, particularly given economic inequality levels not seen since before the Great Depression. After adjusting for inflation, wages are just 10% higher in 2017 than they were in 1973, amounting to real annual wage growth of just below 0.2% a year, the report says. That’s basically nothing, as the chart below indicates.”

The problem with this, of course, is that if wages aren’t rising at a pace fast enough to offset the costs of maintaining the “standard of living,” individuals are forced to turn to credit to fill the gap. As I showed recently, this wasn’t a problem initially but now is THE problem for an economy that is roughly 70% driven by personal consumption.

“Therefore, as the gap between the “desired” living standard and disposable income expanded it led to a decrease in the personal savings rates and increase in leverage. It is a simple function of math. But the following chart shows why this has likely come to the inevitable conclusion, and why tax cuts and reforms are unlikely to spur higher rates of economic growth.”

The Federal Reserve Reveals The Ugly Truth

Every three years the Federal Reserve releases a survey of consumer finances that is a stockpile of data on everything from household net worth to incomes. The 2016 survey confirms statements I have made previously regarding the Fed’s monetary interventions leaving the majority of Americans behind:

However, setting aside that point for the moment, how valid is the argument the rise of asset prices is related to economic strength. Since companies ultimately derive their revenue from consumers buying their goods, products, and services, it is logical that throughout history stock price appreciation, over the long-term, has roughly equated to economic growth. However, unlike economic growth, asset prices are psychologically driven which leads to “boom and busts” over time. Looking at the current economic backdrop as compared to asset prices we find a very large disconnect.

Since Jan 1st of 2009, through the end of June, the stock market has risen by an astounding 130.51%. However, if we measure from the March 9, 2009 lows, the percentage gain explodes to more than 200%. With such a large gain in the financial markets we should see a commensurate indication of economic growth – right?”

“The reality is that after 3-massive Federal Reserve driven “Quantitative Easing” programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total more than $33 Trillion, the economy grew by just $2.64 Trillion, or a whopping 16.7% since the beginning of 2009. The ROI equates to $12.50 of interventions for every $1 of economic growth.

The full Federal Reserve report can be found here,  but I have selected a few of the more important charts for the purpose of this post.

While the mainstream media continues to tout that the economy is on the mend, real (inflation-adjusted) median net worth suggests that this is not the case overall. Despite surging asset prices, household net worth has only recovered back to 1995 levels.

But even that view is highly optimistic as the recovery in net worth has been heavily skewed to the top 10% of income earners.

While many economists have tried to explain the plunging labor force participation rate (LFPR) was a function of“baby boomers” entering into retirement, such is hardly the case given the collapse in net worth of those in that age group. It’s not that they don’t want to retire, they simply can’t afford to.

The “economic recovery” story is also extremely fragmented when looking at median incomes. According to the Fed survey, median household before-tax incomes have fallen from near $55,000 annually to roughly $53,000 currently.

Again, the real story becomes much more apparent when incomes are broken down into deciles.

Interestingly, the ONLY TWO age-groups where incomes have improved since 2007 is for those two groups of 65 and older. Again, this suggests that the plunge in the LFPR is not a function of “retirement” as individuals are working well into their retirement years, not because of a desire to work, but due to necessity.

Despite the mainstream media’s rhetoric the surging stock market, driven by the Federal Reserve’s monetary interventions, has provided a boost to the overall economy. The reality is quite different.

Since the bulk of the population either does not, or only marginally, participates in the financial markets, the “boost” has remained concentrated in the upper 10%. The Federal Reserve study breaks the data down in several ways, but the story remains the same.

The median value of financial assets for families has fallen sharply since the turn of the century.

Except for those in the top 10 percent of the population.

While the Federal Reserve hoped that inflating asset prices would boost consumer confidence, consumption, and economic growth, the problem is that with falling incomes and rising costs of living, the ability to save and invest eluded the majority of families.

