Monthly Archives: March 2017

Soar Above Overconfidence To Fortify Your Wealth

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Soar Above Hubris and Overconfidence To Fortify Your Wealth

Neither Bull nor Bear

A growing deflationary hurricane is churning off the coast. At the same time, a massive inflationary warm front is surging toward us, threatening inflation like we have not seen in forty years.  As if forecasting future economic conditions was not tricky enough, both systems are being fueled in unknown ways by the convergence of historical amounts of monetary and fiscal stimulus.

The two ominous and encroaching weather systems make economic and market forecasting extremely difficult. The most recent evidence came from last week’s BLS employment report. The consensus of economic forecasters missed the mark by 734,000 jobs. That is over three times the average monthly job growth pre-pandemic.

To add insult to injury, consider forecasters must also untangle global supply line problems and resulting shortages of many commodities and finished goods. Further, robust pent-up demand from the lifting of economic restrictions and a global pandemic significantly influences the economic climate.

Despite such extraordinary circumstances, the level of confidence in economic and market forecasts is remarkably high. Many “experts” forecast beautiful days with a temporary bout of above-average inflation. There is nary a mention of the potential for debilitating inflation and almost no recognition of the troubling deflationary hurricane off at sea.

The confidence and hubris backing forecasts should be of great concern, not comfort.

The Butterfly Effect

In 1963, Edward Lorenz, a meteorology professor from MIT, wrote a white paper called Deterministic Nonperiodic Flow. Years later, his theories became a core foundation of Chaos Theory.

Per the MIT Technology Review, the essence of his work is that “small  changes can have large consequences.” His logic is better known as the Butterfly Effect.

“Lorenz suggested that the flap of a butterfly’s wings might ultimately cause a tornado. And the butterfly effect, also known as “sensitive dependence on initial conditions,” has a profound corollary: forecasting the future can be nearly impossible.”

Yet Lorenz’s own deterministic equations demonstrated how easily the dream of perfect knowledge founders in reality. That the tiny change in his simulation mattered so much showed, by extension, that the imprecision inherent in any human measurement could become magnified into wildly incorrect forecasts.”

Misplaced Confidence

How a simple flap of a butterfly wing can change the environment attests to the difficulty in predicting the weather. Meteorologists are quick to describe their limitations and relatively poor level of confidence around longer-range forecasts. They understand the impossibility of calculating millions of variable factors affecting the weather.

During more typical economic and market conditions, prognosticators struggle with forecasts. For example, the first graph below shows how the Fed consistently overestimated economic growth coming out of the last recession.

The following graph, courtesy of Deutsche Bank, highlights how Wall Street economists have consistently erred in their expectations for higher interest rates over the last fifteen years.

As the title of the next graph tells, investors have a long history of poor Fed Funds forecasts.

Today, those at the Fed offer investors a good amount of confidence in predicting the pace of the economic recovery. They appear highly confident that any spurt of inflation will be transitory. If wrong, they offer complete confidence in their unproven tools to halt inflation. We know from historical experience that when the inflation genie gets out of the bottle, it is very difficult to arrest.

Wall Street analysts shrug off record equity and bond market valuations with forecasts of growth and normality.  Investors buying in at such valuations must have total trust that the Fed and Wall Street are correct. Despite the evidence that professional economic prognosticators are not very good at their jobs, everyone seems assured of the future.

The graphs below show money supply growth, and the fiscal deficit are at levels that are anything but ordinary. Are we to believe the effects and consequences of such extreme monetary and fiscal policy, occurring concurrently, are easy to predict? What kind of professional would fail to recognize the peril of such a claim?

Confidence Despite A Poor Track Record

The cocksure attitudes of leadership, economic and political, and blind confidence put in them is perplexing given their poor track record. Consider a small sample of their dreadful forecasts:  

  • In June of 2017, Janet Yellen, Fed Chair, stated: Would I say there will never, ever be another financial crisis? … Probably that would be going too far. But I do think we’re much safer, and I hope that it will not be in our lifetimes, and I don’t believe it will be.” Less than three years later, GDP fell over 9% in a quarter, and the unemployment rate shot up from 3.5% to 14.8% in a month. The S&P 500 fell over 40% in four weeks.
  • In May of 2007, a year before the subprime crisis would bankrupt many financial institutions and cripple others, Ben Bernanke stated: “we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” 
  • “I believe that the general growth in large [financial] institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically — I should say, fully — hedged.” Alan Greenspan 2000
  • We will not have any more crashes in our time.” Famed economist John Maynard Keynes 1927
  • “There is no cause to worry. The high tide of prosperity will continue.” – Andrew W. Mellon, Secretary of the Treasury. September 1929

Flip a Coin

The point in highlighting forecasting blunders is not to shame the forecasters. Instead, it is to help our readers understand that despite decades of experience, reams of data and information, and well sought-after educations, economists and market forecasters are human. They, like everyone else, have little ability to forecast the future accurately.   

From an economic and market perspective, we are not in the lazy days of summer. Instead, we are in a highly charged, volatile environment. As a result, there are many unknowns, well beyond anything these brave forecasters ever witnessed or studied.

Their rosy forecasts may be correct. The economy might continue to recover gradually. The recent spike in inflation may be transitory, and economic data will assume prior trends. Unicorns may spew rainbows.

However, there are excellent odds they will once again be wrong. Lorenz stated: “small changes can have large effects.” Now consider the potential range of effects from the plethora of economic and policy factors exerting significant influence over economic activity and human behaviors.

The reality is like meteorologists predicting next week’s weather; no one knows what the economy holds in store. Of course, they can extrapolate current trends and make educated guesses on how consumers and corporations react to future events. Still, no one has ever experienced anything like what we face today.

fundamentals, The Death Of Fundamentals & The Future Of Low Returns

Summary & Advice

At RIA Advisors, we have a marketing tag line as follows:

Bulls win in Bull Markets; Bears win in Bear Markets. Eagles soar above and take advantage of opportunity. Let us help you soar as you reach your financial goals with R-I-A Advisors. Neither Bull nor Bear.

Given the economic climate and extreme market risks and rewards, we take an agnostic view of markets. We are not wed to opinions of economic activity or inflation and how they may steer markets. We are not self-proclaimed bulls or bears.

Paying top dollar for assets requires independent thinking and careful attention to market activity. To grow and preserve wealth in what may be a coming melt-up or meltdown, we must soar well above the nonsense and confidence spewed by so-called experts.  

From the brightest traders on Wall Street to the halls of the Federal Reserve and in the studios of the self-anointed media economic experts, there is zero appreciation for the potential of massive forecasting errors.

Quite often, investors are rewarded for going against the crowd, especially when the masses are in agreement on what the future holds.

 

Technically Speaking: If Everyone Sees It, Is It Still A Bubble?

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“If everyone sees it, is it still a bubble?” That was a great question I got over the weekend. As a “contrarian” investor, it is usually when “everyone” is talking about an event; it doesn’t happen.

As Mark Hulbert noted recently, “everyone” is worrying about a “bubble” in the stock market. To wit:

“To appreciate how widespread current concern about a bubble is, consider the accompanying chart of data from Google Trends. It plots the relative frequency of Google searches based on the term ‘stock market bubble.’ Notice that this frequency has recently jumped to a far-higher level than at any other point over the last five years.”

What Is A Bubble?

“My confidence is rising quite rapidly that this is, in fact, becoming the fourth ‘real McCoy’ bubble of my investment career. The great bubbles can go on a long time and inflict a lot of pain, but at least I think we know now that we’re in one.” – Jeremy Grantham

What is the definition of a bubble?  According to Investopedia:

“A bubble is a market cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. Typically, what creates a bubble is a surge in asset prices driven by exuberant market behavior. During a bubble, assets typically trade at a price that greatly exceeds the asset’s intrinsic value. Rather, the price does not align with the fundamentals of the asset.

This definition is suitable for our discussion; there are three components of a “bubble.” The first two, price and valuation, are readily dismissed during the inflation phase. Jeremy Grantham once produced the following chart of 40-years of price bubbles in the markets. During the inflation phase, each was readily dismissed under the guise “this time is different.” 

Stock Market Bubble, Yes, Virginia. There Is A Stock Market Bubble.

We are interested in the “third” component of “bubbles,” which is investor psychology.

A Bubble In Psychology

As Howard Marks previously noted:

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

Currently, it’s difficult for investors to become any more enthusiastic about market returns. (The RIAPro Fear/Greed Index compiles measures of equity allocation and market sentiment. The index level is not a component of the measure that runs from 0 to 100. The current reading is 99.9, which is a historical record.)

Such is an interesting juxtaposition. On the one hand, there is a rising recognition of a “bubble,” but investors are unwilling to reduce “equity risk” for “fear of missing out or F.O.M.O.” Such was a point noted explicitly by Mark:

“Rather than responding by taking some chips off the table, however, many began freely admitting a bubble formed. They no longer tried to justify higher prices on fundamentals. Rather, they justified it instead in terms of the market’s momentum. Prices should keep going up as FOMO seduces more investors to jump on the bandwagon.”

In other words, investors have fully adopted the “Greater Fool Theory.”

Okay, Boomer!

I know. The discussion of “valuations” is an old-fashioned idea relegated to investors of an older era. Such was evident in the pushback on Charlie Munger’s comments about Bitcoin recently:

While Munger has never been a bitcoin advocate, his dislike crystalized into something close to hatred. Looking back over the past 52 weeks, the reason for Munger’s anger becomes apparent with Berkshire rising only 50.5% against bitcoin’s more than 500% gain.” – Coindesk

In 1999, when Buffett spoke out against “Dot.com” stocks, he got dismissed with a similar ire of “investing with Warren Buffett is like driving ‘Dad’s old Pontiac.'”

Today, young investors are not interested in the “pearls of wisdom” from experienced investors. Today, they are “out of touch,” with the market’s “new reality.”

“The big benefit of TikTok is it allows users to dole out and obtain information in short, easily digestible video bites, also called TikToks. And that can make unfamiliar, complex topics, such as personal finance and investing, more palatable to a younger audience.

That advice runs the gamut, from general information about home buying or retirement savings to specific stock picks and investment ideas. Rob Shields, a 22-year-old, self-taught options trader who has more than 163,000 followers on TikTok, posts TikToks under the username stock_genius on topics such as popular stocks to watch, how to find good stocks, and basic trading strategies.” – WSJ:

Of course, the problem with information doled out by 22-year olds is they were 10-year olds during the last “bear market.” Given the lack of experience of investing during such a market, as opposed to Warren Buffett who has survived several, is the eventual destruction of capital.

Plenty Of Analogies

“There is no shortage of current analogies, of course. Take Dogecoin, created as a joke with no fundamental value. As a recent Wall Street Journal article outlined, the Dogecoin ‘serves no purpose and, unlike Bitcoin, faces no limit on the number of coins that exist.’

Yet investors flock to it, for no other apparent reason than its sharp rise. Billy Markus, the co-creator of dogecoin, said to the Wall Street Journal, ‘This is absurd. I haven’t seen anything like it. It’s one of those things that once it starts going up, it might keep going up.’” – Mark Hulbert

That exuberance shows up with professionals as well. As of the end of April, the National Association Of Investment Managers asset allocation was 103%. 

As Dana Lyons noted previously:

Regardless of the investment acumen of any group (we think it is very high among NAAIM members), once the collective investment opinion or posture becomes too one-sided, it can be an indication that some market action may be necessary to correct such consensus.

Give Me More

Of course, margin debt, which is the epitome of “speculative appetite,” soared in recent months.

As stated, “bubbles are about psychology,” which the annual rate of change of leverage shows.

Another form of leverage that doesn’t show up in margin debt is ETF’s structured to multiply market returns. These funds have seen record inflows in recent months.

With margin debt reaching levels not seen since the peak of the last cyclical bull market cycle, it should raise some concerns about sustainability. It is NOT the level of leverage that is the problem as leverage increases buying power as markets are rising. The unwinding of this leverage is critically dangerous in the market as the acceleration of “margin calls” leads to a vicious downward spiral.

Importantly, this chart does not mean that a massive market correction is imminent. It does suggest that leverage, and speculative risk-taking, are likely much further advanced than currently recognized.

Pushing Extremes

Prices are ultimately affected by physics. Moving averages, trend lines, etc., all exert a gravitational pull on prices in both the short and long term. Like a rubber band, when prices get stretched too far in one direction, they have always eventually “reverted to the mean” in the most brutal of manners. 

The chart below shows the long-term chart of the S&P 500 broken down by several measures: 2 and 3-standard deviations, valuations, relative strength, and deviations from the 3-year moving average. It is worth noting that both standard deviations and distance from the 3-year moving average are at a record. 

During the last 120-years, overvaluation and extreme deviations NEVER got resolved by markets going sideways.

The only missing ingredient for such a correction currently is simply a catalyst to put “fear” into an overly complacent marketplace. Anything from economic disruption, a credit-related crisis, or an unexpected exogenous shock could start the “panic for the exits.”

Conclusion

There is more than adequate evidence a “bubble” exists in markets once again. However, as Mark noted in his commentary:

‘I have no idea whether the stock market is actually forming a bubble that’s about to break. But I do know that many bulls are fooling themselves when they think a bubble can’t happen when there is such widespread concern. In fact, one of the distinguishing characteristics of a bubble is just that.”

However, he concludes with the most important statement:

“It’s important for all of us to be aware of this bubble psychology, but especially if you’re a retiree or a near-retiree. That’s because, in that case, your investment horizon is far shorter than for those who are younger. Therefore, you are less able to recover from the deflation of a market bubble.”

Read that statement again. 

Millennials are quick to dismiss the “Boomers” in the financial markets today for “not getting it.” 

No, we get it. We have just been around long enough to know how these things eventually end.

Viking Analytics: Weekly Gamma Band Update 5/10/2021

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We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

Gamma Band Update

The S&P 500 (SPX) passed an important technical test this past week right near our Gamma Flip levels and launched to new highs. We agree with many others that options and VIX order flow have become one of the primary “fundamentals” of the market, and this past week is an example of why this perspective matters.  As long as SPX closes above its gamma neutral level, stocks remain in a bullish mode.

Our Gamma Band model[1] maintained a 100% allocation to the S&P 500 (SPX) last week, and the Gamma Flip level moved higher to 4,175.  When the daily price closes below “Gamma Flip,” the model will reduce exposure in order to avoid price volatility. If the market closes on a daily basis below the lower gamma level (currently near 3,917), the model will reduce the SPX allocation to zero.

Investors who keep an eye on various gamma-related levels are more aware of when market volatility is expected to increase.  One application of Gamma Bands is to maintain high allocations to stocks when risk is expected to be lower.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

Perhaps Bubble-ishious?

Gamma Bands is one of several indicators that we publish daily in our SPX Report. Overall, we continue to rate our indicators as “cautiously bullish” or perhaps bubble-ishious.  Perhaps we are in the middle of a final melt-up in a multi-year bull market.  With stocks continuing to extend historically high valuations, risk management tools are more important than ever to manage the next drawdown, whenever it comes.

A sample of the SPX report can be downloaded from this link.  Please visit our website to learn more about our daily reports and quantitative algorithms.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to reduce tail risk.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

 Authors

Erik Lytikainen, the founder of Viking Analytics. He has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a B.S. in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space.  He is a former Managing Director at a multi-billion dollar hedge fund. Furthermore, he has deep experience with market data, software, and model building in financial markets. Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.


The Problem Of Pulling Forward Sales & Revenue

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There is a problem of pulling forward sales and revenue when it comes to future outcomes.

Currently, analysts are incredibly exuberant about earnings for the S&P 500 index. In just the last month, they sharply increased 2021 earnings. The chart below shows where 2021 estimates were in January 2020 versus the previous two months.

The near $20 jump in EOY estimates for 2021 over the last month is highly optimistic. The increase was a function of expectations for a “sugar rush” of economic activity from the stimulus. Of course, after the surge, the growth rate of earnings quickly fade.

But are analysts too optimistic?

A Fading Support

One of the potential issues over the next few quarters is 3-successive rounds of financial stimulus led to a spending spree by recipients.

Retail sales make up roughly 40% of Personal Consumption Expenditures (PCE). Importantly, PCE comprises almost 70% of the GDP calculation.

Given that recipients likely spent the bulk of their stimulus, and each dollar spent has a smaller impact on growth, the rate of change is slowing. With no more stimulus in the pipeline, and other supports fading this year, economic growth will slow to the rate of wage growth.

The problem with all stimulus is that it does not lead to productive activity in the economy.

Therefore, the question becomes, “what happens next?”

Pulling Forward Future Sales

I have shown the following chart previously. It shows the cumulative increase from 2007-present of the S&P 500 index compared to sales and economic growth.

Notably, the outsized growth of the market reflects repetitive interventions into the financial markets by the Fed. Those interventions detached financial asset growth from their long-term correlation to GDP growth, where corporate revenue comes from. Historically, when the S&P 500 becomes detached from economic growth, a reversion occurred.

Currently, analysts are expecting earnings to surge well above economic growth rates. However, the flaw in the analysis is the assumption earnings growth will continue its current trend.

While there will be an economic recovery to pre-pandemic levels, a recovery is very different from an expansion. Following the shutdown, companies such as Zoom, Peleton, Apple, and Microsoft saw a surge in demand due to the shift to “work at home.” Then, following the massive amounts of stimulus, there was a surge in other products. Consumers flush with cash ran out to purchase automobiles, computers, phones, durable goods, home refurbishings, and food. Apple, Home Depot,  Etsy, Pinterest, and others saw a surge in demand as shopping sprees ensued.

Today, with much of the money spent, companies are providing warnings about weaker future growth. Such is the problem of stimulus, which pulls forward “future consumption” to “today.” The void it creates must get filled in the future. The question is, with what?

Without more stimulus, the demand for goods and services fades as the ability to consume reverts back to base wage growth.

But inflation presents another problem.

Inflation Is Also Problematic

While providing stimulus is indeed helpful in boosting short-term demand, it leads to inflationary pressures. When businesses realize consumers have money to spend, the ability to pass on higher prices becomes easier. However, given the nature of the economic shutdown and disruption of supply chains, those price increases occur everywhere.

Companies have two choices to deal with inflationary pressures:

  1. They can absorb the higher costs, which impact profit margins; or,
  2. They can pass the cost on to consumers. 

Given the number of companies mentioning inflation during the latest earnings season calls, I suspect we will see their decision sooner than later.

We bet that we will see it passed on to consumers either in the form of “shrink-flation,” where the price for a good remains the same but less is provided, or “inflation” through higher prices. With stimulus fading, higher costs eat into the discretionary income of households that largely live paycheck-to-paycheck. Once the top-20% of income earners are removed, and we factor in the cost of living, the problem becomes apparent.

What Are You Going To Do For Me Now?

The two-fold problem of the temporary nature of stimulus and inflation leaves the market vulnerable to a downshift in earnings expectations over the next couple of quarters. As is always the case, Wall Street has ratcheted up expectations to try and justify current prices.

However, a bit of analysis suggests that over-estimating earnings will lead to a price correction when it becomes realized. While that is something we do not expect immediately, we expect that markets will wake up to this reality in the last half of the year.

By no measure is the market valued at a level that supports current valuations. The average of the 10-year expected returns from four of the most popular measures is -0.75%.

Earnings Growth Disappoint 2021, #MacroView: Earnings Growth Will Disappoint In 2021

While The Fed will continue to supply liquidity, their programs’ efficacy has become less with each iteration. While monetary interventions allow market participants to ignore the reality of the economic ties to the market, such does not preclude hair-raising volatility and large declines as in March 2020.

In 2021, earnings are likely to come in once again substantially lower than analyst’s exuberant estimates. But such shouldn’t be a surprise since they are never accurate historically. More importantly, if the Fed backs off, whether by its design or due to inflation, slower economic growth, or massive debt overhead, rich valuations will matter.

The risk of disappointment is high. And so are the costs of being “wilfully blind” to the risks.

Poor Jobs Report Gives Bulls A Reason To Charge

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In this issue of “Poor Jobs Report Gives Bulls A Reason To Charge.

  • Market Review And Update
  • Peak Earnings
  • Bonds Aren’t Buying It
  • Portfolio Positioning
  • #MacroView: No. Bonds Aren’t Overvalued.
  • Sector & Market Analysis
  • 401k Plan Manager

Follow Us On: Twitter, Facebook, Linked-In, Sound Cloud, Seeking Alpha



Catch Up On What You Missed Last Week

 


Market Review & Update

Last week, we said:

“While the market remains in a very tight range, the ‘money flow’ sell signal (middle panel) is reversing quickly. Importantly, note that the money flows (histogram) are rapidly declining on rallies which is a concern.”

This past week, market action was sloppy as investors are finding fewer reasons to push stocks higher. Friday’s very disappointing jobs report provided some catalyst as the Fed is assured not to reduce monetary support anytime soon. However, despite the push, the overall conviction was lacking.

Notably, the “money flow buy signal” seemed to cross; however, we need some follow-through action on Monday to confirm. As shown, the uptick in money flows did allow us to add some exposure to portfolios in holdings we had taken profits in with the previous “sell” signal. 

Again, we do want to see confirmation that the breakout above the consolidation range can hold. The last breakout failed, so, again, we do need “follow-through” to confirm buyers are indeed back. Notably, the MACD “sell signal” in the lower panel remains, which suggests upside likely remains limited at this juncture. If the “buy signals” align, we will have a much higher level of conviction about higher prices. 

Overall, the market trend remains bullish, so there is no need to be overly defensive. Just a regular process of tweaking risk and managing exposures is all that portfolios require for now. Such is what we have recommended over the last several weeks, so we are now in a position to take advantage of a short-term bullish move. 

For the rest of this week’s message, we will go into deeper detail on the issues I discussed in the latest “3-Minutes” video:

  1. Peak Earnings,
  2. Inflation, and Margins, and
  3. Hedgefund selling.

Santa Claus Broad Wall, Technically Speaking: Will “Santa Claus” Visit “Broad & Wall”

Peak Earnings?

Over the last few weeks, we have seen numerous companies report stellar earnings growth. Yet, the market has failed to reward the good news as stocks get sold off. As the chart below shows, it has not been just a few select isolated cases. 

There are a couple of reasons for this. 

The first is that earnings guidance has not been “exuberant.” Many companies are starting to express concerns over inflationary costs (including labor) and weaker future demand as stimulus fades. Secondly, the problem with earnings in the near term is that most earnings improvement has come from expanding net margins. 

That massive boost to net margins came from the economic shutdown. With reduced workforces, a shift to lower-cost “work-from-home,” and increases in productivity through technology, the surge in margins is not surprising. However, as the economy “reopens,” that tailwind to earnings will fade quickly. The rise of inflationary inputs, increased employment, and potentially higher taxes will shrink net margins dramatically in the quarters to come. 

Such also suggests that analyst’s extremely optimistic earnings revisions will likely need to shift down as well. If the market is indeed sniffing out an “earnings peak” short term, it could be increasingly difficult to justify currently high asset prices and valuations. 

Here is the problem for investors currently. Given analysts’ assumptions are always high, and markets are trading at more extreme valuations, such leaves little room for disappointment. As shown, using analyst’s price target assumptions of 4700 for 2020 and current earnings expectations, the S&P is trading 2.6x earnings growth.

In other words, is the recovery all priced in? The bond market thinks so.

Bonds Aren’t Buying It.

Over the last couple of weeks, we have discussed the correlation between rates and economic growth. To wit:

“As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.”

Bonds Overvalued, #MacroView: No, Bonds Aren’t Overvalued. They’re A Warning Sign.

Not surprisingly, given the substantial rise in asset prices, the ratio of stocks to bonds (S&P Index / Bond Total Return) surged to a record high. It is worth noting that previous stock/bond ratio peaks have coincided with corrections and bear markets. 

Given we already know high valuations equate to low long-term returns, the outlook for returns gets confirmed by the extreme stock/bond ratio,

Importantly, as discussed here, indicators like stock/bond ratios, valuations, and fundamentals all suggest low returns over the longer term. However, in the short-term, the next few weeks or months, there is very little correlation. 

It will be the Federal Reserve that controls the near term.

The Fed May Not Like What It Gets

Over the last couple of weeks, both Fed members and Treasury Secretary Janet Yellen floated “trial balloons” that it may be time for the Fed to start lifting rates. The latest comments came from Dallas Fed President Robert Kaplan when he noted the Fed is likely to achieve its “substantial progress” metric as the economy recovered faster than expected.

As I discussed last week: 

“The Fed is again suppressing rates but should be using the massive liquidity injections and economic recovery for hiking rates and taper bond purchases to prepare for the next downturn.” 

Over the next couple of months, there will be an evident surge in inflation, which the Fed wanted. However, that surge in inflation may come in a lot “hotter” than they anticipated. If that occurs, bond yields will jump higher, effectively “tightening” monetary policy very quickly. 

“The Fed has been very articulate in the message they are sending, and as I mentioned the last time, they are placating the equity market. But at the same time, daring the bond market to push rates higher. If the Fed gets its wish of higher inflation, it will push long-term rates significantly higher from here, and there is no way for the equity market to combat that.

The problem is that the market already is trading at its most overvalued levels vs. the 10-year since the mid-2000s when all of this low rate policy began.The higher stocks and yields move, the more overvalued the equity market grows, and the more dangerous it becomes.” – Mott Capital Management

Maybe More Than Just Talk

While the Fed continues to push the narrative, they “aren’t even thinking about thinking about tapering,” the recent “trial balloons” from both the Fed and Treasury may suggest differently. More importantly, as Mott concludes:

“While it sounds all fine and great for the equity market now, it won’t be if rates get just a little bit higher. Powell clearly made the correct call at the March meeting, buying himself another six weeks, but with a slew of economic data coming in the next few days that will show a lot of inflation, he may find the next six weeks harder to endure.”

While the “bullish mantra” has continued to be, correctly, keep buying dips as long as the “Fed Goes BRRRRR,” there is a rising possibility the “printing presses” may need to be turned off. The Fed faces the problem and understands that if inflation runs hot, interest rates will rise. When that happens, it isn’t just the equity market that comes under pressure. Every market built on debt from houses to automobiles, credit markets, mortgage markets, and consumer credit is at risk. 

Of course, the biggest issue of all is when the reversal in equities occurs. That reversal will ignite the leverage that now extends into levered ETF’s, cryptocurrencies, options, and a myriad of other speculative investments. 

In other words, the Fed got trapped between continuing to suppress interest rates or deflating the most significant asset bubble in financial history. While the hope is that the Fed can do it in a controlled manner (a soft landing), the Fed’s past attempts have been less than successful.

Portfolio Update

As we noted last week,

“Another reason we don’t expect a lot of upside to markets because the recent “consolidation” failed to work off any of the overbought conditions. Notably, the market remains more than 5% above its 50-dma, which is historically extreme. Such gets corrected, usually through a price decline or a consolidation.” 

Our “sell signals” have kept us somewhat underexposed to equities and slightly overweight cash. However, the deterioration of “money flows” concerns us and aligns with hedgefund liquidations over the last several weeks. 

Given the more extreme selling pressure and the current short-term oversold condition of the market, we have begun nibbling at exposures that we like. There is also a reasonable expectation we will start to see the major tech companies pick up a bid as managers look for positions with lots of liquidity as we head into the weaker summer months. 

As shown, we are continuing to run a “barbell” approach to portfolios by overweighting our inflation sectors and underweighting our deflation sectors relative to the benchmark. (60/40 index) We have a very short-duration bond portfolio, which is why our “cash” is overweight. (Primarily 1-3 year duration holdings)

Once we get the next “buy” signal, we will adjust our weightings accordingly, but for now, we remain comfortable with our exposures. We continue to “tweak” the allocation as needed to adjust for risk as our intermediate-term concerns remain.

As David Rosenberg recently noted:

“The worst thing anyone can do is to extrapolate to the future. As Bob Farrell once said: ‘When all the experts and forecasts agree, something else is going to happen.’ The consensus has never been more lopsided, and that is reflected in asset allocations that heavily weight stocks relative to bonds.”

We agree.


The MacroView

 

If you need help or have questions, we are always glad to help. Just email me.

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” is oversold. The current reading is 89.34 out of a possible 100.


Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 99.9 out of a possible 100.


Sector Model Analysis & Risk Ranges

How To Read This Table

  • The table compares each sector and market to the S&P 500 index on relative performance.
  • “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
  • The risk range is a function of the month-end closing price and the “beta” of the sector or market.
  • Table shows the price deviation above and below the weekly moving averages.


Weekly Stock Screens

Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

 

 Low P/B, High-Value Score, High Dividend Screen

Fundamental Growth Screen

Aggressive Growth Strategy


Portfolio / Client Update

Another week has slipped by, and while we are getting close to triggering our next “buy signal,” it hasn’t occurred just yet. Importantly, and as noted last week, given that the market did not correct but just consolidated, the overbought conditions remain. As such, the upside remains limited. 

We continue to make minor tweaks to portfolios to adjust allocations and rebalance risks. And, as noted over the last couple of weeks:

“When both buy signals are misaligned, such leads to short-term consolidations rather than deeper corrections. When they align, which we suspect will happen this summer, more significant draw-downs tend to follow. That is when we will get more aggressive on reducing equity risk.

That view remains and is how we are looking to position portfolios over the next few weeks. For now, the ‘barbell approach’ in our portfolios has continued to work well. With our holdings split between ‘reflation’ trades such as Energy, Financials, and Materials and ‘growth’ focused on Technology, performance has been stable.”

As noted in the main body of this week’s newsletter, our main concern remains the Fed. There is likely about to be a rather large “shock” of inflation as the “base effects” from the shutdown last year come roaring through the data. The problem for the Fed is counterbalancing their stance of “doing nothing,” with the market’s reaction to increasing input and labor costs.

Our short-term concern is the Fed “panics” and makes a mistake that shocks the market. It won’t be the first time it has happened and is always unexpected.  

Portfolio Changes

During the past week, we made minor changes to portfolios. We post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

“In the Equity and ETF models we are adding to our “inflation” plays by adding a starter position to Barrick Gold (GOLD) in the equity portfolio and adding to Industrials (XLI) in the ETF Model.” – 05/06/21

Equity Model

  • Initiate a 1% “Starting” position in GOLD 

ETF Model

  • Increase XLI from 2% to 3% of the portfolio.

As always, our short-term concern remains the protection of your portfolio. We have now shifted our focus from the election back to the economic recovery and where we go from here.

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


If you need help after reading the alert, do not hesitate to contact me.


Model performance is a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. Such is strictly for informational and educational purposes only, and one should not rely on it for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.  

Have a great week!

Technical Value Scorecard Report For The Week of 5-07-21

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The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You can find more detail on the model and the specific tickers below the charts.

Commentary 5-07-21

  • On a relative basis versus the S&P 500, materials are literally off the charts with a normalized score (sigma) of 3.4. Many companies in the materials sector are benefitting from the surge in raw commodity prices. While the sector’s relative score is extreme, it may remain overbought as inflation data will likely be strong for the coming few months. The outperformance of “inflation” stocks can also be seen in our Inflation index, which rose sharply last week. The relative performance of inflationary versus deflationary sectors is shown in the upper right graph.
  • The last graph below shows implied inflation expectations (blue) are starting to break out higher after consolidating for a couple of months. Not surprisingly the inflationary sectors are greatly outperforming the deflationary sectors. The shaded areas highlight the recent periods when inflation expectations trended upward. A listing of the sectors in each category can be found beneath the charts.
  • Technology stocks are now the most oversold sector. Technology tends to do better in moderate inflation or even a deflationary environment. As we suspected real-estate was overbought and due for a correction. Last week the sector lost 2.55% versus the S&P 500.
  • Value continues to shine versus growth, which is not surprising given the inflationary impulse. RSP, equal-weighted, has also benefited from the outperformance of the smaller, more “value” oriented companies. Not surprisingly QQQ and momentum (MTUM) are the most oversold factors/indexes.
  • The scatter plot shows a very high correlation (.8154), denoting that our sector scores and their relative performance have been in line. This provides us more confidence in the data.
  • Financials, Industrials, and Materials are the most overbought sectors on an absolute basis. Both materials and financials are above 2 standard deviations above their respective 20, 50, and 200-day ma. Caution is warranted, but again the sectors may stay hot as inflation is expected to pick up in the coming months.
  • On an absolute basis, every sector is in overbought territory. The same holds true for factors/indexes, except the NASDAQ and mid-cap stocks which have a slightly negative normalized score. The S&P 500 remains overbought but not quite at extreme levels.

Graphs (Click on the graphs to expand)


Users Guide

The score is a percentage of the maximum/minimum score, as well as on a normalized basis (sigma) for the last 200 trading days. Assets with scores over or under +/-60% and sigmas over or under +/-2 are likely to either consolidate or change trend. When both the score and sigma are above or below those key levels simultaneously, the signal is stronger.

The first set of four graphs below are relative value-based, meaning the technical analysis score and sigma represent a ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

#MacroView: Are Stocks Cheap, Or Just Another Rationalization?

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Are stocks “cheap,” or is this just another bullish “rationalization.” Such was the suggestion by the consistently bullish Brian Wesbury of First Trust in a research note entitled “Yes, Stocks Are Cheap.” To wit:

“The Fed remains highly accommodative, there are trillions of dollars of cash on the sidelines, vaccines have reached over 50% of Americans, and the economy is expanding rapidly. Some valuations have been stretched, but the market as a whole remains undervalued. As a result, we remain bullish and are lifting our targets.”

Yes, it is true the Fed remains highly accommodative, which has undoubtedly pushed asset prices higher. In fact, financial conditions recently reached a historic low, which suggests elevated asset valuations ironically.

We have busted the “myth of cash on the sidelines” previously, but this is a “rationalization” that won’t seem to die.

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

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

In the last 5-months, more money flowed into equities than in the past 12-years combined. That flow pushed investor allocations to historic extremes suggesting there is little “on the sidelines.”

Difference Between Expansion & Recovery

With vaccines reaching more Americans, the economy is indeed recovering. However, there is a difference between an economic “recovery” and an “expansion,” as noted recently.

“The “Economic Activity Index” is an average of the 4-most essential components of organic economic activity. Interest rates have a long historical correlation to economic activity, along with inflationary pressures. Without productivity and business investment, jobs do not get created to support consumption which is ~70% of the GDP calculation.”

Bull Market End Badly, There Is No Way This Bull Market Doesn’t End Very Badly

However, I want to focus on the valuation component of his thesis and whether stocks are actually “cheap.”

Through the first quarter of 2021, the expected economic recovery runs well ahead of what the “economic activity index” approximates. Furthermore, given the market’s advance is based on optimistic expectations, there is potential for disappointment.

Such is where fundamentals become extremely important. When expectations of the recovery are disappointed, the market will begin to reprice itself for its intrinsic value. With the market is trading more than twice the level of underlying economic growth, such suggests a significant risk.

Growth Versus Recovery

With real GDP growth of 6%+ this year and S&P 500 earnings expected to grow by 27%, or more. We think stocks
will easily bust through our original target by year-end, so we are raising our year-end target to 4,500. That is 7.5% higher than the Friday close.” – Wesbury

The story would have merit IF the economy were expanding at 6% annually, every year. Notably, 2021 economic growth is primarily a function of annual comparisons recessionary growth. Unfortunately, once the initial recovery is complete, both economic and earnings growth will revert to historical norms.

Since corporate profit growth is a function of economic growth, the relationship is also a cause of concern. With the price to profits ratio elevated well above the long-term trend, there is little to suggest that markets haven’t already priced in the expected recovery.

Earnings Optimism Explodes, #Fundamentally Speaking: Earnings Optimism Explodes

While the U.S. economy will indeed exit the recession in 2021, it may be a statistical result rather than an economic recovery leading to broader prosperity. The most significant risk, which Wesbury overlooks, is a surge in inflationary pressures, undermining more optimistic projections. That concern will manifest itself as a stagflationary environment where wages remain suppressed while costs of living rise. Such will hurt earnings and profitability in an already overvalued market.

Value Isn’t Cheap

“Some investors and analysts are skittish about further gains in equities. The price-to earnings (P/E) ratio on the S&P 500 is 32.6 (based on trailing earnings) is high by historical standards. And the total market capitalization of the S&P 500 has reached about 175% of GDP.” – Wesbury

While Wesbury suggests that valuations are cheap, there is little evidence that such is the case. Most of the assumption is that earnings and the economy will “catch up” with prices. Such would suggest that prices remain stagnant during that process, yet Wesbury assumes prices will surge to 4500 in 2021, eclipsing the benefit of assumed growth. 

Therefore, valuations are not only high by historical standards now but will remain high in the future as prices rise along with economic and earnings growth. The consequence of over-paying for valuations today is substantially lower long-term returns from asset classes in the future. The eponymous GMO noted such in their most recent 7-year forecasts.

However, as we showed previously, such is also proven out by the historical correlations between a majority of the most relevant valuations models: Tobin’s Q, Price/Sales, Market Cap/GDP, and CAPE:

one, You’ve Got To Ask Yourself One Question. Do You Feel Lucky?

The Fed will continue to supply liquidity, which will help the market ignore the reality of the barometers shown above. As we saw in March, that does not preclude hair-raising volatility and significant declines, but it does support prices on the margin regardless of the environment.

The average of the 10-year expected returns from the four gauges is -0.75%. Whether by design or due to inflation, slower economic growth, or massive debt levels, rich valuations will matter whenever the Fed backs off.

Rationalizing Valuations

“Also, persistently low-interest rates make higher P/E ratios more sustainable as future profit growth is worth more with a lower discount rate.” – Wesbury

The view that low interest rates justify high valuations has little historical evidence to support such a claim. As I discussed recently:

  • Exceptionally high interest rates, which have occurred twice, coincided with low stock market valuations. 
  • Exceptionally low interest rates, which have occurred twice, have coincided with high stock market valuations only once; today. 
  • Only once (1/3 probability historically) did high stock valuations coincide with low-interest rates; today.
  • If extremely low interest rates do not cause high stock market valuations, then a rise in rates should not necessarily cause a decline in stocks. 

Furthermore, if we run a correlation between 10-year yields and forward returns, as suspected, we find there is virtually no correlation to support Wesbury’s claim.

Notably, in studying if  low rates justified high valuations, we quoted Cliff Asness of AQR:

Instead of regarding stocks as a fixed-rate bond with known nominal coupons, one must think of stocks as a floating-rate bond whose coupons will float with nominal earnings growth. In this analogy, the stock market’s P/E is like the price of a floating-rate bond. In most cases, despite moves in interest rates, the price of a floating-rate bond changes little, and likewise the rational P/E for the stock market moves little.”

Simply, if you are going to discount the “P” due to low rates, you also have to discount the “E” as well.

Not Today, But Eventually

While it is “bullish” to come up with reasons to justify overpaying for assets in the short-term, outcomes are quite different long-term.

If this wasn’t the case, then “riddle me this.”

If investing works like the media suggests, then why are 80% of Americans living paycheck-to-paycheck? Why is it just the top 10% of income earners own 88% of the stock market?

The reality is that investing long-term is hard. Short-term exuberance tends to lead to poor long-term returns.

Let me conclude with this crucial quote from Vitaliy Katsenelson, which sums up our investing view:

Our goal is to win a war, and 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. 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.”

Rationalizing high valuations today will likely lead to ultimately “losing the war.” 

#WhatYouMissed On RIA This Week: 05-07-21

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What You Missed On RIA This Week Ending 05-07-21

It’s been a long week. You probably didn’t have time to read all the headlines that scrolled past you on RIA. Don’t worry, we’ve got you covered. If you haven’t already, opt-in to get our newsletter and technical updates.

Here is this week’s rundown of what you missed.


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors now has the capability to manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes we can get you in the “right lane” for retirement.


What You Missed This Week In Blogs

Each week, RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risks that may negatively impact our client’s capital. These are the risks we are focusing on now.



What You Missed In Our Newsletter

Every week, our newsletter delves into the topics, events, and strategies we are using. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how we plan to trade it.



What You Missed: RIA Pro On Investing

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now for 30-days free) If you are a DIY investor, this is the site for you. RIA PRO has all the tools, data, and analysis you need to build, monitor, and manage your own money.