Again, the benefit of the Federal Reserve’s interventions was clearly concentrated in the top 10%.

When looking at the financial landscape of families, the future does not look bright. The percentage of families with retirement accounts is at the same level as it was in 2000, despite surging asset prices. Again, this is a function of the disparity between incomes and the cost of living.

But once again, for the top 10%, the last five years has been a windfall. However, it is interesting to note that values dropped in 2013 despite the surge in asset prices. The 80th percentile performed better.

Lastly, as discussed recently, there is a deep flaw in the Bureau Of Labor Statistics adjustments to the employment report and little evidence to support the “birth/death” model which has accounted for roughly all of the job growth since 2009. The assumption is that each month individuals are either starting or closing a business that is not reflected in the more normalized employment data. The problem, however, is that the number of families that owned business equity has been on the decline since 1992.

Well, except for those in the top 10%.

The lack of economic improvement is clearly evident across all data points. However, it has been the very policies of the current and past administrations that have fostered that wealth divide more than anything else. While the ongoing interventions by the Federal Reserve propelled asset prices higher, and fueled the demand for risks, the majority of American families were left behind.

Tax Cuts Won’t Work This Time

This is also why Trump’s recent tax cut policy will fail to fuel the economic prosperity he is hoping for. With the bottom 80% of the population still earning below $50,000 on average, a tax cut will do little to increase their consumption in the economy. Those in the top 20% may well see a tax-savings from the reform but they are already consuming at a level that will likely not change to any great degree.

As David Stockman pointed out this past week:

“The Donald’s new tax reform airball promises to make the filing with the IRS more palatable to rank and file America. Yet 101 million taxpayers (69%) have no exposure to the complexity of the IRS code at all. They owe virtually nothing.

And I mean nothing. Among the 148 million income tax filers, the bottom 53 million owed zero taxes in the most recent year (2014), and the bottom half (74 million) paid an aggregate total of just $45 billion.

By contrast, the top 4% or 6.2 million filers paid $802 billion in Federal income taxes. That amounted to nearly 58% of total Federal income tax payments.”

While the financial media incessantly drones on about the rise of the stock market, what is missed is that after two devastating bear markets many families no longer have the capacity to participate (particularly after following Wall Street advice).

Furthermore, the structural transformation that has occurred in recent years has likely permanently changed the financial underpinnings of the economy as a whole. This would suggest that the current state of slow economic growth is likely to be with us for far longer than most anticipate. It also puts into question just how much room the Fed has to extract its monetary support before the cracks in the economic foundation begin to widen.

“The chickens have likely come home to roost.” 

As reported earlier this morning by the Wall Street Journal, President Trump and Treasury Secretary Mnuchin met with Kevin Warsh yesterday to discuss the potential vacancy at the Fed next February.

Warsh already has central banking experience, having sat on the Federal Open Market Committee (FOMC) from February 2006 until March 2011.

Two and a half years after he resigned from the Fed, he emerged as a vocal critic of FOMC policies, including those policies he helped craft. He published an op-ed in the WSJ on November 12, 2013, and it was quite the editorial. As that happened to be the first week of hunting season, we suggested that Warsh had declared open season on his ex-colleagues, and we came up a gimmicky picture to go along with our reporting:

But we also thought his op-ed needed translation. It was written with the polite wording and between-the-lines meanings that you might expect from such an establishment figure. He seemed to be holding back. We offered our guesses on what he was really trying to say. And with today’s breaking news, we thought it would be a good time to reprint our translation.

So, if you’re wondering what the current frontrunner as Trump’s choice for the Fed chairmanship really thinks, here are Warsh’s comments on nine topics, followed by our translations.

Quantitative Easing

“The purchase of long-term assets from the U.S. Treasury to achieve negative real interest rates is extraordinary, an unprecedented change in practice since the Treasury-Fed Accord of 1951.