Video Of The Week

What? You didn’t tune in last week. That’s okay. Here is one of the best clips from the “Real Investment Show.” Each week, we cover the topics that mean the most to you from investing to markets to your money.

Video Of The Week For 05-07-21The Cobra Effect Full Episode


Latest 3-Minutes On Markets & Money



Our Best Tweets For The Week: 05-07-21

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. However, just in case you missed it, here are a few from this past week you may enjoy. You may also enjoy the occasional snarky humor.

See you next week!

Noah Didn’t Yield To FOMO, Neither Should You

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Noah didn’t yield to FOMO, neither should you. 

In the beginning, God created the heavens and the earth” reads the first sentence of the bible. Later in the book of Genesis, God created cycles.

“Then Joseph said to Pharaoh, “Both of these dreams have the same meaning. God is telling you what will happen soon. The seven good cows and the seven good heads of grain are seven good years. And the seven thin, sick-looking cows and the seven thin heads of grain mean that there will be seven years of hunger in this area. These seven bad years will come after the seven good years. Genesis 41:25-36

Eons later, famed mathematician Benoit Mandelbrot wrote on the similarity between naturally occurring cycles and market cycles. He used the terms Joseph Effect and Noah Effect to define the good and bad years, respectively.

Despite the sharp decline last year, equity markets are back to record highs, and the Joseph Effect is running strong. But, while investors are enthusiastic, the odds are growing that the Noah Effect may come sooner than most investors fathom. The math is clear that returns over the next ten years will pale in comparison to the last.

In this article, we diverge from the math and appreciate the behavioral traits that allow markets to reach extremes. These qualitative factors will help you make sense of today’s market and better prepare for tomorrow.

Smile, You’re On Candid Camera

From 1960 to 1975, Allen Funt hosted a TV series called Candid Camera. The show secretly filmed people doing peculiar things. In addition to being hilarious, the show highlights how inane behavioral traits drive our actions.

For example, the episode Elevator Psychology exhibits how humans tend to follow the lead of others. In market parlance, this is coined FOMO, or the fear of missing out.

In the first scene of the linked video, a man enters an elevator, followed by Candid Camera actors. The actors entering the elevator all face the rear of the car. Upon seeing this, the puzzled man slowly turns around and faces the rear of the elevator. In the second skit, another man not only follows the actors facing backward but then proceeds to rotate back and forth as the actors do. As the scene goes on, he takes off his hat and puts it back on, following the lead of the actors.

The skits highlight our instinctive need to follow the actions of others, regardless of the logic of such activities. Importantly, they highlight the stupid things we do to battle our fear of not conforming.

FOMO

Financial markets often experience similar behavioral herding. Most investors blindly mimic the behavior of other investors without seeking the rationality behind it.

Investors get gripped by a fear of missing out in the extremes of bull markets, aka FOMO. As asset bubbles grow and valuation metrics get stretched, the FOMO strengthens. Patient investors grow impatient watching neighbors and friends make “easy” money. One by one, reluctant investors join the herd despite their concerns.

“There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich” -Charles Kindleberger: Manias, Panics, and Crashes

Famed investors, Wall Street analysts, and the media prey on ill-equipped investors by justifying ever-higher prices.  Their narratives rationalizing steep valuation premiums become widespread. Despite evidence to the contrary and historical precedence, investors always buy the hype. “This time is different,” say the promoters.

This time is rarely different. For a better appreciation of financial bubbles built on false premises and FOMO, we recommend reading “Manias, Panics, and Crashes” by Charles Kindleberger.

Per a recent report, J.P. Morgan had the following to say on bubbles:

Both begin with a compelling narrative that eventually leads analysts to discard previous valuation yardsticks because “this time is different.” Occasionally times have changed, but often they haven’t.”

Defying Our FOMO

Our investing behaviors are quite different from our consumer behaviors. As consumers of goods, we seek discounts on products we want and shun products we think are too expensive. On the other hand, as investors, we seem to prefer to pay top dollar for stocks and avoid them like the plague when they trade at a deep discount. Dare to employ the logic of your inner consumer, not your average investor.

Markets fluctuate between periods where greed runs rampant such as today and periods of fear. Unfortunately, greed causes many investors to ignore or belittle facts and history.

Fear also prevents us from making intelligent decisions. Investors have a fear of catching the proverbial falling knife, even though a stock may already be discounted significantly.

To be successful investors, we must balance our Jekyll and Hyde personalities and silence the crowd’s din. As hard as it is to resist, we cannot fall prey to periods of grossly unwarranted market optimism, nor should we be shy to invest during periods of deep pessimism. TO repeat, avoiding our instincts, like not turning with the crowd in an elevator, is challenging to put it mildly.

How We Keep our Investment Zen

One way to find comfort in both booms and busts is to have well-thought-out investment strategies and risk limits. A good plan should encourage steady, long-term returns and employ active strategies. The plan should ensure you stay current with potential risks, technical setups, and market valuations.  These measures help keep us mindful and vigilant.

As of writing this, we are nearly fully invested in equities. Make no mistake, we are keenly aware current valuations portend poor and likely negative returns for the upcoming ten-year period. What we do not know is the path of returns for the next ten years. Will the market fall 70% tomorrow and rally back over the next nine years? Will it continue rallying to even greater valuations and tumble in a few years? The iterations are endless.

Given the current risks, we actively manage our exposure. If our shorter-term technical models indicate weakness, we reduce exposure and or add hedges. If they signal strength, we may add exposure. Of course, we always have a finger on the sell trigger.

The Coming Noah Effect

Hearing the crowd and sensing the palpable enthusiasm is easy. But, listening to the lessons of the math and history books is difficult. The graphs below are two examples of data and history that provide sobriety to help counter the pull of FOMO.

The first graph shows that the S&P 500 cycles between periods of strong returns and weak returns. Currently, returns for the last ten years are at the upper end of the range, portending weak forward returns.

The following graph uses four valuation techniques to highlight that returns are likely to be flat to negative over the next ten years.

The following quote is from our article Zen and the Art of Risk Management:

“When markets are frothy and grossly overvalued, greed takes over, leading to lofty performance expectations and excessive risk stances. Equally tricky is buying when fear grips the markets.”

“In both extremes and all points in between, we must maintain investor Zen. The best way to accomplish such mindfulness and awareness of market surroundings is to understand the risks and rewards present in markets. Zen-like awareness allows us to run with the bulls and hide from the bears.”

fundamentals, The Death Of Fundamentals & The Future Of Low Returns

Summary

TINA is another popular acronym – “There Is No Alternative.” Despite popular logic today, there are alternatives to blindly employing passive strategies that will fully partake in the upside but leave investors facing significant downside risks.

As a steward of our client’s wealth, we take special care at market junctures like the present to understand the risks. Timing the market is impossible, but full-time awareness of the long-term goals will help our clients avoid the pitfalls that inevitably set investors back years.

Equally damaging for passive investors when the tables turn is the inability to take advantage of the multitude of opportunities that emerge when fear reigns market sentiment.

Technically Speaking: Doug Kass’ 50-Laws Of Investing

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Over the years I have published numerous articles with “investing laws” from some of the great investors in history. These laws, or rules, are born of experience, tested by markets, and survived time.

Here are some of our previous posts:

Throughout history, individuals have been drawn into the more speculative stages of the financial market under the assumption that “this time is different.” Of course, as we now know with the benefit of hindsight, 1929, 1972, 1999, and 2007 were not different. They were just the peak of speculative investing frenzies.

Most importantly, what separates these individuals from all others was their ability to learn from those mistakes, adapt, and capitalize on that knowledge in the future.

Experience is an expensive commodity to acquire, which is why it is always cheaper to learn from the mistakes of others.

Importantly, you will notice that many of the same lessons are not new. This is because there are only a few basic “truths” of investing that all of the great investors have learned over time.

The next major down market cycle is coming, it is just a question of when? These rules can help you navigate those waters more safely, because “you’re different this time.”

The Rules 1-10

  • Common sense is not so common.
  • Greed often overcomes common sense.
  • Greed kills.
  • Fear and greed are stronger than long-term resolve.
  • There is no vaccine for being overleveraged.
  • When you combine ignorance and leverage – you usually get some pretty scary results.
  • Operate only in your area of competence.
  • There is always more than one cockroach.
  • Stocks have a gravitational pull higher – over long periods of time equities will rise in value.
  • Long investing generates wealth.

The Rules 11-20

  • Short selling protects wealth.
  • Be patient and learn how to sit on your hands.
  • Try to get a little smarter every day and read as much as humanly possible – an investment in knowledge pays the best dividends.
  • Investors sometimes think too little and calculate too much.
  •  Read and reread Security Analysis (1934) by Graham and Dodd – it is the most important book on investing ever published.
  • History is a great teacher.
  • History rhymes.
  • What we have learned from history is that we haven’t learned from history.
  • Investment wisdom is always 20/20 when viewed in the rearview mirror.
  • Avoid “first-level thinking” and embrace “second-level thinking.”

The Rules 21-30

  • Think for yourself – those who can make you believe absurdities can make you commit atrocities.
  • In investing, that what is comfortable – especially at the beginning – is most often not exceedingly profitable at the end.
  • Avoid the odor of “group stink” – mimicking the herd and the crowd’s folly invite mediocrity.
  • The more often a stupidity is repeated, the more it gets the appearance of wisdom.
  • Always have more questions than answers.
  • To be a successful investor you must have accounting/finance knowledge, you must work hard and you have to be keenly competitive.
  • The stock market is filled with individuals who know the price of everything but the value of nothing.
  • Directional call buying, when consumed as a steady appetite, is a “mug’s game” and is often a path to the poorhouse.
  • Never buy the stock of a company whose CEO wears more jewelry than your mother, wife, girlfriend or sister.
  • Avoid “the noise.”

Rules 31-40

  • Directional call buying, when consumed as a steady appetite, is a “mug’s game” and is often a path to the poorhouse.
  • Never buy the stock of a company whose CEO wears more jewelry than your mother, wife, girlfriend or sister.
  • Avoid “the noise.”
  • Reversion to the mean is a strong market influence.
  • On markets and individual equities… when you reach “station success,” get off!
  • Low stock prices are the ally of the rational buyer – high stock prices are the enemy of the rational buyer.
  • Being right or wrong is not as important as how much you make when you are right and how much you lose when you are wrong.
  • Too much of a good thing can be wonderful – look for compelling ideas and when you have conviction go ahead and overweight “bigly.”
  • New paradigms are a rare occurrence.
  • Pride goes before fall.

Rules 41-50

  • Consider opposing investment views and cultivate curiosity.
  • Maintain a healthy level of skepticism as you never know when the Cossacks might be approaching.
  • Though doubt is uncomfortable, certainty is ridiculous and sometimes dangerous.
  • When investing and trading, never let your mind dwell on personal problems and always control your emotions.
  • ‘Rate of change’ is the most important statistic in investing.
  • In evaluating the attractiveness of a company always consider upside reward vs. downside risk and ‘margin of safety.’
  • Don’t stray from your investing and trading methodologies and timeframes.
  • “Know” what you own.
  • Immediately sell a stock on the announcement or discovery of an accounting irregularity.
  • Always follow the cash (flow).
  • When new ways of earnings are developed – like EBITDA (and before stock-based compensation) – substitute them with the word… “bullshit.”

2-Bonus Rules

  • Favor pouring over balance sheets and income statements than spending time on Twitter and r/wallstreetbets.
  • Always pay attention to what David Tepper and Stanley Druckenmiller are thinking/doing. (Trade/invest against them, at your own risk). 

The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.” – Howard Marks

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

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

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

As I stated at the beginning of this missive, every great investor throughout history has had one core philosophy in common; the management of the inherent risk of investing to conserve and preserve investment capital.

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

Viking Analytics: Weekly Gamma Band Update 5/03/2021

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We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

Gamma Band Update

The S&P 500 (SPX) continues to melt up, along with an increasing Gamma Neutral level which keeps the market advance on its toes. The Gamma Band weekly model[1] maintained a 100% allocation to the S&P 500 (SPX) all last week, and the Gamma Flip level moved higher to 4,160.  When the daily price closes below “Gamma Flip,” the model will reduce exposure in order to avoid price volatility. If the market closes on a daily basis below the lower gamma level (currently near 3,913), the model will reduce the SPX allocation to zero.

Investors who keep an eye on various gamma-related levels are more aware of when market volatility is expected to increase.  One application of Gamma Bands is to maintain high allocations to stocks when risk is expected to be lower.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.   

Gamma Bands is one of several signals that we publish daily in our SPX Report. Overall, we continue to rate our SPX signals generally as “cautiously bullish,” and perhaps we are in the middle of a final melt-up mode in a multi-year bull market.  With stocks continuing to extend historically high valuations, risk management tools are more important than ever to manage the next drawdown, whenever it comes.

A sample of the SPX report can be downloaded from this link.  Please visit our website to learn more about our daily reports and quantitative algorithms.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to reduce tail risk.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size daily based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

Erik Lytikainen, the founder of Viking Analytics. He has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a B.S. in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space.  He is a former Managing Director at a multi-billion dollar hedge fund. Furthermore, he has deep experience with market data, software, and model building in financial markets. Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.


Cartography Corner – May 2021

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J. Brett Freeze and his firm Global Technical Analysis (GTA) provides RIA Pro subscribers Cartography Corner on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework. We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

GTA presents their monthly analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide


April 2021 Review

E-Mini S&P 500 Futures

We begin with a review of E-Mini S&P 500 Futures (ESM1) during April 2021. In our April 2021 edition of The Cartography Corner, we wrote the following:  

In isolation, monthly support and resistance levels for April are:

o M4                4311.00

o M3                4125.75

o M1                4008.25

o PMH              3983.75           

o Close            3967.50       

o MTrend        3812.97

o M2                3784.50     

o PML              3720.50       

o M5               3481.75

Active traders can use PMH: 3983.75 as the pivot, maintaining a long position above that level and a flat or short position below it.

Figure 1 below displays the daily price action for April 2021 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The price action in April followed our map to a Tee.  The first trading session of April saw the market price exceed and settle above both our isolated pivot at PMH: 3983.75 and first resistance at M1: 4008.25.  As suggested, once above those levels no Monthly Resistance existed until M3: 4125.75.  Six trading sessions later, April 12th, realized a high price of 4124.50.  The following two trading sessions saw the market price consolidate on either side of that level.  (Those three trading sessions are circled on the graph.)

As a reminder, when performing technical analysis, analysts should always work down in time-period with longer periods being more important.  We have included two Quarterly Resistance levels on the graph and the price action around them demonstrates their importance.  Over April 15th and 16th, the market price rose 65.50 points with the high price of 4183.50, stopping just short of Quarterly Resistance at Q3: 4186.25.  As is often the case, the market price retreated significantly from that level on the first test.  The market price rolled back down to Monthly Resistance at M3: 4125.75, now acting as support.  Although breaching that level intra-session, importantly, the market price did not settle below it.          

The four trading sessions of April 23rd, 26th, 27th, and 28th (squared in the graph) all saw their intra-session highs testing Q3: 4186.25 but did not settle above it.  On April 29th, the market price again broke above Q3: 4186.25 yet immediately faced Q1: 4214.50 as resistance.  The high price of that session stopped just short at 4211.00.  The final trading session of April saw the market price settle below both isolated Quarterly Resistance levels.

Active traders following our analysis realized a gain of 4.10%.  

Figure 1:

 

Australian Dollar Futures

We continue with a review of Australian Dollar Futures (6AM1) during April 2021.  In our April 2021 edition of The Cartography Corner, we wrote the following:  

In isolation, monthly support and resistance levels for April are:

o M4         0.8140

o PMH       0.7853

o MTrend  0.7707

o M1         0.7697

o Close      0.7602

o PML          0.7566                 

o M2         0.7566             

o M3         0.7493                         

o M5           0.7123

Active traders can use MTrend: 0.7707 as the pivot, maintaining a long position above that level and a flat or short position below it.  

Figure 2 below displays the daily price action for April 2021 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  Within the overall context of a move to higher prices, the realized price action in April consisted of three consolidations and three swings.  Our isolated pivot level at MTrend: 0.7707 was the center point of the realized range. 

Consolidations:

  1. April 1 – April 12
  2. April 16 – April 22
  3. April 27 – April 28

Up Swings:

  1. April 13 – April 15, 0.7600 to 0.7750
  2. April 23 – April 26, 0.7700 to 0.7800

Down Swing:

  1. April 29 – April 30, 0.7800 to 0.7700

Active traders following our analysis “scratched” on the trade.

Figure 2:

May 2021 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESM1).  The same analysis can be completed for any time-period or in aggregate.

Trends:  

o Daily Trend             4185.39        

o Current Settle         4174.50

o Weekly Trend         4164.33        

o Monthly Trend        3938.53        

o Quarterly Trend      3591.98

The relative positioning of the Trend Levels is bullish yet shows early indications of a possible phase transition.  Think of the relative positioning of the Trend Levels like you would a moving-average cross.  In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures are “Trend Up”, having settled above Quarterly Trend for four quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures are “Trend Up”, settling six months above Monthly Trend.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures are “Trend Up”, settling eight weeks above Weekly Trend.

The early indications of a possible phase transition that we referred to are related to two aspects.  First, Weekly Trend has risen to be at-the-market.  It will only take an eleven-point decline for the bears to be “in control” in the weekly time-period.  Secondly, the slope of the Weekly Trend has started to flatten out.  From the week of March 8th, the distance (measured in points from previous week) between observations of Weekly Trend progressed as follows: -6.56, 24.94, 33.83, 29.98, 56.53.  It peaked the week of April 12th at 76.11 and has declined to 31.92 currently.  The blue dots on the weekly graph are starting to crest.   

Support/Resistance:

In isolation, monthly support and resistance levels for May are:

o Q4                 4742.50

o M4                4701.50

o M1                4438.25

o M3                4381.50

o Q1                 4214.50

o PMH             4211.00            

o M2               4208.50

o Q3                 4186.25     

o Close             4174.50

o PML               3964.50    

o M5                 3945.25      

o MTrend        3938.53

Active traders can use Q1: 4214.50 as the pivot, maintaining a long position above that level and a flat or short position below it.

Soybean Futures

For May, we focus on Soybean Futures (“beans”).  We provide a monthly time-period analysis of ZSN1.  The same analysis can be completed for any time-period or in aggregate.

Trends:  

o Current Settle       15.3420         

o Daily Trend           15.1547

o Weekly Trend       14.7678         

o Monthly Trend      14.3512         

o Quarterly Trend    11.9636

The relative positioning of the Trend Levels is as bullish as possible.  Think of the relative positioning of the Trend Levels like you would a moving-average cross.  As can be seen in the quarterly chart below, beans are “Trend Up”, having settled above Quarterly Trend for three quarters.  Stepping down one time-period, the monthly chart shows that beans are “Trend Up”, having settled above Monthly Trend for eleven months.  Stepping down to the weekly time-period, the chart shows that beans are “Trend Up”, settling above Weekly Trend for three weeks.

Figure 3 below, shows the relative positioning of Speculative Money and Patient Money.  We model the positioning of these participants within the context of price and volatility, measured as Z-Score.  This allows us to not have to depend upon Commitment of Traders reports which reflect a time delay.  The correlations noted in the graph are between our model positioning and the complete set of actual historical COT reports.

Speculative Money participants’ decision-making framework centers on momentum, trend, and price.  They typically employ leverage and focus on short time-periods.  Patient Money participants’ decision-making framework centers on value, mean-reversion, and fundamental reality.  They typically do not employ leverage and play the long game.

Concerning commodity trading, our experience suggests that you want to trade with the Speculative Money except for at extreme positioning.  At the extreme, the speculative narrative is likely fully reflected in the price (and we should anticipate mean-reversion).

Figure 3:

Figure 4 below, shows the Structural Momentum of beans, using monthly inputs.  Structural Momentum measures the absolute dispersion of returns, in units of Z-Score.  The red and green diamonds are scripted to appear when a certain Confidence Interval is reached.  They do not appear often and isolate significant turning points in price well.  Take heed.

Figure 4:

One rule we have is to anticipate a two-period low (high), within the following four to six periods, after an Upside (Downside) Exhaustion level has been reached.  The signal was given the week of April 19th to anticipate a two-week low within the next four to six weeks (now, three to five weeks).  That low can be achieved this week with a trade below 14.234. 

Support/Resistance:

In isolation, monthly support and resistance levels for May are:

o Q4                 19.0700

o M4                17.9228

o M1                16.8920

o M3                16.3900

o Q1                 15.9940

o Q2                 15.8300

o PMH             15.7460            

o Q3                 15.4780

o Close             15.3420    

o MTrend        14.3512

o M2                13.9228     

o PML              13.7460       

o M5                12.8920

Active traders can use Q1: 15.9940 as the pivot, maintaining a long position above that level and a flat or short position below it.

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight into many different markets.  If you are a professional market participant and are open to discovering more, please connect with us.  We are not asking for a subscription; we are asking you to listen.

The Adverse Consequences Of A $15/Hour Wage Hike

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What’s the big “hubbub” over raising the minimum wage to $15/hour? After all, the last time the U.S. lifted the minimum wage was in 2009. The argument for increasing the minimum is to create a “livable wage” for those working at that level. However, is that the best way to help “the poor?”

The Biden Administration wants to include an increase of the minimum wage in the proposed “Infrastructure” plan. Many may forget the attempt to hike the minimum wage during his tenure as Vice-President with the Obama Administration. At that time, there was such an immense level of table-pounding you would assume a majority of Americans got trapped at minimum wage. However, let’s take a look at some numbers.

How Many Work For Minimum Wage?

According to the latest available annual data from the Bureau Of Labor Statistics:

“In 2019, 82.3 million workers age 16 and older in the United States were paid at hourly rates, representing 58.1 percent of all wage and salary workers. Among those paid by the hour, 392,000 workers earned exactly the prevailing federal minimum wage of $7.25 per hour. About 1.2 million had wages below the federal minimum.

Together, these 1.6 million workers with wages at or below the federal minimum made up 1.9 percent of all hourly paid workers.”

Notably, that 1.9% of minimum wage, or less, workers declined 50% from the same report in April 2015:

“In 2014, 77.2 million workers age 16 and older in the United States were paid at hourly rates, representing 58.7 percent of all wage and salary workers. Among those paid by the hour, 1.3 million earned exactly the prevailing federal minimum wage of $7.25 per hour. About 1.7 million had wages below the federal minimum.

Together, these 3.0 million workers with wages at or below the federal minimum made up 3.9 percent of all hourly-paid workers.”

Notably, this number has been reduced drastically from the 13.4% of workers earning minimum wage in 1979.

Of those 1.6 million workers, 49% were aged 19-25, according to the KFF Organization.

Not surprisingly, we primarily find these individuals in the fast food, retail, and service industries.

So What?

“So what? People working at restaurants need to make more money.”

Okay, let’s hike the minimum wage to $15/hr. That doesn’t sound like that big of a deal. Let’s do that math:

My son turned 16 last November and got his first job. He works as a “packer/runner” for a local restaurant to pack orders for pickup due to Covid-19 seating restrictions. Importantly, he has no experience. He also has no idea what “working” actually means and is about to experience the cruel joke of taxes.

However, let’s do the math of $15/hr assuming he works full-time this summer.

  • $15/hr X 40 hours per week = $600/week
  • $600/week x 4.3 weeks in a month = $2,580/month
  • $2580/month x 12 months = $30,960/year.

Let that soak in for a minute. We are talking about paying $30,000 per year to a 16-year old to run food out to customers. (That salary would put him in the top 1% of  wages earners globally.)

Now, let’s expand the math to the current situation.

  • 1.9 Million Workers
  • $30,960 / year (assuming all workers work full time)
  • Assuming everyone worked previously at $7.50/hour
  • Wages increase by $29.4 billion over the year.

An increase in wages of $29.4 billion will either get passed onto consumers at higher costs, or the number of jobs decline.

The Trickle Up Effect:

According to Payscale, the median hourly wage for a restaurant manager is $13.00 an hour.

What do you think happens when my son, with no experience, is making more than the restaurant manager?

The owner will have to increase the manager’s salary. But wait. Now the manager is making more than the district manager, which requires another pay hike. So forth, and so on.

Of course, none of this is a problem as long as you can pass on higher payroll, benefits, and rising healthcare costs to the consumer.

Small Business Already Noticing

But that is a problem already. As the National Federation Of Independent Business (NFIB) noted in a recent survey. To wit:

“Yes, injecting stimulus into the economy will provide a short-term increase in demand for goods and services. When the funds are exhausted, the demand fades. However, small business owners understand the limited impact of artificial inputs. As such, they will not make long-term hiring decisions, an ongoing cost, against a short-term artificial increase in demand. 

Also, given President Biden is focused on more government regulation and higher taxes (which falls squarely on the creators of employment), increased costs will further deter long-term hiring plans.”

Such was explicitly a point made by the Congressional Budget Office as well.

“Higher wages would increase the cost to employers of producing goods and services. Employers would pass some of those increased costs on to consumers in the form of higher prices. Those higher prices, in turn, would lead consumers to purchase fewer goods and services.

Employers would consequently produce fewer goods and services. As a result, they would tend to reduce their employment of workers at all wage levels. When the cost of employing low-wage workers goes up, the relative cost of employing higher-wage workers or investing in machines and technology goes down. Some employers would therefore respond to a higher minimum wage by shifting toward those substitutes and reducing their employment of low-wage workers.”

Been Here Before

That analysis dovetailed with previous research from the Manhattan Institute when the Obama Administration tried lifting the minimum wage previously.

By eliminating jobs and/or reducing employment growth, economists have long understood that adoption of a higher minimum wage can harm the very poor who are intended to be helped. 

But this groundbreaking paper by Douglas Holtz-Eakin, president of the American Action Forum and former director of the Congressional Budget Office, and Ben Gitis, director of labormarket policy at the American Action Forum, comes to a strikingly different conclusion:

Overall employment growth will be lower as a result of a higher minimum wage. Furthermore, much of the increase in income that results for those fortunate enough to have jobs, would go to relatively higher-income households. It would not help those households in poverty in whose name the campaign for a higher minimum wage gets waged.”

Problems With Hiking The Minimum Wage

  • Raising the minimum wage has a variety of effects on both employment and family income. By increasing the cost of employing low-wage workers, a higher minimum wage generally leads employers to reduce the size of their workforce.
  • The effects on employment would cause changes in prices and different labor and capital types.
  • By boosting the income of low-wage workers who keep their jobs, a higher minimum wage raises their families’ real income, lifting some families out of poverty. However, real income falls for some families because other workers lose their jobs, business owners lose income, and prices increase for consumers.

Net Impact

  • The net effect of a minimum-wage increase is to reduce average real family income.

Minimum Wage Impact On Employment

  • Higher wages increase the cost to employers of producing goods and services. The employers pass some of those increased costs on to consumers in the form of higher prices. Those higher prices, in turn, lead consumers to purchase fewer goods and services.
  • The employers consequently produce fewer goods and services, reducing their employment of low-wage and higher-wage workers.
  • When the cost of employing low-wage workers goes up, the relative cost of hiring higher-wage workers or investing in machines and technology goes down.

Net Impact:

  • An increase in the minimum wage affects those components in offsetting ways.
    • It increases the cost of employing new hires for firms
    • Reduces the costs of higher-wage workers and productivity-increasing technology
    • Makes firms raise wages for all current employees whose salaries are below the new minimum, regardless of whether new workers get hired.

, The Costs & Consequences Of $15/Hour

Minimum Wage Increase Effects Across Employers

Employers vary in how they respond to a minimum-wage increase.

  • Employment tends to fall more at firms whose sales decline when they raise prices. Also, at firms that can readily substitute machines or technology for low-wage workers.
  • They might reduce workers’ fringe benefits (such as health insurance or pensions) and job perks (such as employee discounts). Such lessens the effect of the higher minimum wage on total compensation. 
  • Employers could also partly offset their higher costs by cutting back on training. They could also opt to assign work to independent contractors who the FLSA does not cover.

Net Impact

  • Employers respond to higher minimum wages by cutting costs or benefits elsewhere.

Conclusion

Should we raise the minimum wage from $7.25 an hour to say $9.00 an hour? Probably. The cost of living has risen since the 2009 wage hike, and an increase would likely be more palatable than a doubling.

However, while a drastic hike to $15 sounds innocent enough, it has the most significant negative impact on the poor, as reported by the Foundation For Economic Freedom:

Minimum wage laws create a barrier to getting a job that the privileged are better able to overcome than the underprivileged. When jobs are scarce, then immigrants, workers with few skills or little education, and those with limited English proficiency are going to have a harder time convincing employers that their labor is worth $15 an hour than their better-skilled, native, English-speaking competitors. As Thomas Leonard has recently shown, unemploying such marginalized groups are regarded as part of the point of minimum wage laws by early 20th-century ‘progressives’ who saw the minimum wage as a useful tool for keeping immigrants, blacks, and women out of the labor market.”

Notably, the unintended consequences of a minimum wage hike in a weak economic environment are not inconsequential. Given that businesses are already fighting for profitability, hiking the minimum wage, given the subsequent “trickle up” effect, will lead to further increases in productivity and a reduction in employment.

S&P 500 Monthly Valuation & Analysis Review – 04-30-21

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S&P 500 Monthly Valuation & Analysis Review – 04-30-21

Also, read our commentary on why low rates don’t justify high valuations.


J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long-term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.

All Inflation Is Transitory. The Fed Will Be Late Again.

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In this issue of “All Inflation Is Transitory, The Fed WIll Be Late Again.

  • Market Review And Update
  • All Inflation Is Temporary
  • The Fed Should Be Hiking Now
  • Portfolio Positioning
  • #MacroView: No. Bonds Aren’t Overvalued.
  • Sector & Market Analysis
  • 401k Plan Manager

Follow Us On: Twitter, Facebook, Linked-In, Sound Cloud, Seeking Alpha



Catch Up On What You Missed Last Week

 


Market Review & Update

Last week, we said:

“The market is trading well into 3-standard deviations above the 50-dma, and is overbought by just about every measure. Such suggests a short-term ‘cooling-off’ period is likely. With the weekly ‘buy signals’ intact, the markets should hold above key support levels during the next consolidation phase.” 

“As shown above, that is what is currently occurring. While the market remains in a very tight range, the “money flow” sell signal (middle panel) is reversing quickly. Importantly, note that the money flows (histogram) are rapidly declining on rallies which is a concern.”

While the “sell signal” remains intact, not surprisingly, the breakout above the consolidation on Thursday failed, with the selloff on Friday putting the market back where it started the week. Furthermore, the MACD “sell signal” in the lower panel also suggests that prices may remain somewhat capped for the time being. 

As noted, the concern remains of the decline in actual money flows. While the market is holding up near all-time highs, the support of positive money flows continues to deteriorate. Weakening money flows with the market remaining at more overbought conditions also suggest upside is limited over the next few weeks. 

We discussed these concerns in more detail in the latest 3-Minutes video (click to subscribe.)

For now, the market trend remains bullish and doesn’t suggest a sharp decrease of risk exposures is required. However, after reducing equity exposure previously, we are starting to look for the next short-term opportunity to increase risk. However, we aren’t expecting much before we get into the summer months, where, as we will discuss, the risk begins to rise markedly. 

Santa Claus Broad Wall, Technically Speaking: Will “Santa Claus” Visit “Broad & Wall”

All Inflation Is Transitory

On Wednesday, Jerome Powell commented that while he sees inflation, he believes it to be transitory. As my colleague Mish Shedlock noted:

“Inflation jumped as predicted, and so was the Fed comment about transitory.”

As Mish discusses, inflation depends much on how you measure it and who it impacts. However, inflation is and remains an always “transient” factor in the economy. As shown, there is a high correlation between economic growth and inflation. As such, given the economy will quickly return to sub-2% growth over the next 24-months, inflation pressures will also subside. 

Significantly, given the economy is roughly comprised of 70% consumption, sharp spikes in inflation slows consumption (higher prices lead to less quantity), thereby slowing economic growth. Such is particularly when inflation impacts things the bottom 80% of the population, which live paycheck-to-paycheck primarily, consume the most. The table below shows the current annual percentage change in the various categories. 

As shown above, food and beverage prices make up 15.08% of the CPI calculation. The chart below from Brett Freeze breaks down how consumers spend their money based on income classes. The lowest income earners, making $15,000 to $29,999, pay almost 25% of their earnings on food. That compares to only 7.5% for families making more than $150,000.

Housing comprises 56.3% of spending for the lowest income class and only 20% for the highest. The CPI inflation calculation does not accurately portray how inflation affects a large percentage of the population. (This is also the group whose entire boost in income from the stimulus will get absorbed by higher prices)

The Fed May Be Right For The Wrong Reason

With double-digit rates of change in essential items like transportation (going back to work), food, goods and services, and energy, the impact on disposable incomes will come much quicker than expected. If we strip out “housing and healthcare,” which are fixed budget items (mortgage and insurance payments), we see that “household” inflation is pushing 3.5% annualized. 

Such is particularly problematic when wages aren’t keeping up with inflation. 

The Fed is probably right. Inflation will be transitory, but for all the wrong reasons. 

Rates Tell The Same Story

As discussed in Friday’s #MacroView, interest rates also tell us that economic growth will deteriorate markedly over the next few quarters. 

“The correlation should be surprising given that lending rates get adjusted to future impacts on capital.

  • Equity investors expect that as economic growth and inflationary pressures increase, the value of their invested capital will increase to compensate for higher costs.
  • Bond investors have a fixed rate of return. Therefore, the fixed return rate is tied to forward expectations. Otherwise, capital is damaged due to inflation and lost opportunity costs. 

As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.”

The problem for the Federal Reserve, and as quoted by Mish, is that the fiscal and monetary stimulus imputed into the economy is “dis-inflationary.” 

“Contrary to the conventional wisdom, disinflation is more likely than accelerating inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. Once these base effects are exhausted, cyclical, structural, and monetary considerations suggest that the inflation rate will moderate lower by year end and will undershoot the Fed Reserve’s target of 2%. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation.” – Dr. Lacy Hunt

The point here is that while economic growth may be booming momentarily, inflation, which is destructive when not paired with rising wages, will be transient. Given the massive surge in prices for homes, autos, and food, the reversal will cause a substantial disinflationary drag on economic growth. 

The Fed Should Be Hiking And Tapering Now

There is a significant difference between a “recovery” and an “expansion.” One is durable and sustainable; the other is not. 

Following the financial crisis, the Federal Reserve cut rates and flooded the markets with liquidity. As discussed in “The Fed Continues To Make Policy Mistakes,” the Fed should have acted sooner to prepare for the next economic downturn. 

“The Fed should have started lifting rates as the spike in economic growth occurred in 2010-2011 as both the Fed and Government flooded the economy with liquidity. While hiking rates would have slowed the advance in the financial markets, the excess liquidity sloshing around the system would have offset tighter monetary policy.”

The Fed is again suppressing rates but should be using the massive liquidity injections and economic recovery for hiking rates and taper bond purchases to prepare for the next downturn. 

As Mohammed El-Erian noted:

“The majority of market participants are expecting an undramatic event including an upgraded economic outlook, a reiteration of uncertainties and signaling of no policy changes. Unfortunately, it’s an outcome that kicks the policy can down the road when the central bank should be thinking now about scaling back extraordinary measures. 

The longer it takes to do so, the harder it will be to pull off eventual normalization without risking both significant market volatility and damaging what should and must be a durable and inclusive economic recovery.”

By not hiking rates now, they run the risk of being late once again. 

Given the Fed waited too long to hike rates previously, such will be the same this time as they start hiking rates just as economic growth peaks due to the roll-off of stimulus. 

There have been ZERO times in history when the Fed started a rate hiking campaign that did not lead to a negative outcome.

Something Is Going To Break

The “frenzy” of investors to get into the market is unlike anything we have seen since 1999.

The Fed’s problem is that in 1999 there was a bubble in “Dot.com” stocks but not in many other areas of the market. In 2007, it was a mortgage market bubble, but valuations were not extremely elevated in stocks. 

Today, we are:

  • Pushing the second-highest level of valuations in history
  • Many other valuation measures such as Price-to-Sales, Tobin’s-Q, and Market-Cap to GDP are at a record.
  • Investors are rushing to buy the most speculative assets from various Cryptocurrencies, to Non-Fungible Tokens (NFT’s), to highly speculative companies. 
  • Wall Street is rushing IPO’s to market at the fastest pace on record. 
  • SPAC’s are the new asset class.
  • A large portion of the Russell 2000 companies have no income.
  • The bonds with the highest risk of default are trading at historically low rates.
  • Individuals are rushing to pay the highest prices on records for housing and used cars.
  • And, it’s all done with the highest margin debt levels in history.

Of course, corporations are in on it as well, buying back their shares at a record pace (just after asking the government for a taxpayer-funded bailout in March 2020.)

Trapped With No Escape

In other words, it isn’t just one bubble the Fed will have to deal with during the subsequent market melt-down. It will be all of them. The magnitude of the meltdown of multiple asset classes at one time will likely be larger than the Fed can bailout. 

Importantly, I believe they know this already and hope that an inflationary push will help deflate some of the risks before the bubble bursts. As my colleague Doug Kass wrote on Thursday:

“From my perch, and in the end, of course, all violation of the fundamental laws of economic and financial common sense are paid for – but every Bull thinks he will unload before the break. 

John Kenneth Galbraith once wrote that “What we do know is that speculative episodes never come gently to an end. The wise, though for most the improbable, course is to assume the worst.”

I believe that there are numerous other bubbles or inflated values. Moreover, I see numerous headwinds that could reset broad valuations lower. Such includes higher corporate and individual tax rates, inflation, and inflated bullish investor sentiment. 

It is easy enough to burst a bubble. To incise it with a needle so that it subsides gradually is an operation of undoubted delicacy.” 

I agree. 

The bottom line is the Fed is trapped. If they hike rates, they bust the bubble and destroy economic growth. If they do nothing, the bubble inflates to a point it breaks under its weight. 

In my opinion, not that it matters; it seems the risk of doing nothing far outweighs doing something. Taking small actions today to slowly deflate risk seems a much better alternative to the eventual bust.

Portfolio Update

As noted above, we will trigger the next short-term “buy signal,” likely next week. As we have discussed regularly, given the daily “sell signal” was offset by a weekly “buy signal,” there was little downside risk. Such turned out to be the case.

We can now start adding some additional exposure to areas that we need, but with equity holdings at near target weights, only minor adjustments need to get done. We still carry a very short-duration bond portfolio currently as interest rates continue to push towards our target of 1.8-1.9%. At that level, we will start accumulating long-duration bonds and increasing portfolio hedges.

Another reason we don’t expect a lot of upside to markets because the recent “consolidation” failed to work off any of the overbought conditions. Notably, the market remains more than 5% above its 50-dma, which is historically extreme. Such gets corrected, usually through a price decline or a consolidation. 

Over the last two weeks, we had suggested cleaning up portfolios and rebalancing risk. With that complete, portfolios should be in an excellent position to participate in whatever rally we get over the next couple of weeks. 

As we head into summer, we will likely see our weekly and daily signals align with “sell signals” in late May or early June. Such will likely coincide with a realization of peak earnings and economic growth. While we don’t expect a significant reversion at this juncture, given the ongoing liquidity support, a 7-10% correction is possible and well within annual norms. 

Could it be more? Absolutely. 

But that is something we will navigate once we get there. 


The MacroView

If you need help or have questions, we are always glad to help. Just email me.

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” is oversold. The current reading is 89.34 out of a possible 100.


Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 99.9 out of a possible 100.


Sector Model Analysis & Risk Ranges

How To Read This Table

  • The table compares each sector and market to the S&P 500 index on relative performance.
  • “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
  • The risk range is a function of the month-end closing price and the “beta” of the sector or market.
  • Table shows the price deviation above and below the weekly moving averages.


Weekly Stock Screens

Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

 Low P/B, High-Value Score, High Dividend Screen

Fundamental Growth Screen

Aggressive Growth Strategy


Portfolio / Client Update

After taking profits in our index “trading positions” and rebalance overall exposures, there has not been much else to do recently. However, we are now close to getting our next “buy signal,” so we will begin looking at portfolios to adjust exposures for whatever rally we get next. 