The Fed is directly influencing the price of long-term Treasurys—the most important asset in the world, the predicate from which virtually all investment decisions are judged. Earlier this year the notion that the Fed might modestly taper its purchases drove significant upheaval across financial markets. This episode should engender humility on all sides. It should also correct the misimpression that QE is anything other than an untested, incomplete experiment.”

What he really wants to say:

We’d all be better off if the central banking gods (myself included) hadn’t been so damn arrogant to think that we actually understood QE. We don’t, and it never should have been attempted.

The Fed’s Focus On Inflation

“Low measured inflation and anchored inflationary expectations should only begin the discussion about the wisdom of Fed policy, not least because of the long and variable lags between monetary interventions and their effects on the economy. The most pronounced risk of QE is not an outbreak of hyperinflation. Rather, long periods of free money and subsidized credit are associated with significant capital misallocation and malinvestment—which do not augur well for long-term growth or financial stability.”

What he really wants to say:

The inflation target is stupid. It’s not the CPI that’s killing us, it’s the credit booms and busts. The best way out of this mess is to lose the inflation target and go back to the old-fashioned approach of “taking the punch bowl away when the party gets going.”

Pulling Off The Exit From Extraordinary Measures

“[T]he foremost attributes needed by the Fed to end its extraordinary interventions and, ultimately, to raise interest rates, are courage and conviction. The Fed has been roundly criticized for providing candy to spur markets higher. Consider the challenge when a steady diet of spinach is on offer.”

What he really wants to say:

Pundits who praise the courage of our central bankers are clueless. The true story is that we consistently take the easy way out. If the current cast of characters wanted to show courage, they’d man up and replace the short-term sugar highs with long-term thinking.

The Fed’s Relationship To The Rest Of Washington

“The administration and Congress are unwilling or unable to agree on tax and spending priorities, or long-term structural reforms. They avoid making tough choices, confident the Fed’s asset purchases will ride to the rescue. In short, the central bank has become the default provider of aggregate demand. But the more the Fed acts, the more it allows elected representatives to stay on the sidelines. The Fed’s weak tea crowds out stronger policy measures that can only be taken by elected officials. Nobel laureate economist Tom Sargent has it right: ‘Monetary policy cannot be coherent unless fiscal policy is.’”

What he really wants to say:

And if we don’t man up, you can count on Congress to continue its egregious generational theft and destroy our nation’s finances, just as Stan, Geoff and I have been warning.

Who Benefits From QE And Who Doesn’t?

“Most do not question the Fed’s good intentions, but its policies have winners and losers, which should be acknowledged forthrightly.

The Fed buys mortgage-backed securities, thereby providing a direct boost to balance sheet wealth of existing homeowners to the detriment of renters and prospective future homeowners. The Fed buys long-term Treasurys to suppress yields and push investors into riskier assets, thereby boosting U.S. stocks.

The immediate beneficiaries: well-to-do households and established firms with larger balance sheets, larger risk appetites, and access to low-cost credit. The benefits to workers and retirees with significant fixed obligations are far more attenuated. The plodding improvement in the labor markets offers little solace.”

What he really wants to say:

Unbelievably, my ex-colleagues still don’t acknowledge their policies are killing the middle class to support the plutocracy. Their silence on this is wholly unacceptable and has to stop (and so do the policies).

Domestic Versus Global Policy Considerations

“[T]he U.S. is the linchpin of an integrated global economy. Fed-induced liquidity spreads to the rest of the world through trade and banking channels, capital and investment flows, and financial-market arbitrage. Aggressive easing by the Fed can be contagious, inclining other central banks to ease as well to stay competitive. The privilege of having the dollar as the world’s reserve currency demands a broad view of global economic and financial-market developments. Otherwise, this privilege could be squandered.”

What he really wants to say:

We really need to climb out of our shell and look at things from a global perspective. The rest of the world knows that we’re selling a bill of goods and won’t continue buying it forever. If we don’t change, you can kiss the dollar goodbye.