Given that the market did not correct much over the last couple of weeks, the overbought conditions remain, limiting the current upside. Furthermore, the threat of increased taxes may also weigh on stocks as we get closer to debates over the bill. 

For now, we will maintain our exposures. But, as I stated last week:

“We did not get substantially MORE aggressive on selling positions because the weekly indicator remains on a “buy” signal. When both signals are misaligned, such leads to short-term consolidations rather than deeper corrections. When they align, which we suspect will happen this summer, more significant draw-downs tend to follow. That is when we will get more aggressive on reducing equity risk.”

That view remains and is how we are looking to position portfolios over the next few weeks. For now, the “barbell approach” in our portfolios has continued to work well. With our holdings split between “reflation” trades such as Energy, Financials, and Materials and “growth” focused on Technology, performance has been stable.

As always, we are on the lookout for the “unexpected” risk that upsets the market. If that changes, we will take action accordingly.

Portfolio Changes

During the past week, we made minor changes to portfolios. We post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

Both Equity and ETF Models

“We are selling 100% of our gold position in IAU. We bought it for a trade, and it looks as if that move has finished. Taking the small gain and will re-evaluate the position for another opportunity.” – 04-26-21

  • Selling 100% of IAU

As always, our short-term concern remains the protection of your portfolio. We have now shifted our focus from the election back to the economic recovery and where we go from here.

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


If you need help after reading the alert, do not hesitate to contact me.


Model performance is a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. Such is strictly for informational and educational purposes only, and one should not rely on it for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.  

Have a great week!

Technical Value Scorecard Report For The Week of 4-30-21

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The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You can find more detail on the model and the specific tickers below the charts.

Commentary 4-30-21

  • Other than the real estate and materials sector, which are overbought versus the S&P 500, most other sectors are hovering around fair value. The graph looks similar to last week, albeit energy improved to fair value as it was the best performing sector of the week. Staples and Utilities are slipping having been the most overbought sectors a few weeks ago. This can be explained by the Fixed income graph (top right) which shows the inflation/deflation index is now slightly overbought. TIPs and Inflationary sectors were back in vogue this week.
  • In the scatter plot, note that the return on XLE is well below what the model would expect. XLE had a great week, beating the S&P by over 5%, but it is still underperforming the S&P by 4% over the last 20 days and 12% over the last 35 days. Along the same lines, since April 20th, the inflation index has outperformed the deflation index by over 6%.
  • On an absolute basis, most sectors drifted higher into overbought territory. In particular, real estate is now extremely overbought. As shown in the 3rd table below, it is now nearly 3 standard deviations above its 200-day ma, a level that usually results in a correction or best case consolidation. The financial and communications sectors are also at levels versus their respective Bollinger bands that threaten a reprieve in their recent strong performance.
  • Like the sector readings, the factors/indexes also drifted slightly higher on the week.
  • In general, it is not surprising that this week’s results are very similar to last week. Other than yesterday’s .60% gain, the market traded in a tight range.
  • Our money flow indicators are inching toward a buy signal on the S&P 500, albeit a weak one, due to where it is starting and collaborating indicators.
  • Over the past month or so, the daily rotation trades in and out of sectors have largely abated. Most indexes and sectors are trading more in line with each other.

Graphs (Click on the graphs to expand)


Users Guide

The score is a percentage of the maximum/minimum score, as well as on a normalized basis (sigma) for the last 200 trading days. Assets with scores over or under +/-60% and sigmas over or under +/-2 are likely to either consolidate or change trend. When both the score and sigma are above or below those key levels simultaneously, the signal is stronger.

The first set of four graphs below are relative value-based, meaning the technical analysis score and sigma represent a ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

#MacroView: No, Bonds Aren’t Overvalued. They’re A Warning Sign.

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There has been much commentary suggesting bonds have gotten overvalued due to historically low rates.

“Stocks are expensive, but bonds are enormously overvalued on a long-term basis” – Jeremy Siegel

However, is that the case?

There is no argument stocks are highly overvalued. We spent much of the past week discussing why forward returns will be lower over the next decade.

The basic premise is that overpaying for earnings today leads to lower rates of return in the future. Of course, given the flood of liquidity from global Central Banks, the overvaluation of markets is of no surprise.

However, while analysts develop various rationalizations to justify high valuations, none hold up under objective scrutiny. While Central Bank interventions boost asset prices in the short-term, there is an inherently negative impact on economic growth in the long term.

However, bonds are a different story.

Forward Returns Fall, Technically Speaking: Forward Returns Continue To Fall

Bonds Can’t Get Overvalued.

Unlike stocks, bonds have a finite value. At maturity, the principal gets returned to the “lender” along with the final interest payment. Therefore, bond buyers are very aware of the price they pay today for the return they will get tomorrow. As opposed to an equity buyer taking on “investment risk,” a bond buyer is “loaning” money to another entity for a specific period. Therefore, the “interest rate” takes into account several substantial “risks:”

  • Default risk
  • Rate risk
  • Inflation risk
  • Opportunity risk
  • Economic growth risk

Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer will not pay a price that yields a negative return in the future. (This assumes a holding period until maturity. One might purchase a negative yield on a trading basis if expectations are benchmark rates will decline further.) 

As noted, since bonds are loans to borrowers, the interest rate of a bond is tied to the prevailing rate environment at the time of issuance. (For this discussion, we are using the 10-year Treasury rate often referred to as the “risk-free” rate.)

However, with existing bonds traded on secondary markets, the price is determined by the difference between the coupon rate and prevailing rates for similar obligations. The benchmark rate acts as the baseline.

A Very Basic Example.

Let’s review an example.

Bond A:

  • Current benchmark interest rates = 5%
  • A $1000 bond gets issued at 100.00 (par) with a 5% coupon with a 12-month maturity.
  • At the end of 12-months, Bond A matures. $1000 gets returned to the lender with $50 in interest, equating to a 5% yield.

For the person who loaned the money, the 5% coupon for 12-months is sufficient to offset various market and economic risks.

Now, let’s assume the benchmark interest rate falls to 4%.

  • What is the “fair value” of Bond A in a 4% rate environment?
  • Since the fixed coupon is 5%, the price must change adjust the “yield at maturity.”
  • In this case, the price of Bond A would rise from $100 to $101.
  • At maturity, the principal value of $1000 gets returned along with $50 in interest to the holder.
  • However, if the bond was sold at $1010 ($1000 x 101%), there is a loss of $10 in value ($1010 – $1000) at maturity. Such equates to a net return of $1000 +($50 in interest – $10 loss in principal = $40) = $1040 or a 4% yield.

Got it?

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

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

Is that the case now?

Forward Returns Fall, Technically Speaking: Forward Returns Continue To Fall

Rates Are A Function Of The Economy

As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship, shown below, should not be surprising given that, as stated above, the “rate” charged for lending money must account for economic growth and inflation.

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

Again, the correlation should be surprising given that lending rates get adjusted to future impacts on capital.

  • Equity investors expect that as economic growth and inflationary pressures increase, the value of their invested capital will increase to compensate for higher costs.
  • Bond investors have a fixed rate of return. Therefore, the fixed return rate is tied to forward expectations. Otherwise, capital is damaged due to inflation and lost opportunity costs. 

As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.

Forward Returns Fall, Technically Speaking: Forward Returns Continue To Fall

Longer Views Tell The Same Story

“But Lance, this year, GDP is expected to surge to 6%, so doesn’t that change things?”

The answer is “no.

The jump in GDP growth in 2021 has several problems attached to it.

  1. It is a recovery from deeply depressed levels in 2020, not expanding growth absorbing population growth.
  2. The recovery is a reflection of an artificial stimulus that has a minimal effective window before depletion. As such, it has an almost negative multiplier effect economically. 
  3. Lastly, given that businesses understand the “bump” of activity is temporary, they are unwilling to make long-term investment commitments requiring a cost-of-capital above longer-term economic growth projections.

As Goldman Sachs recently showed, economic growth will quickly return to 2% growth trends as the “artificial” support fades.

These “bumps” of activity are not uncommon throughout history. However, if we smooth the data using a 5-year average of both the economic composite and rates, the correlation emerges.

As shown, the current 5-year average suggests that rates and growth will continue to run along much lower levels. Such does not foster increased capital investment, strong employment above population growth rates, or increase labor-force participation rates. With a near 90% correlation, economists and analysts will likely be disappointed as growth slows and rates fail to rise. 

Forward Returns Fall, Technically Speaking: Forward Returns Continue To Fall

Bonds Are Sending A Warning

Currently, investors are exuberant in the financial markets due to theMoral Hazard” created by the Federal Reserve. However, as stated in “No Way, This Doesn’t End Badly,”

“Such is where fundamentals become extremely important. When, or if, expectations of recovery are disappointed, the market will begin to reprice itself for its intrinsic value. Given that the market is currently trading more than twice the level of underlying economic growth, which is where corporate profits come from, such suggests a significant risk.”

Bull Market End Badly, There Is No Way This Bull Market Doesn’t End Very Badly

The correlation between the “economic composite” and “rates” currently suggests that the “risk of disappointment” is elevated.

At the peak of nominal economic growth over the last decade, interest rates rose to 3% as GDP temporarily hit 6%. However, what rates predicted is that economic growth would return to its long-term downtrend line. In other words, while the stock market was rising, predicting more robust growth, the bond market was sending out a strong warning. 

Once again, economists predict 6% or better economic growth, yet interest rates are roughly 50% lower than previously. In other words, the bond market is suggesting that economic growth will average between 1.75% and 2% over the next few years.

From our view, rates matter. Given their close tie to economic activity and inflation, we think they will matter a lot.

Are bonds overvalued? No.

But stocks are, and the bond market is ringing alarm bells warning you of the same.

#WhatYouMissed On RIA This Week: 4-30-21

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What You Missed On RIA This Week Ending 4-30-21

It’s been a long week. You probably didn’t have time to read all the headlines that scrolled past you on RIA. Don’t worry, we’ve got you covered. If you haven’t already, opt-in to get our newsletter and technical updates.

Here is this week’s rundown of what you missed.


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors now has the capability to manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes we can get you in the “right lane” for retirement.


What You Missed This Week In Blogs

Each week, RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risks that may negatively impact our client’s capital. These are the risks we are focusing on now.



What You Missed In Our Newsletter

Every week, our newsletter delves into the topics, events, and strategies we are using. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how we plan to trade it.



What You Missed: RIA Pro On Investing

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now for 30-days free) If you are a DIY investor, this is the site for you. RIA PRO has all the tools, data, and analysis you need to build, monitor, and manage your own money.



Video Of The Week

What? You didn’t tune in last week. That’s okay. Here is one of the best clips from the “Real Investment Show.” Each week, we cover the topics that mean the most to you from investing to markets to your money.

Video Of The Week For 4-30-21Interview With Daniel Lacalle


Latest 3-Minutes On Markets & Money



Our Best Tweets For The Week: 4-30-21

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. However, just in case you missed it, here are a few from this past week you may enjoy. You may also enjoy the occasional snarky humor.

See you next week!

Seth Levine: Bitcoin Doesn’t Fix Defi, Defi Fixes Bitcoin

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Does Bitcoin Fix Defi (Definancialization)?

“Bitcoin fixes this.” I cringe every time I see this popular meme. I find it worse than nails on a chalkboard. Bitcoin and other cryptocurrencies (crypto) supporters seem to wheel this tired trope out for every problem they see, particularly at economic ones. To their credit, they genuinely want to fix the financial system’s problems. I do too! However, crypto’s supporters have their subjects completely reversed.

To be sure, our modern-day financial system has problems. It’s plagued by “Too Big to Fail”, embarrassingly slow innovation, poor user experiences, and recurrent cronyism (real and perceived). Like the crypto-crowd, I see centralization as the root cause. We agree: decentralization is the only cure. We need to decentralize finance (DeFi).

Yet, I see crypto as a sideshow. It’s a distraction from the main event—truly decentralizing the financial system. While these innovative tools are worthy of admiration, crypto simply doesn’t address the root causes; and quite frankly, it can’t. Thus, from an investment perspective, I’m cautious when it comes to crypto (at least from a fundamental thesis). Crypto’s best chance for utility is in a decentralized financial system, not the other way around.

Why Decentralization

Decentralized systems are more stable than centralized ones. This broad principle applies to all situations from investment portfolios, to supply chains, to insect colonies. Decentralization ensures that risks don’t concentrate such that a single failure point can bring the whole system down. Centralization breeds instability and fragility. This is all too evident in our financial system.

Unfortunately, there are several modern-day examples of centralized risks threatening entire economies. “Too Big to Fail” banks in 2008 and Long-Term Capital Management’s epic collapse in 1998 are notable ones. Here, the failure of, literally, a handful of institutions endangered the entire economy. How could this possibly be? The global economy is enormous. That we all were thrust into a no-win situation—to foot the bill for these actors’ mistakes or suffer hefty consequences by no fault of our own—is as astonishing as it is unjust. Yet it happened and centralization is to blame.

Decentralized And “Free” Banking

What if there were no banking laws? Would bankers ignore all risks and treat their capital like unconstrained madmen? Of course, they wouldn’t. Those who did would not be in business for long (there are always outliers). History confirms this unpopular view.

Freed from codified capital requirements, banks would create a whole host of different risk management strategies. They would because it’s a business necessity. There is no greater regulator than the market. To be sure, a range of efficacies would emerge with some banks proving safer than others. This diversity, though, would prove protective. It dampens the threat of systemic failure due to anyone bank’s action. The wisdom of crowds protects us all by localizing the damage of mistakes.

In my view, crypto’s biggest promise is to help decentralize financial services—a.k.a. DeFi. DeFi is the practical solution for the centralized financial system’s failures. However, we don’t need crypto to decentralize banking and finance. So-called “free banking” is hardly novel.

Free banking existed to various degrees throughout history, most notably in Scotland, Canada, and the antebellum period in the U.S. During these periods, banks were lightly regulated and issued private notes that were convertible into gold. These notes widely circulated and acted as currency. While far from perfect, the financial system’s stability in these periods compares favorably to our current ones based on central banks. This is due to decentralization.

“A tally of recessions, bank panics, and bank failures reveal that “[the] widespread belief among economists, historians, and journalists that the Federal Reserve [created in 1914] was an essential, major improvement appears to be no more than unreflective faith in government economic management, with little foundation in the historical evidence.”

Source: Alt-m.org

Before Crypto, There Were Shadow Banks

The financial system’s fragility is an unnecessary and terrifying risk, in my view. Thus, I absolutely love that crypto’s mission is DeFi. Bitcoin and other cryptocurrencies are essentially workarounds to archaic laws and financial regulations that prevent innovation, competition, and, ultimately, concentrate systemic risks. However, in these regards, crypto is not unique.

There is already a large and burgeoning industry busy working around regulations to increase efficiency in finance. It’s callously known as the shadow banking or Eurodollar system. The shadow banking system is a network of interconnected financial services companies spanning the globe. It operates in the “shadows” (i.e. favorable offshore jurisdictions) to escape regulatory scrutiny and oversight; hence its moniker. In essence, shadow banking is an attempt at DeFi. While it gets a bad rap, particularly due to its role in the GFC, the shadow banks have been quite effective at improving the industry’s performance.

Note though, that when the shadow banking system failed in the GFC it was around common points of centralization. Capital efficiency is the name of the game when it comes to financial services. However, there’s only so much wiggle room to circumvent capital requirement rules. Thus, the shadow banks naturally piled into similar assets as they sought to optimize for these regulatory constraints. Unfortunately, the regulations proved dangerous. The NSROs were very wrong about home prices and the safety of the assets they backed. The result was system collapse around this common vulnerability that regulations created.

Shadow Banking Isn’t Perfect

While the shadow banking system is crafty, it is not perfect. In my view, it wouldn’t exist in a lightly regulated regime. Maintaining this complex patchwork of interconnected entities around the globe requires lots of expertise and skill. Said differently, it’s expensive. Simplifying the landscape removes the need for these workarounds that only add complexity, opacity, and cost to an already intricate industry. Thus, liberalizing banking is the only way to eliminate the shadow banks; it’s the only way to remove their utility. It’s also the only way to create DeFi.

In my view, it’s folly to think crypto is a DeFi gamechanger. Rather, I see it as merely an evolution in the perpetual “cat and mouse game” played between productive financiers and overbearing regulators. Is there really a fundamental difference between shadow banks and decentralized tokens? Both exist to evade jurisdictional roadblocks to efficiency, innovation, and progress. Instead, crypto seems like a new tool to be used towards DeFi’s end.

The Post-Pandemic Retirement Survival Guide. Part 2.

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Consider the post-pandemic retirement survival guide as the catalyst for renewal.

(Read Part 1 – Here)

At the least, I hope it serves as a reminder of how a retirement planning strategy may require change when conditions warrant. Turbulent periods can lead to great self-awareness, a sense of inner fulfillment that no amount of money can purchase.

Perhaps you’re confident in your current strategy. Market prognosticators believe that economic ‘normal’ is mere months away (normal is yet to be defined). They may help to validate your hope for financial recovery in your household.

Ostensibly, experts go so far as to say the pandemic and its after-effects will disappear by late this year. It’ll be like the global economies never experienced economically devastating lockdowns, a spike in mental health obstacles, and substance abuse. Also, let’s not forget the mind-blowing increase in extreme poverty.

I mean, just like that, the world’s economies will recover from the odd global quarantine of healthy people (never happened before). Oh, the lofty, idealistic haze of markets and its prognosticators tipsy on the never-empty punchbowls of fiscal and monetary stimulus. Their rosy outlooks make me smile. I hope they’re correct.

What does post-pandemic financial recovery mean to you?

Keep in mind, many retirees or those looking to retire soon perceive economic recovery through a darker lens. In other words, a post-pandemic retirement may be ‘no retirement.’ More lower-income workers than ever believe that working much longer is in the cards for them due to COVID financial setbacks.

“With the present economy due to Covid, I am afraid it will take several years to recover and for our retirement savings and investments to be enough for us to retire the way we originally set it up.”

National Institute of Retirement Security, February 2021.

Pew Research, a bipartisan research think tank, conducted a study of 10,334 adults in January 2021 and discovered that a quarter of adults 50 and older who have not yet retired expect the coronavirus outbreak to affect their ability to retire.  This data includes 7% who say they have already delayed their retirement, and an additional 17% think they might have to wait for it.

We can work together to make sense of it all.

Part 2 of the Post-Pandemic Survival Guide is qualitative because planning isn’t exclusively about numbers. Sometimes it’s messy and emotional. No matter how diligent one may be about saving and investing, life can get in the way of even the most perfect of formal plans. 

I request you dig deep and consider how the pandemic may have changed your habits. Maybe the time in quarantine served as a catalyst, a  mental reshuffle of what you define as important. Retirement doesn’t have to be some fantasy or a magic number. It merely requires a tincture of self-reflection mixed with reality. Define what’s truly important outside the borders of the financials and within your own heart. Then go back and worry about numbers.

This begs me to ask:

Action #1: What will be your ‘Grand Reset?’

Do you have what it mentally takes to get over yet another hurdle to retirement? Has the pandemic been the catalyst to search inward for a revised vision of a secure retirement? A personal definition of security has only partly to do with money. I know people with retirement coffers in low six-figures that experience more secure retirements than some with eight-figure balances.

Maybe an open-minded approach based more on qualitative elements of retirement can enhance your thinking. Can one adjust expectations and, at the same time, not give up on the idea of a fruitful, productive retirement? I know so as I witness people accomplish this all the time.

Giving up on planning for retirement isn’t an option. Throwing in the towel isn’t a strategy. Resetting how you think about retirement can be. Hey, when the computer freezes up, what’s the first thing we do? We restart it! 

REINVENT – that’s what matters. Use the lessons learned during the pandemic. And if they’re not your lessons, steal them from what others have experienced! Walk a path, form a voice specific to you. Design a retirement formula that isn’t dictated by what financial media says it should be. 

A real-life example.

I worked with a 67-year-old gentleman who was planning to retire at 72. Then the pandemic hit. He wasn’t affected financially. His plan remained on track. However, what changed was his realization that life is short, and perhaps lofty overseas travel and other big-spending goals weren’t that important after all. The quarantine altered the client’s retirement aspirations. From a quality of life perspective, he gained five years of richness beyond what dollars can purchase – more significant time with loved ones, peace of mind, flexibility, sleeping in!

Formulate a grand reset that adds rich layers to retirement that have nothing to do with spending. Can you reduce a financial goal, downsize, work a part-time job at something you’re passionate about, all to gain another year or longer away from daily rituals that exhaust you?

What are your rules?

I have a friend who used the pandemic time to create a series of NEVER AGAIN statements. He wrote them on an index card.  The note serves as a constant reminder to follow the rules and avoid the temptation to spend on impulse items or extravagant wants. 

NEVER AGAIN will:

  • I live above my means.
  • Society dictate what’s right for me.
  • I have personal boundaries crossed, financial or otherwise.

You get the picture. Here’s one I created: NEVER AGAIN, will I be unprepared for financial vulnerability. Thus, my motivation to maintain at least a year’s worth of living expenses in a cash reserve. At RIA, we call it a Financial Vulnerability Cushion.

Write your NEVER AGAINS. Review them regularly, so you remember long after this event passes.

NEVER FORGET your NEVER AGAINS.

It’s not the Great Pandemic; it’s the Grand Reset. Use the experience and aftermath to discover a more authentic, pragmatic retirement planning process. 

Action #2: Are your thoughts around money ‘sub-optimized?’

Thirty years of partnering with 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 curiosity. 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, thus throwing us off track to hit retirement or any other financial goal.

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 good core money habits, and yet sub-optimization thrives because we’re human.

As in the case of this fifty-something couple: Six-figure wage earners, ambitious savers who set aside 20% of income for retirement 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 handling their money. However, a simple solution to reduce the high-interest debt was clearly in front of them, but 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.

Sub-optimization is a challenge for all of us.

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

Dan Ariely, a 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.” It’s sort of how Social Security recipients perceive the retirement benefits claiming strategy through the lens of break-even and not how taking benefits before full retirement age can reduce overall consumption dollars over a lifetime.

I’ve noticed that the pandemic has helped people ‘unpack’ their thoughts about money and finally realize that financial crises occur more often than initially told. It’s like getting smacked in the side of the head with reality.

So, how does one think full circle financial?

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 have 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 most significant impact on your bottom line.

For example, there’s massive structure In screenwriting, a formula based on horizontal thinking—a beginning, middle, and end. However, vertical thought, or where a writer breaks away from the procedure, is where great conflict, interest, ideas, actions deepen that captivate audiences. Why would the perception be different for retirement planning?

When performing an exercise on broader thinking 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 a 21% interest rate was an optimum conclusion.  It was a significant improvement never considered because the mental barriers were thick between business and personal accounts. Once they removed the borders, a solution was obvious. 

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.

Before ordering at an iconic Texas barbecue place, I stepped back and thought of what else I could do with the money during a recent evening out.  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 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 other qualitative factors.

If anything, this thought process can allow you to pause before making a purchase or setting a financial retirement goal that, in the long-term, is not that important and also create awareness about choices of greater satisfaction and value. Oh, and I went for the pork ribs and fixings (in case you were wondering).

Think rooftop, not basement.

When you bust down the walls between dollars, you begin to think larger (and wiser). 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 conclude in the basement or the specific issues at hand.

Hire a navigator.

The navigators exist. 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. Your net worth should be affected positively, too.

Create retirement plan optimization.

Most people do not have a written retirement strategy. One that breaks down mental boundaries and takes into account a holistic view of finances. 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 consider the entire financial picture, they direct investors to focus on the big picture. Eventually, emotional walls crumble, and one quickly thinks full circle and able to assess clearly how every decision can affect a retirement start date.

Like the 67-year-old gentleman who underwent formal retirement planning. For every expense cut, he ostensibly gained time. For every year gained away from his job, the richer the picture of his life became. He realized the impact of his decisions immediately through the improved results of his financial plan.

How sub-optimized are your relationships?

As you grow as an individual, consistently optimize relationships to determine who is worthy of your presence.  Surround yourself with those wiser (not just book but life smart) who will motivate you out of your comfort zones. Also, people who can make you laugh and share a lighter perspective will 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 don’t apply 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.

A recent study has a positive conclusion.

On a positive note, www.EBRI.org outlines overall encouraging results in their long-running Retirement Confidence Survey.  The survey of over 3,000 Americans in January showcases the resiliency of retirement confidence where half of workers and 7 out of 10 retirees are somewhat confident in living comfortably in retirement.

More than half of workers and a third of retirees call debt a problem. Half of workers say their non-mortgage debt negatively impacts their ability to save for retirement in general and 4 in 10 say it negatively impacts their ability to participate in a workplace retirement plan.

The top five actual sources of retirement income are Social Security (92%), followed by personal savings (66%), company retirement plans, and defined contribution plans. The results showcase the importance (devoid of emotion) of making the right decision regarding Social Security claiming strategies. Confidence in Social Security continuing to provide benefits of at least equal value to those received today also reached an all-time high among retirees (72%) and workers (53%).

Medicare and Social Security are essential.

Three-quarters of retirees and two-thirds of workers feel confident they will have enough money to handle medical expenses in retirement. An increase from 2020 among retirees. Also up significantly from last year and reaching an all-time high for both retirees and workers, 3 in 4 retirees and nearly 6 in 10 workers are confident that Medicare will continue to offer benefits of at least equal value to those received today.

As we stress at RIA, Social Security and Medicare are crucial to retirement security regardless of saving and investment habits, so our planners spend much time educating clients on the topics.

Unfortunately, one out of three workers says that the pandemic has negatively impacted their ability to save for retirement. To read the complete survey, click here.

Overall, I believe worker and retiree awareness of expenses and other goals in retirement has reached a new level. And that’s a good thing as it will enhance mental resiliency to switch gears, change course, adjust accordingly and yet still happily define a personal and fulfilling retirement lifestyle even if it’s modest at best.

Here’s what to do next.

Ask yourself the questions: How do I define retirement outside the boundaries of money and investments? What can I do to maintain a fulfilling retirement experience based on simplicity and internal drives of happiness instead of outward displays of wealth? 

We possess the power and skills to craft a retirement lifestyle that’s genuinely and internally worthwhile. It will be perfect, individualistic, and reside within the boundaries of what’s truly important to our well-being.

 

The Battle Royale: Stocks vs. Bonds (Which Is Right?)

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The Battle Royale: Stocks vs. Bonds.

The S&P 500 is at valuations higher than those in 1929 and rival those of 1999. Despite a recession, the index is 25% above where it was trading before the pandemic. The equity stampede is undoubtedly bullish about corporate earnings prospects and, by default, economic growth.  

As the stock bulls party, bond investors are glum about future economic prospects. Bond yields are below where they were before the pandemic started. Current yields warn of paltry economic growth and little inflation in the future.

Who has it right? (My colleague Lance Roberts touched on this issue in this past weekend’s newsletter.)

Flipping Valuations

Traditional equity valuation analysis frequently involves the comparison of a fundamental metric to share price. The result is often interpreted as quantifying the richness or cheapness of the numerator in the ratio. In the case of the more popular metrics like P/E or P/BV, that is price. 

By assuming the price is fair, we can reverse traditional logic and calculate what the market implies for the denominator.

For example, assume the P/E ratio on XYZ stock jumps to 20 after lingering around 10 for decades. With this knowledge, we can make one of two assumptions.

  • The price of XYZ is twice as high as it should be
  • XYZ’s earnings are going to grow at twice the historical rate in the future.

The first bullet point assumes XYZ’s price must decline to bring its valuation to fair value. The second bullet point assumes XYZ’s earnings must increase to get its valuation to fair value.

The Peak Concept

Before diving in, it’s important to note we use peak earnings and peak GDP throughout this analysis. Peak means we use the highest level of earnings or GDP at each point in time. This method helps eliminate anomalies and better focus on more durable trends. For example, the current peak earnings per share of the S&P 500 is $139.47/share, the highwater mark from 2019. The current level is $94.14. The peak P/E is only 26.50, as compared to the actual P/E of 39. 

The graph below compares peak S&P 500 earnings per share to actual earnings per share. As shown, peak earnings reduce volatility and better focus on the trend.

S&P Earnings Expectations

To calculate the implied growth rates of future earnings and economic activity, let’s look at the peak P/E of the S&P 500 and assume its price S&P 500 is fairly valued.

The following graph compares the secular peak earnings growth rate (blue) to the secular peak GDP growth rate. There are two important takeaways.

  • Earnings and GDP are well correlated
  • Both have been trending lower for the past 40 years

So, with an understanding of economic and earnings growth trends, we have context for comparison to market expectations.

Based on the current peak P/E versus the 20-year average and assuming the price is fair, the market implies earnings growth for the next ten years of 7.17%. By looking at the graph above, we can see it is more than 2% above the trend.

The following graph compares implied earnings growth (black) to the trend earnings growth shown(blue). The current and historical difference is highlighted in red and green.

Stock investors are betting that earnings growth (blue) will accelerate markedly and reverse the multiple decade-long trends. Such implies that GDP growth rates will also turn up.

It is worth highlighting the cyclicality of earnings forecasting errors, as shown in red and green. Periods in which forecasts were higher than actual earnings are often followed by periods where the market underestimates earnings.

We remind you: “Periods in which equities are overpriced with high valuations are followed by periods with lower returns. Conversely, periods when stocks are cheap, are often followed by periods of strong returns.” From our article: Are You Playing Roulette With Your Retirment?

Bonds

Bond yields, like corporate earnings, track nominal GDP exceptionally well. Assessing what bond yields tell us about implied future growth is straightforward as we directly compare yields to peak GDP growth rates. The graph below shows the significant statistical correlation between 10-year bond yields and 10-year nominal GDP growth.

As represented by the green dot, the current ten-year yield is 1.72%, and the ten-year nominal GDP growth rate is 3.71%.

The bond market currently implies sub 2% GDP growth, well below the current trend. Bond yields expect the decades-long trend lower in GDP growth to continue. By default, bond investors forecast earnings growth will continue to trend downward.

Place Your Bets – Bonds

Bond yields argue for longer-term economic trends continuing. Stock prices imply earnings and economic growth will accelerate meaningfully, reversing long-term trends.

Supporting the bond market’s view are the macroeconomic headwinds we frequently discuss. For economic growth rates to rise, we need to see productivity and or demographic trends reverse.

Barring a significant reversal of immigration policy, demographics will continue to contribute less to economic growth. In fact, the Census Bureau just announced the U.S. population grew at its slowest rate since the 1930s, and prior to that, the late 1700s. They attribute the decline to low rates of immigration and births.

Productivity growth depends on capital expenditures, education, employee training, and new technologies. There are few signs spending in these areas is occurring at any greater rate than it has in the past decade. Worse, COVID-related stimulus and related spending point to a surge in non-productive debt and consumption. The additional non-productive debt burden will further hamper productivity growth.

Unfortunately, the recent surge in the amount of debt is likely to do little for future growth. As Lance Roberts discussed, “Debt Doesn’t Create Growth.”

“More debt doesn’t lead to more robust economic growth rates or prosperity. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the change in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.”

Place Your Bets Stocks

While the equity bulls must contend with well-established trends, they do have a couple of cards up their sleeve. For starters, the nation runs a $4 trillion annual deficit which is significantly boosting economic activity. While more debt will impede longer-term growth, fiscal stimulus will flow through to corporate earnings for the time being. Further, it’s not unreasonable to think that massive deficits will continue well beyond the end of the pandemic.

Second, the Fed seems intent on generating inflation. If they do, earnings will be boosted artificially by inflation. However, valuations tend to shrink in inflationary periods, which may not be so bullish for stock prices.

fundamentals, The Death Of Fundamentals & The Future Of Low Returns

Summary

Our bet is with the bond investors. Earnings will recover as spurts of temporary inflation and massive fiscal spending ripple through corporate income statements. However, the fiscal and monetary pandemic response only strengthens our resolve that economic growth rates will continue to trend lower.  

The only difference between the response to the 2008 financial crisis is the government and Fed did more of it this time. The economic growth rate following the financial crisis was weaker than the prior expansion. Given the same stimulus playbook is being used, albeit to a more considerable degree, we can only assume the results will be similar.

 

 

Eric Hickman: The Stock Market’s Collapse Is Near

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Eric Hickman discusses why the stock market’s collapse is near.

Because stock market performance is an essential factor in U.S. Treasury behavior, I study it closely. I wrote a paper in 2012 that, among other things, examined the consistency (or inconsistency) of long-term S&P 500 performance. Between our founder Robert Kessler’s indelible memory of slogging his way through the futile stock market of the 1960s and 1970s and my study of the long-term history of the S&P 500, you will see below that the powerful up-trend of the last 12 years is not a comprehensive representation of the stock market.

There is a bad side, too, one whose magnitude and duration may surprise you. The alternating pattern of extended good and bad stock market periods, an all-time high valuation, and questionable-quality asset appreciation say we are near the end of this good stock market period. There will be a significant drawdown and an extended low/negative return period to balance out the above-average return of the last 12 years.

About The Data And Study

The chart and table that follow show the cumulative real total return (dividends reinvested) and various statistics from the S&P 500 back to 1910 split into eight periods: four good (2, 4, 6, and 8) and four bad (1, 3, 5, and 7). The S&P 500 index formally began in 1957 but has been back-analyzed (not by Kessler) to provide comparable information to the early 1900s.

The chart is shown on a logarithmic vertical axis to normalize it for exponential growth, i.e., each axis label is double that below it. I chose period demarcations subjectively, but at points to best isolate good periods from bad. I use the real (return after taking out inflation) rather than the nominal return because it better captures the difficulty of the stock market in the 1960s and 1970s.

For instance, because annual inflation averaged 7% in period 5 in the first chart below, stocks made a significant positive return on a nominal basis (+5.2% annualized) but were negative (-1.7% annualized) after inflation. The net inflation figure (real) is more relevant to the experience than the nominal return. The analysis follows the chart and table. Print this pdf of the first two charts to consult as you read the text.

There are several things to point out.

Alternating Good To Bad

Looking at the line chart as a whole, the S&P 500 has gone through long periods of good returns (green boxes) alternating with just as long periods of bad returns (red boxes). For the 111+ years, the time spent in good periods is nearly the same length as time spent in bad periods; 55+ years. It isn’t hard to imagine that at 8.5 years minimum historically, the good and bad periods lasted long enough to condition investors to expect the same indefinitely.

Returns in the good periods look almost like diagonal lines with little volatility. Returns in the bad periods look jagged with multiple significant drawdowns (losses). They make little if any return. At the end of good periods, it seems nearly everyone is invested in stocks. At the end of the bad periods, investors say they will never buy a stock again. They are two different experiences – in the midst of one, you wouldn’t know the other type existed before experiencing it.

The Bad Periods

The long timeframe of this chart belies just how hard the bad periods were. Period 3, the Great Depression and WWII lasted 19.8 years with no real return (-0.5% annualized) and a paltry nominal return of 1.2% annualized. In those 20 years, there were three serious drawdowns; -79%, -50%, and -49%. Period 5, the 1960s and 1970s, lasted 16.3 years and lost 1.7% annualized real return. There were four major drawdowns; -18%, -36%, -52%, and -27%. Period 7, the dot-com and housing bubbles, was shorter at 8.5 years but lost 8.8% annualized real and had two major drawdowns: -47% and –52%. Despite these drawdowns eventually being recovered, they were severe enough to tempt selling at the wrong time and not experiencing the recovery.

The Good Periods

The good periods are just as good as the bad periods are bad. They rise up consistently with few reminders of risk. The more consistent the movement, the more it attracts new investment and leverage that propels the price even higher – a positive feedback loop. Such is the environment we are in now.

The red “Consistency of Real Returns” data in the table above shows that the three measures of consistency I’ve chosen are pretty different in good periods than bad. The good periods have had between 80%-90% positive rolling 12-month periods; wherein bad periods are 40%-60%. The good periods’ “Worst YoY%” are between -8% and -20%, ranging from -38% to -64% in bad periods. The worst drawdown in good periods ranges from -15% to -30%, wherein in bad periods it is -50% to -80%.

The last 12 years (period 8) have been the most consistent period in two of the three metrics and just a tad worse than the roaring 1920s in maximum drawdown. The unprecedented consistency of this bull market has created the appearance of a sure thing – exemplified by the Reddit mantra of “stonks always go up.” Risk has never gotten so forgotten.

Valuation

Low P/E ratios (less than 15) indicate attractive pricing, where high P/E ratios (say more than 25) indicate expensive pricing.

If you look under the black heading of “Valuation (P/E Ratio)” in the table above, you will see that the price-earnings ratio falls from high to low in the bad periods and rises from low to high in the good periods. Multiples (P/E ratios) expand (prices rising faster than earnings) in good periods as investors invest for momentum and not fundamentals. Multiples compress in bad periods (prices fall more than earnings) as the past good period gets attenuated, and fundamentals (low P/E ratios or high dividends) are needed to attract equity investment.

In the most recent period 8, the P/E ratio has risen to an all-time high level, over 32x in recent days. Stocks have never been more expensive.

Mean Reversion

The good periods appreciate faster than the long-term average at a broad level, and the bad periods balance that, returning less than the long-term average. In other words, the stock market overshoots on the upside in good periods and then in bad ones, overshoots several times on the downside; the combination makes the long-term average.

There is no official long-term average to revert to; it is a moving target. A fair estimate uses the growth trend where the index spends equal time below and above the average. That number is 5.75% annualized (shown as a dotted line in the first chart). For the S&P 500 to return to that level, it needs to fall by 45%. Markets overshoot, and so it is logical to think an initial drawdown will exceed that.

GDP Limitation

Many think that aggregate stock market returns (the S&P 500 is a proxy for the aggregate) over a long period shouldn’t exceed the growth of its country – its GDP. Such is because the stock market is the economy, and there is no apparent reason why its composite returns should sustainably exceed GDP growth without an equivalent-sized group underperforming.

And yet, stock returns have outpaced GDP over the long term – by a lot. Since the inception of official records (Q1 1947, 74 years ago), real GDP has grown at a 3.1% annualized pace. Over the same period, the S&P 500 has a real return of 7.7% annualized (nominal of 11.4%) and has thus outperformed real GDP by 2.5x, a precarious outperformance that we shouldn’t expect to continue.

Dividend Limitation

Another factor stacked against stock investors is the lack of meaningful dividends. Stock issuers pay dividends as a way of compensating shareholders with a portion of their earnings. Over the 111+ year history studied, dividends are responsible for about two-thirds of the real return. Dividends were 4.3% annualized of the 6.5% annualized real return. But dividends are much lower now. The dividend yield of the S&P 500 is just 1.4% per year (4/19/2021). In other words 2.9% (4.3% – 1.4% = 2.9%) of annual past performance is no longer there for the future.

Similarity To The Spanish Flu And The Roaring Twenties

Stock market bulls are using the narrative that the 2020s will be like the Roaring 1920s because of the COVID-19 pandemic’s similarity to the 1918-1919 Spanish flu; it is 100 years later, and a remarkable decade of stock market performance followed. The S&P 500 had an astonishing 27.2% annualized real return in the 1920s (period 2).

There are immediate reasons why the stock market of the 2020s will not be like the 1920s. The 1910s (period 1) was a terrible decade for the stock market (-4.9% annualized real return), and so the 1920s had a low base to build from. In contrast, the 2010s (period 8) was a high-performing decade, returning 15.3% annualized real. Such gets seen with P/E ratios. The P/E ratio at the start of the 1920s was 9.6x, where the P/E ratio of the S&P 500 now is over 32x, more than 3-times more expensive. In other words, the bull market already happened. Finally, the 1920s followed World War I. Economic booms follow major wars. There was no equivalent war in the 2010s.