Forward Guidance

“Since QE began, Fed policy makers have tried to explain that asset purchases and interest rates are different. Hence their refrain that tapering is not tightening, and that very low interest rates will continue after QE. Investors do not agree. Once the Fed begins to wind down its asset purchases, these market participants are likely to reassert their views with considerable force.

Recently, the Fed has elevated forward guidance as a means of persuading investors that it will indeed keep interest rates exceptionally low even after QE. Forward guidance is intended to explain how the central bank will react to incoming data. Fed projections for example, may show below-target inflation and a residual output gap justifying very low interest rates several years from now. But words are not equal to concrete policy action. And the Fed hasn’t received many awards for prescience in recent years.”

What he really wants to say:

Forward guidance is a load of crap. First, you won’t convince the market of any of your dumb ideas. Investors can and will think for themselves. Second, talk is cheap. And talk that’s based on the Fed’s ability to foresee the future? C’mon, that’s ridiculous.


“[T]ransparency in communications about future policy is not a virtue unto itself. The highest virtue is getting policy right. Given manifest uncertainties about the state of the economy, oversharing policy deliberations is not useful if markets are led astray, or if public commitments reduce policy makers’ flexibility to call things the way they see them.”

What he really wants to say:

Transparency, shmansparency. I’ve had it up to here with taper, untaper, maybe taper, maybe not taper. I’ll trade a transparent central bank for one that knows what it’s doing any day.

Obama’s Nomination Of Janet Yellen As The Next FOMC Chair

“The president has nominated a person with a well-deserved reputation for probity and good judgment. The period ahead will demand these qualities in no small measure.”

What he really wants to say:

The president made a bad choice.


These are only our guesses, not actual thoughts from Kevin Warsh, who hasn’t told us what he really wants to say.  We don’t even know if he hunts.  (We’re guessing no.)

Our Up-To-Date Reflections

Back to the present now, we’ve reread our translations and have to admit that the last one—on the Janet Yellen nomination—was purely smart-alecky. But we don’t think the others were far-fetched—they seem consistent enough with Warsh’s carefully expressed opinions. If we were right, we could be facing big-time changes at the Fed. Then again, many Trump supporters expected a less war-mongering foreign policy from the presidential candidate who claimed we were being overly aggressive overseas.

So, if Warsh is indeed appointed as Yellen’s replacement, the key question is this:

Will the individual change the institution, or will the institution change the individual?

We’ll see…

On Wednesday, the President announced his plan to cut taxes for Americans, return jobs to America and return the country to economic prosperity.

It’s a tall order to fill, and the proposed tax reform is a “Christmas Wish List” that will have to checked twice to determine which parts are “naughty” and “nice.”

As I pointed out yesterday,

“The belief that tax cuts will eventually become revenue neutral due to expanded economic growth is a fallacy. As the CRFB noted:

‘Given today’s record-high levels of national debt, the country cannot afford a deficit-financed tax cut. Tax reform that adds to the debt is likely to slow, rather than improve, long-term economic growth.’

The problem with the claims that tax cuts reduce the deficit is that there is NO evidence to support the claim. The increases in deficit spending to supplant weaker economic growth has been apparent with larger deficits leading to further weakness in economic growth. In fact, ever since Reagan first lowered taxes in the ’80’s both GDP growth and the deficit have only headed in one direction – lower.’

That little green bump in the deficit was when President Clinton “borrowed” $2 trillion from Social Security to balance the budget, and since there were no cuts to spending, led a surplus that lasted about 20-minutes.

The problem is that the tax plan may not provide the benefits as hoped. While President Trump suggests the plan will return “trillions” of dollars locked up overseas to create jobs, the reality, according to Goldman Sachs, is likely closer to $250 billion that will primarily go to share buybacks, dividends, and executive compensation.  

Of course, such actions do not boost economic growth but are a boon to Wall Street and the 10% of the economy that invest in the market. 