Signposts Of The End

There are other familiar signposts and the consistent, strong bull market and record price/earnings ratio. Towards the end of a stock bull market, questionable assets appreciate with abandon. There are many examples now:

  1. Tech stocks: Tesla trades at 949x earnings (4/19/2021) and has a market cap (company value) nearly as great (87% on 4/19/2021) as the seven other big car companies combined; Toyota, Volkswagen, Daimler, GM, BMW, Honda, and Ford.
  1. Meme stocks: investors came together on popular anonymous social media platform Reddit to drive the price of GameStop, a shrinking brick and mortar retailer of video games, up more than 8x in January. It now trades at less than half of that (4/19/2021).
  1. Crypto-currencies: Bitcoin is up 1,026% (or 11.3x) since the low in March last year (3/16/2020 – 4/19/2021).
  1. Non-fungible tokens (NFTs), which facilitate an immutable transfer of ownership for a digital file, have traded at “double-take” levels. For instance, digital artist Beeple sold a collage of his art that anyone else can see (albeit without official ownership or full resolution) in a Christie’s auction for $69.3 million on 3/11/2021. Such was the third most expensive piece of art ever sold by a living artist, and it isn’t tangible.
  1. Special purpose acquisition companies (SPACs) are an investment vehicle that serves as a loophole to take a company public before it meets the standards it would need to go public by itself. It has created a frenzy in companies raising funds from eager investors without meeting the standards of an individual stock listing.
  1. Sporadic blowups: The $10bn family office Archegos lost all of its money and more when large leveraged holdings Viacom (VIAC) and Discovery (DISCA) quickly lost half of their value in March. Some think this is just a precursor of future similar incidents.

Stock market bulls suggest the stock market will continue rising because the pandemic will end (I’m not so sure.) Also, developed economy governments have put enough money into their economies to keep their stock markets elevated (not sure about that either.) Investors have become lulled into complacency as the stock market rallied through every risk for more than a decade. It is a mistake to think this is normal or sustainable.

Some features of COVID-19 will likely be the stock market’s undoing, but it doesn’t have to be. Possible candidates include an emerging market sovereign fiscal crisis, a prominent hedge-fund/bank blow-up, fraud, social unrest, or a geopolitical crisis. There is also the possibility that an inflection point won’t have an identifiable catalyst but could happen just from a collective realization that asset prices reflect optimism extrapolated further into the future than is realistic. I don’t know when or how, but the sentiment will change; the boom and bust process is as old as civilization.

When it happens, nobody is big enough to stop it from coming down. Fiscal and monetary stimulus is this cycle’s “false idol.” Every cycle has one – a reason why it can’t come down. Before the stock market crash of 1929, Yale economist Irving Fisher said stock prices were in “what looks like a permanently high plateau.” Portfolio insurance was the culprit in 1987. In 2000, the internet was a “new paradigm” obviating historical comparisons. Before the 2007-2008 stock market crash, Alan Greenspan, chairman of the Federal Reserve, said the housing market was too varied geographically to come down at once. Ben Bernanke, the subsequent chairman of the Federal Reserve, infamously said that he thought losses to subprime mortgage loans were “contained.” All of them were wrong.

The Last Dance

As Jeremy Grantham, co-founder of Boston investment firm GMO said in his essential 01/04/2021 article “Waiting for the Last Dance,”

Nothing in investing perfectly repeats. Certainly not investment bubbles. Each form of irrational exuberance is different; we are just looking for what you might call spiritual similarities. Even now, I know that this market can soar upwards for a few more weeks or even months – it feels like we could be anywhere between July 1999 and February 2000. This is to say it is entitled to break any day, having checked all the boxes, but could keep roaring upwards for a few months longer.

My best guess as to the longest this bubble might survive is the late spring or early summer, coinciding with the broad rollout of the COVID vaccine. At that moment, the most pressing issue facing the world economy will have been solved. Market participants will breathe a sigh of relief, look around, and immediately realize that the economy is still in poor shape, the stimulus will shortly be cut back with the end of the COVID crisis, and valuations are absurd. ‘Buy the rumor, sell the news.’ But remember that timing the bursting of bubbles has a long history of disappointment.

Conclusion

Many will wait to see the stock market come down before they believe it, but keep in mind the adage that “a bull market will do everything to keep you out, a bear market will do everything to keep you in.” As it comes down, lower prices will entice bulls, who then end up losing more than they otherwise would as it falls more. They mistakenly use the prior period’s consistency to trade the new bear market, which, pun intended, is an entirely different animal.

My firm expresses this opinion by owning the long-end of the Treasury yield curve – 10-year and 30-year bonds. In Treasury bonds, you get paid to wait. If you were short stocks instead, you have to pay the dividend to wait. When a “risk-on” product becomes risky again, there are only a few reliable appreciating assets; the U.S. Treasury market being the best. 10-year U.S. Treasury yields fell 367 and 324 basis points, respectively, surrounding the last two major stock market drawdowns in 2000 and 2008. The 10-year U.S. Treasury has a yield of 1.58% now (4/19/2021). It falling the average 346 basis points would take it to -1.87%. I am not suggesting it gets that deeply negative, but there is certainly plenty of room for Treasury bonds to appreciate (prices rise as yields fall).


Eric Hickman is president of Kessler Investment Advisors, Inc., an advisory firm located in Denver, Colorado, specializing in U.S. Treasury bonds.

Technically Speaking: Forward Returns Continue To Fall

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One of the interesting aspects of “bull markets” is the further they go, the lower forward returns fall. In hindsight, such an idea seems counter-intuitive, but ultimately it always comes down to valuations. As Warren Buffett once quipped: “Price is what you pay. Value is what you get.”

(Click Here To Read Why Low Returns Requires A Bear Market)

When markets are incredibly exuberant, as they are currently, it is not surprising that such is commonly associated with previous market peaks. The chart below shows the annual rate of change of the inflation-adjusted S&P 500 index from March to March. The recent market surge marks one of the largest on record. Such increases typically preceded corrections (10-20%) to outright bear markets.

As we will discuss momentarily, a look at GAAP valuations as a ratio to the “Volatility Index” also finds potential “Trouble in Paradise.”

However, despite these more basic understandings, investors still cling to the belief “this time is different.” To support that thesis, investors have pointed to low interest rates as support for excess valuations.

But does that theory hold?

Low-Interest Rates & Forward Returns

We previously discussed whether low rates justified high valuations, to wit:

“The primary argument is that when inflation or interest rates fall, the present value of future cash flows from equities rises, and subsequently, so should their valuation. While true, assuming all else is equal, a falling discount rate does suggest a higher valuation. However, when inflation declines, future nominal cash flow from equities also falls, this can offset the effect of lower discount rates. Lower discount rates are applied to lower expected cash flows.

In other words, without adjusting for inflation and, in no small degree, economic growth, suggesting low rates justify overpaying for cash flows is a very flawed premise.”

Or, as Cliff Asness of AQR Capital confirmed:

Instead of regarding stocks as a fixed-rate bond with known nominal coupons, one must think of stocks as a floating-rate bond whose coupons will float with nominal earnings growth. The stock market’s P/E is like the price of a floating-rate bond. In most cases, despite moves in interest rates, the price of a floating-rate bond changes little, and likewise the rational P/E for the stock market moves little.”

In other words, if you are going to discount the “P” due to low rates, you also have to discount the “E” as well. Before we get to “earnings yield,” a look at the history of interest rates can tell us something.

The chart below is the “real” S&P index versus the 10-year Treasury bond. What you will notice is that there is not a high degree of correlation between rates and markets.

Some Analysis

Looking at the chart above, we find:

  • Exceptionally high interest rates, which have occurred twice, coincided with low stock market valuations. This fact does not prove that high interest rates “cause” low stock valuations. But at least the historical record is consistent with such a statement.
  • Exceptionally low interest rates, which have occurred twice, have coincided with high stock market valuations only once; today. The historical record (1/2 probability) does not validate the highly-confident mainstream narrative that low-interest rates “cause” or “justify” high stock market valuations.
  • Extremely high stock valuations have occurred three times. Only once (1/3 probability) did high stock valuations coincide with low-interest rates; today.
  • If extremely low-interest rates do not cause extremely high stock market valuations, then a rise in rates should not necessarily cause a decline in stocks. That is, the historical record does not support the near-certain mainstream narrative that an increase in rates will torpedo stock prices.

Furthermore, if we run a correlation between 10-year yields and forward returns, as suspected, we find almost no correlation to support the claim.

Earnings Yield & Forward Returns

As noted, if we are going to talk about low yields, we also need to discuss “earnings yield,” which is simply the inverse of the “price to earnings” ratio.

Historically, when interest rates or infla­tion are low, the stock market’s E/P is also. When isolating periods where interest rates were low, such occurred only twice; in the 1940s and currently. In the 1940s, stock valuations were low, along with interest rates. Therefore, the statement that low-interest rates cause high valuations is a .500 batting average, equivalent to a coin-flip. 

However, if we look at periods of exceptionally low earnings yields compared to the market, we find a better correlation to corrections and outright bear markets.

As shown, there is a reasonable correlation between low earnings yields and low forward returns. Historically speaking, with an earnings yield of 2.66%, forward returns over the next decade should somewhere between +2 and -5%.

But what about the excess yield?

Excess CAPE Yield & Forward Returns

We previously discussed Dr. Robert Shiller’s attempt to justify high valuations. To wit:

“There has been much puzzlement that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic. Especially in the United States, which has recently been setting record highs for new cases. But maybe it isn’t such a puzzle. A measure we call the Excess CAPE Yield (ECY) puts the long-term outlook for the world’s stock markets in better perspective.”

Essentially, the “Excess Cape Yield” is the difference between the “Earnings Yield” less the “10-Year Interest Rate.”  Shiller’s calculation is shown below and compared to the “real” S&P 500 index.

A cursory glance of “low” excess CAPE yields, compared to the index, suggests an alignment with historical market peaks rather than advancing “bull markets.”

Again, running a correlation of the “excess yield” to forward 10-year returns, we find an even higher correlation between low excess yields and low returns. If we use Shiller’s excess yield of 2.56%, such would suggest that returns from equities over the next decade will likely average between -5% to +5%.

Does that mean that every year will be a low return year?

No.

It does suggest that there will be a nasty bear market somewhere along the way.

Conclusion

It is imperative to remember valuations are very predictive of long-term returns from the investment process. However, they are horrible timing indicators. 

Beware the investment advisor, pundit, or superstar investor who is sure that extremely low rates cause incredibly high stock valuations.

There is much to debate about the current level of interest rates and future stock market returns. However, what is clear is the 40-year decline in rates did not mitigate two extremely nasty bear markets since 1998, just as falling rates did not mitigate the crash in 1929 and the subsequent depression.

As Clifford Asness concluded:

So, when pundits say it is a good time for long-term investors to buy stocks because interest rates are low, and then show you something like chart above to prove their point, please watch the tense of what they say, as what they often really mean is that it WAS a good time to buy stocks ten years ago, as investors are now paying a very high P/E for the stock market (perhaps fooled into doing so by low interest rates as I contend), and the story going forward may be painfully different.” 

Do low rates justify high valuations?

History suggests they don’t. 

Viking Analytics: Weekly Gamma Band Update 4/26/2021

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We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

Gamma Band Update

The S&P 500 (SPX) continues to advance, and this week’s dips were bought on Wednesday and Friday.   The Gamma Band weekly model[1] maintained a 100% allocation to the S&P 500 (SPX) all week, and the Gamma Flip level moved higher to 4,100.  When the daily price closes below the “Gamma Flip” level, the model will reduce exposure in order to avoid price volatility. If the market closes on a daily basis below the lower gamma level (currently near 3,860), the model will reduce the SPX allocation to zero.

Investors who keep an eye on the Gamma Flip level are more aware of when market volatility is expected to increase.  The chart below shows how the length of daily candles tends to be longer when the market price is below or near the Gamma Flip level. 

One application of the Gamma Band concept is to maintain high allocations to stocks when risk is expected to be lower.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

 

This is one of several signals that we publish daily in our SPX Report. Overall, we continue to rate the SPX options signals as “cautiously bullish.” Periodic pullbacks will be necessary to keep the bull well fed.  With stocks continuing to extend historically high valuations, risk management tools are more important than ever to manage the next big drawdown, whenever it may come.

A sample of the SPX report can be downloaded from this link.  Please visit our website to learn more about our daily reports and quantitative algorithms.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to reduce tail risk.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size daily based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

Erik Lytikainen, the founder of Viking Analytics. He has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a B.S. in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space.  He is a former Managing Director at a multi-billion dollar hedge fund. Furthermore, he has deep experience with market data, software, and model building in financial markets. Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.


Low Future Returns Requires A “Real” Bear Market

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When there is a discussion of low future returns due to valuations, what gets missed is that such requires a bear market.

Let me explain.

In “Do You Feel Lucky,” Michael Lebowitz compiled a series of valuation metrics and their correlation to future returns. To wit:

“The average of the 10-year expected returns from the four gauges is -0.75%. When the Fed backs off, whether by its design or due to inflation, slower economic growth, or massive debt overhead, rich valuations will matter.”

one, You’ve Got To Ask Yourself One Question. Do You Feel Lucky?

The mistake many investors make is assuming that such means every year, over the next decade, returns will be near zero. As we will discuss, it is not every year, but one or two awful years, impacting the whole.

Fun With Math

The vital point to understand is that over the long-term investing period, “value” and “returns” are both inextricably linked and opposed. As shown above, forward return expectations are lower than the long-term average given current valuation levels.

Let’s review what “low forward returns” does and does not mean before looking at different valuation measures.

  • It does NOT mean the stock market will have annual rates of return of sub-3% each year over the next 10-years.
  • It DOES mean the stock market will have stellar gains in some years, a big crash somewhere in between, or several smaller ones, and the average return over the decade will be low. 

“This is shown in the table and chart below which compares a 7% annual return (as often promised) to a series of positive returns with a loss, or two, along the way. (Note: the annual average return without the crashes is 7% annually also.)”

, Fundamentally Speaking: 7-Measures Suggest A Decade Of Low Returns

“From current valuation levels, two-percent forward rates of return are a real possibility. As shown, all it takes is a correction, or crash, along the way to make it a reality.”

Such isn’t a prediction; it is just statistical probability and simple math.

Most importantly, as stated above, none of these factors or measures mean the markets will produce single-digit rates of return each year for the next decade. The reality is there will be some strong return years during that period. Unfortunately, the bulk of those years will get spent making up previous losses. 

That is the nature of investing in the markets. It is just part of the full-market cycle.

Why A 50% Correction Is Required

One of the essential issues overhanging the market is simply that of valuations. As Goldman Sachs pointed out recently, the market is pushing the 89% percentile or higher in 6 out of 7 valuation metrics.

, Why Another 50% Correction Is Possible

So, just how big of a correction would be required to revert valuations to long-term means? Michael Lebowitz recently did some analysis for RIA PRO:

“Since 1877 there are 1654 monthly measurements of Cyclically Adjusted Price -to- Earnings (CAPE 10). Of these 82, only about 5%, have been the same or greater than current CAPE levels (30.5). Other than a few instances over the last two years and two others which occurred in 1929, the rest occurred during the late 1990’s tech boom. The graph below charts the percentage of time the market has traded at various ranges of CAPE levels.”

, Why Another 50% Correction Is Possible

Given that valuations are at 30.5x earnings and that profit growth tracks closely with economic growth, a reversion in valuations would entail a decline in asset prices from current levels to somewhere between 1350 and 1650 on the S&P (See table below)From the recent market highs, such would entail a 54% to 44% decline, respectively. (To learn how to use the table below to create your own S&P 500 forecast, give RIA Pro a 14-day free trial run.)

, Why Another 50% Correction Is Possible

Such also corresponds with the currently elevated “Price to Revenue” levels, which are now higher than at any point in previous market history. Given the longer-term norm is 1.0, a reversion as seen in 2000 and 2008, each required a price decline of 50% or more.

Bull Market End Badly, There Is No Way This Bull Market Doesn’t End Very Badly

As expected, 10-year forward returns are below zero historically when the price-to-sales ratio is at 2x. There has never been a previous period with the ratio climbing to near 3x.

Bull Market End Badly, There Is No Way This Bull Market Doesn’t End Very Badly

What Would A Mean Reversion Entail?

The chart below uses Fibonacci retracement measurements as potential reversion levels. It is worth pointing out markets are currently pushing 2-standard deviations above the 50-week moving average. As noted, markets trend above the 50-week moving average during bull markets. Bear markets trend below that average.

Importantly, corrections during bull markets can temporarily break below that average but quickly rise back above it. Such is why March of 2020 was a “correction” and not a “bear market,” as price trends did not change.

Using those Fibonacci retracement levels:

  • A 23.6% correction would pull markets back to roughly 3100, leaving the current bull market intact.
  • The 38.2% retracement level would start retesting the March 2020 lows. Such will begin pushing the early boundaries of a “bear market” if prices do not recover quickly. 
  • A bear market will be well entrenched at the 50% retracement level. Valuation levels will approach more reasonable levels of “fair value,” and sentiment will turn negative.
  • At a 61.8% retracement level, it will erase a majority of the last decades bull market. While many will suggest such a retracement is unlikely, history suggests such is indeed possible.
  • If the 74.6% retracement level gets reached, there will not be many investors left in the market. However, valuations will have reverted to historically cheap levels, which have been the foundation for long-term secular bull markets to begin.

It’s Not Impossible

Such a level certainly seems unthinkable, but as Shawn Langlois previous penned:

I recognize the notion of a two-thirds market loss seems preposterous. Then again, so did similar projections before the 2000-2002 and 2007-09 collapses.”

While the current belief is that such declines are no longer a possibility due to Central Bank interventions, we had two 50% declines just since the turn of the century. The cause was different, but the result was the same.

The next major market decline will get fueled by the massive levels of corporate debt, underfunded pensions, and record “margin debt,” and the lack of “market liquidity.” 

What Will Cause It?

The real problem with discussing corrections is three-fold:

  1. It is has been so long since we have had a bear market, many investors have forgotten what happens, and more importantly, how they reacted previously.
  2. The majority of mainstream media advice gets written by individuals who don’t manage money for a living, have no substantial investment capital at risk, and have never actually been through a bear market. 
  3. Given the extremely long market expansion, many investors have genuinely come to believe “this time is different.”

 What will cause the next bear market?

I do not have a clue. Nor does anyone else.

Numerous catalysts could pressure such a downturn in the equity markets:

  • An exogenous geopolitical event
  • A credit-related event (most likely)
  • Failure of a major financial institution
  • Recession
  • Falling profits and earnings
  • An inflationary or deflationary spike
  • A loss of confidence by corporations that contracts share buybacks

The Cycle Is Always The Same

Whatever the event is, which is currently unexpected and unanticipated, the decline in asset prices will initiate a “chain reaction.”

  • Investors will begin to panic as asset prices drop, curtailing economic activity and further pressuring economic growth.
  • The pressure on asset prices and weaker economic growth, which impairs corporate earnings, shifts corporate views from “share repurchases” to “liquidity preservation.” Such removes critical support of asset prices.
  • As asset prices decline further and economic growth deteriorates, credit defaults begin triggering a near $5 Trillion corporate bond market problem.
  • The bond market decline will pressure asset prices lower, which triggers an aging demographic who fears the loss of pension benefits, sparks the $6 trillion pension problem. 
  • As the market continues to cascade lower at this point, the Fed is monetizing nearly 100% of all debt issuance and has to resort to even more drastic measures to stem selling and defaults. 
  • Those actions lead to a further loss of confidence and pressure markets further. 

The Federal Reserve can not fix this problem, and the next “bear market” will NOT be like that last.

It will be worse.

Low Future Returns Only Require One

Over the next decade, it is unlikely that a 50-61.8% correction will happen without a credit-related event occurring. The question becomes the limits of the Fed’s ability to continue to “bailout” banks and markets once again.

Maybe they can, but I am not sure I want to ride the markets down trying to find out.

The point here is that it only takes one “mean reverting” event over the next decade to lower your annualized returns close to zero. Such does not bode well for retirement plans banking on 6-8% annualized returns or more.

As noted, over the next decade, there will be some terrific “bull market” years to increase portfolio valuations. However, one essential truth is indisputable, irrefutable, and undeniable: “mean reversions” are the only constant in the financial markets over time.

The problem is that the next “mean reverting” event will remove most, if not all, of the gains investors have made over the last five years. Possibly, even more.

Still don’t think it can happen?

“Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as they have predicted. I expect to see the stock market a good deal higher within a few months.” – Dr. Irving Fisher, Economist at Yale University 1929

Interview W/ Daniel Lacalle: Markets Are Pricing Massive Expansion

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Last week, I joined Daniel Lacalle to discuss why markets are mistaken in pricing in a “massive” economic expansion. The discussion covers a lot of ground including:

We unpack many of the mainstream myths on narratives driving markets and why outcomes will be no different than in the past. 

 

Stocks Vs. Rates – Which One Is Most Likely Right?

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In this issue of “Stocks vs. Rates – Which One Is Most Likely Right?

  • Market Review And Update
  • Market Pricing In Huge Recovery
  • Interest Rates Are Not Convinced
  • Portfolio Positioning
  • #MacroView: Siegel On Why Stocks Could Rise 30%
  • Sector & Market Analysis
  • 401k Plan Manager

Follow Us On: Twitter, Facebook, Linked-In, Sound Cloud, Seeking Alpha



Catch Up On What You Missed Last Week


Market Review & Update

Last week, we said:

“With ‘money flows’ turning lower on Thursday and Friday, we will likely get a ‘sell signal’ next week.” Such is what occurred.

Specifically, I stated:

“The market is trading well into 3-standard deviations above the 50-dma, and is overbought by just about every measure. Such suggests a short-term “cooling-off” period is likely. With the weekly “buy signals” intact, the markets should hold above key support levels during the next consolidation phase.” 

As shown above, that is what is currently occurring. While the market remains in a very tight range, the “money flow” sell signal (middle panel) is reversing quickly. Importantly, note that the money flows (histogram) are rapidly declining on rallies which is a concern.

While it is confusing to have contradicting “buy” and “sell” signals, such suggests a consolidation of the recent advance rather than a more significant correction. Such is what seems to be in process during this past week. More sizable declines occur when the short and long-term “sell signals” are in confirmation and a point made in Thursday’s 3-minutes video (Click the link to subscribe). We also explain why growth stocks may be a better place to be this summer.

For now, the market trend remains bullish and doesn’t suggest a sharp decrease of risk exposures is required. However, we did take profits out of our index trading positions last Monday. Risk management is always a prudent exercise as markets can, and regularly do, the unexpected.

Santa Claus Broad Wall, Technically Speaking: Will “Santa Claus” Visit “Broad & Wall”

Markets Are Pricing In A Huge Recovery

The stock market is currently pricing in a “huge” economic recovery. As noted by Goldman Sachs in a recent report, they now expect economic growth in 2021 to hit levels not seen since the early ’90s.

That explosion of economic growth supports the surge in earnings expectations and the surge higher in year-end price targets. Such was a point I discussed in our recent Earnings Analysis Report.

Earnings Optimism Explodes, #Fundamentally Speaking: Earnings Optimism Explodes

There is, however, an essential takeaway in both charts above. After the initial surge of reopening, activity and earnings growth quickly return to historical norms, while expectations for market prices continue higher. In other words, with valuations already elevated, the “hope” was that earnings would catch up with prices. However, given expectations for price growth are increasing faster than earnings, such suggest valuations will continue to increase.

Of course, we know that “valuations” have nothing to do with market prices in the short term. They do, however, have everything to do with long-term returns.  Such was a point made by Michael Lebowitz in “Playing Roulette:”

“No one can tell you with any certainty what stocks will do tomorrow or next month. However, looking further into the future, market returns become easier to forecast. The graph below shows stock returns become increasingly dependent on valuations as the investment horizon increases.”

Retirement, Are You Playing Roulette With Your Retirement?

“Periods in which equities are overpriced with high valuations are followed by periods with lower returns. Conversely, periods when stocks are cheap, are often followed by periods of strong returns.”

Retirement, Are You Playing Roulette With Your Retirement?

The media often quips the stock market looks ahead 6-9 months, but there are plenty of historical examples where that vision wasn’t quite 20/20.

Interest Rates Aren’t Convinced.

Given the historic fallibility of the stock market, do interest rates fare better at predicting economic growth rates? As we discussed previously, there is a high correlation between interest rates and economic growth.

That correlation is essential.

At the peak of nominal economic growth over the last decade, interest rates rose to 3% as GDP temporarily hit 6%. However, what rates predicted is that economic growth would return to its long-term downtrend line. In other words, while the stock market was rising, predicting more robust growth, the bond market was sending out a strong warning. 

Economists are currently predicting 6% or better economic growth, yet interest rates are roughly 50% lower than they were previously. In other words, the bond market is suggesting that economic growth will average between 1.75% and 2% over the next few years.

As we discussed, “Debt Doesn’t Create Growth.”

“More debt doesn’t lead to more robust economic growth rates or prosperity. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the change in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.”

Debt Growth, #MacroView: Debt Fueled Spending Won’t Create Growth

From 1947 to 2008, the U.S. economy had real, inflation-adjusted economic growth than had a linear growth trend of 3.2%. However, following the 2008 recession, the growth rate dropped to the exponential growth trend of roughly 2.2%. Unfortunately, instead of reducing outstanding debt problems, the policies instituted fostered even greater unproductive debt levels. Therefore, economic growth will return to a new lower growth trend in the future.

Debt Growth, #MacroView: Debt Fueled Spending Won’t Create Growth

Such is what the bond market is already telling us.

Who Will Be Right?

So, will stocks get it right this time?

The chart of the bond prices versus the stock market suggests such will not be the case.

The chart shows the 200-Week (4-year) moving average of bond prices. The vertical lines show the retracement of bond prices to that long-term moving average. Each time, that event has coincided with a peak in asset prices, weaker economic growth trends, and generally some financial event.

But it is not just over the last 14-years this has occurred. As Michael Lebowitz noted in “What Interest Rate Will Matter,” rate increases have a history of financial events. To wit:

“Looking back over the last 40 years reveals a troubling problem. Every time interest rates reach the upper end of its downward trend, a financial crisis of sorts occurred. The graph below charts the steady decline in rates and GDP along with the various crisis occurring when rates temporarily rose.”

interest, What Interest Rate Triggers The Next Crisis?

“Given crises frequently occur when rates rise sharply, we should contemplate how high rates can rise before the next crisis. Notice, as time goes on it takes less and less of a rate increase to generate a problem. The reason, as highlighted earlier, is the growth of debt outpaces the ability to pay for it.”

From our view, rates matter. Given their close tie to economic activity and inflation, we think they will matter a lot.

Investors Are All In As Insiders Get Out

Sentiment Trader had a great report out last week that touched on a topic I have discussed recently. Investors are currently “all in” the equity risk pool. Since the March 2020 lows, investors continue to increase “risk appetites” despite an economic shutdown, a recession, surging unemployment, and a collapse in earnings,

However, not only did they increase exposure to equities, they leveraged their portfolios to take on even more risk. Historically, these episodes have not ended well for investors.

Interestingly, while retail investors bet surging economic growth will lift earnings to justify high valuations, companies’ insiders are cashing out at an unprecedented pace.

While such gets ignored in the short-term, it likely confirms the same message the bond market is sending. If economic growth fails to achieve “peak” expectations, the reversion could be pretty extreme.

Portfolio Update

Last Monday, as our indicators started to flip over, we sold off our equity index “trading positions” to raise cash levels in portfolios. We remain primarily allocated to the market in our holdings but are willing to reduce exposure further if markets show increasing weakness.

Just as a reminder from last week, we highly recommend, if you have not done so already, to take some action to rebalance portfolio risk accordingly.

  1. Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)
  2. Sell Those Positions That Aren’t Working. If they don’t rally with the market during this recent rally,  they will decline more when the market sells off again.
  3. Move Trailing Stop Losses Up to new levels.
  4. Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you have an aggressive allocation to equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

Such is the same process we follow consistently with our client portfolios and our asset models. It isn’t glamorous, but it is a simple routine we can replicate when signals occur.

The key to successful portfolio management over time is having a systematic, repeatable process to follow. Much like baking a cake, as long as you follow the recipe, it is hard to mess things up.

With weekly “buy” signals intact and money flows still positive, there is no need to get heavily defensive. We think that time is coming, but likely sometime this summer. 


The MacroView

If you need help or have questions, we are always glad to help. Just email me.

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” is oversold. The current reading is 89.34 out of a possible 100.


Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 97.34 out of a possible 100.


Sector Model Analysis & Risk Ranges

How To Read This Table

  • The table compares each sector and market to the S&P 500 index on relative performance.
  • “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
  • The risk range is a function of the month-end closing price and the “beta” of the sector or market.
  • Table shows the price deviation above and below the weekly moving averages.


Weekly Stock Screens

Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

Low P/B, High-Value Score, High Dividend Screen

Fundamental Growth Screen

Aggressive Growth Strategy


Portfolio / Client Update

After taking profits in our index “trading positions” and rebalance overall exposures, there was not much else needing changes this week. As discussed last week, we did get a “sell signal,” which is why we reduced our equity exposures.

However, we did not get substantially MORE aggressive on selling positions because the weekly indicator remains on a “buy” signal. When both signals are misaligned, such leads to short-term consolidations rather than deeper corrections. When they align, which we suspect will happen this summer, more significant draw-downs tend to follow. That is when we will get more aggressive on reducing equity risk.

For now, the “barbell approach” in our portfolios has continued to work well. With our holdings split between “reflation” trades such as Energy, Financials, and Materials and “growth” focused on Technology, performance has been stable.

With earnings season underway, we see increased volatility in stock prices. We will use opportunities to add to holdings we like as well.

For now, we are okay with our positioning. If that changes, we will take action accordingly.

Portfolio Changes

During the past week, we made minor changes to portfolios. We post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

“As noted in this past weekend’s newsletter, our “money flow” buy signal is very extended and is starting to roll over. As such we are now beginning to cut exposure in portfolios and raise cash levels.  We are preparing to add a short-S&P 500 index position once the “sell signal” engages.” – 04/19/21

Equity Model

  • Sell 100% of SPY 
  • Reduce MSFT from 3.5% of the portfolio to 2%
  • Reduce NEE from 2% to 1% of the portfolio.

ETF Model

  • Sell 100% of SPY 

As always, our short-term concern remains the protection of your portfolio. We have now shifted our focus from the election back to the economic recovery and where we go from here.

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


If you need help after reading the alert, do not hesitate to contact me.


Model performance is a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. Such is strictly for informational and educational purposes only, and one should not rely on it for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.  

Have a great week!

Technical Value Scorecard Report For The Week of 4-23-21

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The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You can find more detail on the model and the specific tickers below the charts.

Commentary 4-23-21

  • On a relative basis, versus the S&P 500, most sectors continue to hover around fair value. Healthcare and Real estate were the two best performing sectors last week. Accordingly, Healthcare is back to fair value after being the only oversold sector last week. Real estate is the most overbought sector this week. Energy and Transports slipped a little lower this past week and are now the most oversold sectors, albeit not grossly oversold.
  • The factors and indexes are largely unchanged on a relative basis versus last week.
  • After two weeks of near-zero correlation, the scatter plot comparing scores to excess returns shows a strong correlation. The stronger the correlation the more trust we put into the model’s results.
  • Energy is now the worst-performing sector across 5, 10, 20, and 35 day time horizons. The third bar chart below shows each sectors’ excess return over the four mentioned time spans.
  • Last week all of the sectors were decently overbought on an absolute basis, and largely in line with each other. With the sell-off this past week, the lower beta/deflationary sectors like Staples, Utilities, and Healthcare, on the left side of the graph remain overbought. On the right side, the more inflationary stocks, like Energy, Financials, and Transportation, moved back toward fair value. On the graph below, most factors and indexes remain close to fair value. The S&P 500, bottom right, is overbought but corrected this past week from more extreme levels.
  • The fourth table shows lower beta, deflationary sectors remain above their 200-day ma’s, likely a sign that they will correct in the coming week or two. Assuming the current correction/consolidation does not gain momentum, it appears that a slight shift toward inflationary sectors from deflationary sectors may be warranted soon. Our money flow signals still favor further correction/consolidation, however.
  • The fifth graph shows as implied inflation expectations (blue) stall at around 2.50%, the inflationary sectors (XLB, XLE, XLF, and Value (IVE) are taking a back seat to the deflationary sectors (XLP, XLU, XLK, and Growth (IWE). Implied inflation expectations are a big factor driving our allocation decision-making.

Graphs (Click on the graphs to expand)


Users Guide

The score is a percentage of the maximum/minimum score, as well as on a normalized basis (sigma) for the last 200 trading days. Assets with scores over or under +/-60% and sigmas over or under +/-2 are likely to either consolidate or change trend. When both the score and sigma are above or below those key levels simultaneously, the signal is stronger.

The first set of four graphs below are relative value-based, meaning the technical analysis score and sigma represent a ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

#MacroView: Siegel On Why Stocks Could Rise 30%

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During a recent CNBC interview, Jeremy Siegel suggested stocks could rise another 30% before the boom ends. Just when it seems like “euphoria” can’t get much more “euphoric,” every bullish guest in the financial media attempts to “out bull” the previous.

“It isn’t until the Fed leans really hard then you have to worry. I mean, we could have the market go up 30% or 40% [this year] before it goes down that 20%. We’re not in the ninth inning here. We’re more like in the third inning of the boom.”

Such isn’t the first time someone has made these types of predictions.

In 2013, I made the same statement:

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

Of course, the reason at that time was more “Quantitative Easing” from the Fed. Bernanke was rapidly expanding its balance sheet as automatic spending cuts from the “Debt Ceiling” comprise started.  However, the “fiscal cliff” never occurred, and massive amounts of liquidity flowed into asset markets instead.

While Siegel makes some valid points about the coming economic expansion due to massive fiscal liquidity, there are significant differences in the technical and fundamental underpinnings.

Valuations Are Astronomical

In 2013, as noted above, valuations on stocks were around 19x trailing earnings. While certainly expensive, valuations had not yet eclipsed previous “bull market” excess of 23x earnings. As shown below, even if we assume no increase in the index price, the market will remain well above 20x earnings over the next two years.

It is worth noting that historically when the market has traded at such a deviated level from valuations, forward returns have not been good.

Furthermore, earnings are currently trading well above the long-term exponential growth trend, and expectations are earnings will surge to a new peak by EOY 2022. Given this deviation from the long-term trend, it leaves a good bit of room for disappointment.

The chart below overlays the “inflation-adjusted” S&P 500 index over the long-term valuation bands. The current excess valuation levels rival that of some of the most critical mean reversions in history. As Carl Swenlin noted recently:

“Historically, price has usually remained below the top of the normal value range (red line); however, since about 1998, it has not been uncommon for price to exceed normal overvalue levels, sometimes by a lot. The market has been mostly overvalued since 1992, and it has not been undervalued since 1984. We could say that this is the ‘new normal,’ except that it isn’t normal by GAAP (Generally Accepted Accounting Principles) standards.”

The hope, as always, is that earnings will rise to justify the over-valuation of the market. However, when earnings are rising, so are the markets. As such, the reversions always occur with prices catching down to earnings.

Roaring 20's Fundamental Bullish, The “Roaring 20’s” – The Fundamental Problem Of The Bullish View

Speaking Of GAAP

As Carl noted, there is nothing normal with GAAP earnings. Of course, today, most companies report “operating” earnings which obfuscate profitability by excluding all the “bad stuff.” However, as discussed previously, there is a tremendous amount of manipulation in both operating and reported earnings. To wit:

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

In a survey conducted with corporate executives, 93% of the respondents pointed to ‘influence on stock price’ and ‘outside pressure’ as the reason for manipulating earnings figures.”

The following table shows the expectations for reported earnings growth:

  • 2020 (actual) = $94.13 / share
  • 2021 (estimate) = $158.97  (Increase of 68.89% over 2020)
  • 2022 (estimate) = $183.76  (Increase of 95.21% over 2020)

The chart below uses these earnings estimates and assumes NO price increase for the S&P 500 through 2022. Such would reduce valuations from 43x earnings currently to roughly 23x earnings in 2022. (That valuation level remains near previous bull market peak valuations.)

As I stated above, investors always bid up prices as earnings increase. With earnings expected to double over the next two years, and if we assume Siegel is correct in his 30% advance, the picture changes. Instead of valuations declining, the increase in price keeps valuations near 30x earnings. (Note: While Siegel discussed a 30% increase over 12 months, I have spread it out over two years.)

If Siegel is correct, a 30% advance will further exacerbate already extreme technical deviations.

Roaring 20's Fundamental Bullish, The “Roaring 20’s” – The Fundamental Problem Of The Bullish View

Technical Extremes

“This time is different” is often the phrase most heard near market peaks. The reason is that it takes time to change psychology embedded during the previous “bear market.” However, once the “fear” is displaced by “greed,” the ensuing “bull market” leads investors to take on increasing levels of risk. Unfortunately, the reality is that eventually, the price reverts to reflect underlying economic and fundamental realities.

What causes that reversion is always unknown. However, it is generally a credit-related event that leads to a rush to protect capital. As I explained in “Fully Invested Bears:”

“Such is the consequence of the Federal Reserve’s ongoing interventions. Portfolio managers must chase performance despite concerns of potential capital loss. In other words, we are all ‘fully invested bears.’ We are all quite aware this will eventually end badly. However, in the short-term, no one is willing to take the risk of being grossly underexposed to Central Bank interventions.”

With the markets significantly deviated from long-term means, the following “reversion” will likely be a reasonably brutal event. As shown below, the market is currently trading nearly 20% above its one-year moving average. Such has only occurred a few times historically and has preceded corrections and outright bear markets.

The market is also trading more than 25% above its 24-month (2-year) moving average. Such has previously only occurred a couple of times previously (1987 and 1999.)

From a technical perspective, such is simply a reflection of current market psychology. That psychology is exceptionally bullish and very lopsided in terms of equity risk allocations. With the market “priced for perfection,” such leaves investors at risk of disappointment.

Roaring 20's Fundamental Bullish, The “Roaring 20’s” – The Fundamental Problem Of The Bullish View

Conclusion

For Jeremy Siegel, making wild predictions about markets has no consequence. If he is wrong, he makes another prediction to cover for the first. However, for you, following such a prediction can have a devastating impact on your short- and long-term financial goals.

The reality is that markets are pushing “rarified air.” It is unlikely that corporate earnings will achieve the lofty goals set out by analysts currently. It is also very probable that economic growth may be weaker than expected. Of course, these are just “concerns” of an overvalued, extended, and overly bullish market.

Sure, the current cyclical bull market could rise another 30%.

Momentum-driven markets are hard to kill in the latter stages, particularly as exuberance builds. However, they do eventually end.

Will the market likely be higher in another decade from now? Maybe. However, if interest rates or inflation rise sharply, the economy moves through a normal recessionary cycle, or if Jack Bogle is correct, things could be much more disappointing. As Seth Klarman from Baupost Capital once stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

We saw much of the same mainstream analysis at the peak of the markets in 1999 and again in 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were common themes. Unfortunately, the outcomes were always the same.

“History repeats itself all the time on Wall Street”  – Edwin Lefevre

#WhatYouMissed On RIA This Week: 4-23-21

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What You Missed On RIA This Week Ending 4-23-21

It’s been a long week. You probably didn’t have time to read all the headlines that scrolled past you on RIA. Don’t worry, we’ve got you covered. If you haven’t already, opt-in to get our newsletter and technical updates.

Here is this week’s rundown of what you missed.


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors now has the capability to manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes we can get you in the “right lane” for retirement.


What You Missed This Week In Blogs

Each week, RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risks that may negatively impact our client’s capital. These are the risks we are focusing on now.



What You Missed In Our Newsletter

Every week, our newsletter delves into the topics, events, and strategies we are using. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how we plan to trade it.



What You Missed: RIA Pro On Investing

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now for 30-days free) If you are a DIY investor, this is the site for you. RIA PRO has all the tools, data, and analysis you need to build, monitor, and manage your own money.



Video Of The Week

What? You didn’t tune in last week. That’s okay. Here is one of the best clips from the “Real Investment Show.” Each week, we cover the topics that mean the most to you from investing to markets to your money.

Video Of The Week For 4-23-21Retirement Roulette

Michael Lebowitz and I discuss why most people are playing “Retirement Roulette” with their portfolios.


Latest 3-Minutes On Markets & Money



Our Best Tweets For The Week: 4-23-21

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. However, just in case you missed it, here are a few from this past week you may enjoy. You may also enjoy the occasional snarky humor.

See you next week!