But here is the key point with respect to tax cuts. History is replete with evidence that shows tax cuts DO NOT lead to a rapid growth in the economy. As shown below, the slope of economic growth has been trending lower since the “Reagan tax cuts” were implemented.

Lastly, tax cuts have relatively low economic multipliers particularly when they primarily only benefit those at the top of the income spectrum. With the average household heavily indebted, credit is being used to sustain the standard of living, there is likely to be little transfer of “tax savings” back into the economy.

It is a simple function of math. But the following chart shows why this has likely come to the inevitable conclusion, and why tax cuts and reforms are unlikely to spur higher rates of economic growth.”

As is always the case…“it’s the debt, stupid.” 

However, here are plenty of discussions both for and against the tax plan so you can decide for yourself.

Trump Tax Cut Plan


Research / Interesting Reads

A bull market is like sex. It feels best just before it ends.” – Warren Buffett

Questions, comments, suggestions – please email me.

I expect comparisons between the FANG stocks and Dr. Evil of the Austin Powers film series to be an ongoing investment storyline over the next year given these digital gatekeepers’ increased dominance over the U.S. economy. This idea might receive a lot more play in U.S. political and antitrust circles — and produce more legal challenges — than most investors currently presume.

For those unfamiliar with Austin Powers, Mike Myers’ character Dr. Evil is a parody of the James Bond villains. He hatches schemes to take over the world with his sidekick Mini-Me and his cat Mr. Bigglesworth. He’s also assisted by Number 2 (played by Robert Wagner), who fronts for his evil corporation, Virtucon Industries. A natural businessman, Number 2 is often more concerned about the financial aspects of world domination than in world domination itself. That sounds a lot like the FANG stocks — Facebook, Amazon , Netflix and Alphabet/Google.

Now, the FANG shares have been slipping recently despite Wednesday’s strength. However, investor sentiment remains almost universally optimistic as it relates to the intermediate term for these names.

Here are just two examples of that enthusiasm:

  • Based on expectations of the FANGs’ glorious future and continued popularity, the Intercontinental Exchange this week announced an early November launch of a “FANG+” ETF. This will combine the FANGs with other hot stocks like Alibaba, Nvidia and Tesla.
  • Some, like my pal Tom Lee of Fundstrat Global, remain ecstatic about the FANGs’ future prospects. In an early June CNBC appearance, Tom explained why, despite having an overall bearish market view, he thinks the FANGs can add nearly 50% over 2017’s second half — and then continue to soar in 2018 and beyond.

Most investors and traders are generally unconcerned about the FANGs’ recent weakness, seeing near-term declines as just another brief speed bump towards an investment pot of gold.

Why The FANGs Might Lose Their Bite

“So, is this it? The end of FANG and company?

I can tell you the news clip files are filled with FANG obituaries and each one seems as cogent as the previous epitaphs.

That’s why I like to have one foot in the rocket ship and another in the terrestrial.

Call me old-fashioned, but when the stock of Facebook gets crushed as it did today, I am more attracted to it than when it’s soaring. I feel the same way about the stock of Alibaba or Nvidia or Electronic Arts (EA). Sure, they might be cheaper tomorrow. That’s the risk you take. But these stocks didn’t get where they were a week ago by alchemy.

They got there because the companies are doing phenomenally and I don’t see anything that tells me they won’t.

I just see profit-taking in the winners and a love of the losers. Own some of both, in a portfolio not just diversified by sector but by riskiness, and you’ll do just fine.” — Jim “El Capitan” Cramer, Rocket-Ship Stocks Look Better When They Return to Earth, Sept. 25, 2017

While I’ve recently shorted both FB and AMZN, I’ve never been a serial basher of FANGs. I’m not one of those who have (as Jim related above) issued frequent FANG epitaphs. As George Lindsay said on Wall Street Week with Louis Rukeyser decades ago, “I am not one of those 600 boys.” (You can listen to him here at the 2:15 mark.)

I realize that calling market tops (or bottoms) for individual stocks, specific sectors or the market as a whole is generally an audacious pursuit and a fool’s errand. It’s also mathematically dangerous, and next to impossible, as there will only be one “generational low” every few decades, and zero “generational tops.” Time is not on forecasters’ side when it comes to projecting a stock’s top.

Generally speaking, stocks also have a gravitational pull higher over time as population and output rise in a secular sense. And while stocks often get out of sync — particularly to the downside — they have a knack at recovering.

As the late great Louis Rukeyser once noted:

The robins will sing,
The crocuses will bloom,
Babies will gurgle,
And puppies will curl up into your lap and go to sleep.
Even when the stock market is temporarily insane.

— Louis Rukeyser, Wall Street Week

My pal Byron Wien of the Blackstone Group often expands on Rukeyer’s view by frequently reminding me that contrary to Lord Keynes (“in the long run, we are all dead”), “disasters have a way of not happening.”

And of course, investors these days are more conditioned than ever to buy any dip thanks to market’s massive liquidity injections and the increased role of passive and machine-based investing (i.e., ETFs and quants).

It’s also important to remember that the FANGs aren’t one stock, but four separate companies serving different customers and end markets. But these companies have grown so dominant and disruptive — to competitors, entire industries and real-estate and the labor markets — that their political and antitrust touch points represent an ever-growing threat to their growth plans and business models.

Concern Abounds

I’ve recently turned more negative on two FANG components — Amazon and Facebook, as well as the Nasdaq and technology in general. That’s why I’m shorting AMZN and FB and have gone long on both the ProShares UltraShort QQQ and the ProShares UltraPro Short QQQ, which are 2x and 3x inverse plays on the Nasdaq 100.

Here are my current views and game plans for each of the FANG components:

  • Amazon. AMZN’s growth plans might be stifled going forward by government regulation. Political and antitrust forces represent an existential threat to the company’s horizontal- and vertical-expansion plans. Click here and here to see more of my views. Recommendation: Short on an investment and trading basis.
  • Netflix. I would avoid NFLX, but high short interest precludes selling it short. Remember, Adam Sandler will eat before Netflix shareholders do. Recommendation: Avoid. Here and Here
  • Alphabet/Google. Alphabet’s dominance in the search-engine space (coupled with consumer reliance on Google) leaves the company vulnerable to government interference. I’m negative on the stock, but not short. Recommendation: Avoid.     

Still, as Jim “El Capitan” Cramer wrote in a thoughtful piece on Monday, it’s possible that the FANGs are simply falling back to Earth (as they have in the past) and might be poised to rebound. Others opine that different sectors or stocks might pick up the slack for the market if the FANGs don’t.

In fact, there’s a growing view that even if I’m correct on the FANG being vulnerable, that won’t impact the overall market. This reminds me of something Helene “The Divine Ms. M” Meisler recently wrote:

“TV folks say the market is healthy without the FANG names. Of course, they said it was healthy when it was just the FANGs.”

However, I suppose that’s a subject for another day. Suffice to say, the consensus sentiment on the market and the FANG remains very upbeat.

But remembering that consensus market views need not be wrong (as the crowd usually outsmarts the remnants), let me outline my deeper concerns for the FANGs.

Existential Threats Abound

Amazon is the titan of 21st century commerce. In addition to being a retailer, it is now a marketing platform, a delivery-and-logistics network, a payment service, a credit lender, an auction house, a major book publisher, a producer of television and films, a fashion designer, a hardware manufacturer and a leading host of cloud-server space.

Although Amazon has clocked staggering growth, it generates meager profits, choosing to price below-cost and expand widely instead. Through this strategy, the company has positioned itself at the center of e-commerce and now serves as essential infrastructure for a host of other businesses that depend upon it. Elements of the firm’s structure and conduct pose anticompetitive concerns — yet it has escaped antitrust scrutiny.

— Lina M. Khan, Amazon’s Antitrust Paradox, Yale Law Journal

I used to make presentations to CFA societies in various cities, and the one chart I always presented was called “Characteristics of a Good Stock.” These included growth, free cash flow, barriers to entry and the hope that the government would leave the firm alone. This is pretty much “Buffett 101,” with the caveat that you had to buy a good stock on the cheap.

Now, while Amazon and Netflix have had free-cash-flow and valuation issues, they and the other FANGs have had consistently dynamic top-line growth — and steadily produced deepening competitive “moats” that have expanded the barriers to entry in their markets. And until recently, government interference wasn’t a major concern.

But that might be about to change. The FANGs’ profound innovation and pervasive influence over the economy have rendered a lot of antitrust laws antiquated. Stated simply, these companies are ahead of the regulators — but that, too, might be about to change.

Moreover, the FANGs have no friend in the White House, as seen most recently by this tweet Wednesday from President Trump:

Now, after meeting with several politicians and bureaucrats more than three decades ago, I wrote in a research note that Washington “is too pessimistic a place for one person to follow.” That probably still applies.

When Uncle Sam gets involved, it’s impossible to predict an outcome or its magnitude. But one thing is certain — with rare exceptions, government involvement with an industry won’t be positive for the companies that are impacted.

Backlash From Washington

Now, a well-received recent book by Franklin Foer called World Without Mind details some nasty effects of the FANGs’ relentless growth. One that I’ve previously discussed in my diary is that every competitor who collects ad dollars is playing a less-than-zero-sum game with the FANGs.

As Foer writes in his book:

“Back in the seventies, Herbert Simon, the Nobel-winning economist, took these inchoate sentiments and explained them rigorously: ‘What information consumes is rather obvious. It consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention.'” — Franklin Foer, World Without Mind: The Existential Threat of Big Tech

I suggest reading this book if you own any FANG stocks, as the companies’ conflicts with competitors and regulators are now arising.

For example, Facebook under intense scrutiny for perhaps helping Russia manipulate the 2016 U.S. presidential election.

Similarly, the push by Amazon into food retailing, prescription-drug distribution and auto-parts sales is also attracting interest. These businesses are all very employment intensive, and competitors’ employees all have senators, House members and votes. Perhaps that’s why AMZN has quietly hit a correction mode and has pulled back some 11% from its high.

Now, it’s important to remember when analyzing government policies that there are typically three lags involved:

  • The Recognition Lag
  • The Action Lag
  • The Impact Lag

We are now at the Recognition Lag, but we could be moving into the Action Lag — and might see the Impact Lag in the fullness of time. If the FANGs are destined to face regulatory problems, we might only be in the early innings of such an issue.

It seems like politicians are slowly recognizing that there’s a problem with the FANGs. If so, new interpretations of antitrust laws (possibly coupled with new antitrust laws as well) seem like they’re on tap. London officials’ recent decision to ban Uber could well be the FANGs “canary in the coal mine,” as was Bear Stearns’ failure in March 2008.

I certainly don’t have all of the answers here, but I hope I’ve presented some good ways to frame and consider these issues.

Getting the answers right could be the investment issue of the next few years.

The Bottom Line

To summarize:

  • FANG valuations are elevated and incorporate the general perception that there’s little threat to the companies’ business models. However, the FANGs and other leading tech companies are likely to get caught in the government’s crosshairs in the years ahead.
  • The FANGs now face existential political and antitrust threats that could inhibit, slow down and/or make growth more expensive and less profitable.

Personally, I would avoid the FANGs until the issue of government intervention (which is likely only in the early innings) gets sorted out.

To paraphrase Dr. Evil,

“The billions that the consensus expects to make on FANGs may turn into millions.”

So, I’d use this week’s market strength to consider reducing exposure to Facebook, Amazon, Netflix and Alphabet/Google.

Position: Long QID, SQQQ (large); Short AMZN, FB, QQQ