Monthly Archives: September 2017

Let me start out by saying that I am all for any piece of advice which suggest individuals should save more. Saving money is a huge problem for the bulk of American’s as noted by numerous statistics. To wit:

“American have an average of $6,506 in credit card debt, according to a new Experian report out this week. But which expenses are adding to that balance the most? A full 23% of Americans say that paying for basic necessities such as rent, utilities and food contributes the most to their credit card debt. Another 12% say medical bills are the biggest portion of their debt.”

That $6500 credit card balance is something we have addressed previously as it relates to the ability of an average family of four in the U.S. to just cover basic living expenses.

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is a $3200 annual deficit that cannot be filled.”

This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.

Flawed Advice

The media loves to put out “feel good” information like the following:

“If you start at age 23, for instance, you only have to save about $14 a day to be a millionaire by age 67. That’s assuming a 6% average annual investment return.”

Or this one from IBD:

“If you’re earning $75,000, by age 40 you need 2.4 times your income, or $180,000, in retirement savings. Simple as that.” (Assumes 10% annual savings rate and a 6% annual rate of return)

See, it’s easy.

Unfortunately, it doesn’t work that way.

Let’s start with return assumptions.

Markets Don’t Compound

I have written numerous times about this in the past.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.”

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.

Here is another way to look at it.

If you could simply just stick money in the market and it grew by 6% every year, then how is it possible to have 10 and 20-year periods of near ZERO to negative returns?

The level of valuations when you start your investing journey is all you need to know about where you are going to wind up.

$1 Million Sounds Like A Lot – It’s Not

I get it.

$1 million sounds like a whole lot of money. It’s a nice, big, round number with lot’s of zeros.

In 1980, $1 million would generate between $100,000 and $120,000 per year while the cost of living for a family of four in the U.S. was approximately $20,000/year.

Today, there is about a $40,000 shortfall between the income $1 million will generate and the cost of living.

This is just a rough calculation based on historical averages. However, the amount of money you need in retirement is based on what you think your income needs will be when you get there and how long you have to reach that goal.

If you are part of the F.I.R.E. movement and want to live in a tiny house, sacrifice luxuries, and eat lots of rice and beans, like this couple, that is certainly an option.

For most there is a desire to live a similar, or better, lifestyle in retirement. However, over time our standard of living will increase with respect to our life-cycle stages. Children, bigger houses to accommodate those children, education, travel, etc. all require higher incomes. (Which is the reason the U.S. has the largest retirement savings gap in the world.)

If you are in the latter camp, like me, a “million dollars ain’t gonna cut it.”

Don’t Forget The Inflation

The problem with all of these “It’s so simple a cave man could do it” articles about “save and invest your way to wealth” is not only the variable rates of returns discussed above, but impact of inflation on future living standards.

Let’s set up an example.

  • John is 23 years old and earns $40,000 a year.
  • He saves $14 a day 
  • At 67 he will have $1 million saved up (assuming he actually gets that 6% annual rate of return)
  • He then withdraws 4% of the balance to live on matching his $40,000 annual income.

That pretty straightforward math.

IT’S ENTIRELY WRONG.

The living requirement in 44 years is based on today’s income level, not the future income level required to maintain the current living standard. 

Look at the chart below and select your current level of income. The number on the left is your income level today and the number on the right is the amount of income you will need in 30-years to live the same lifestyle you are living today.

This is based on the average inflation rate over the last two decades of 2.1%. However, if inflation runs hotter in the future, these numbers become materially larger.

Here is the same chart lined out.

The chart above exposes two problems with the entire premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of current income and what is actually required at 4% to generate the income level needed.

The chart below takes the inflation-adjusted level of income for each brackets and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to common recommendations of 25x current income.

If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years.

Not accounting for the future cost of living is going to leave most individuals living in tiny houses and eating lots of rice and beans.

Things You Can Do To Succeed

The analysis reveals the important points young investors should consider given current valuation levels and the reality of investing over the long-term:

  • Pay yourself first, aggressively. Saving money is how you pay yourself for working. 30% is the real magic number. 
  • It’s all about “cash flow.” – you can’t save if you spend more than you make and rack up debt. #Logic
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over-spending is “social media” and “keeping up with the friends.” If advertisers were not getting your money from social media ads they wouldn’t advertise there. (Side benefit is that you will be mentally healthier and more productive by doing so.)
  • Pick up a side hustle, or two, or threeOnce you drop social media it will free up 4-6 hours a week, or more, with which you can increase your income. There are tons of apps today to let you earn extra money and “No” it’s not beneath you to do so. 
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Future inflation expectations must be carefully considered.
  • Expectations for compounded annual rates of returns should be dismissed 

Don’t misunderstand me….I love ANY program that encourages individuals to get out of debt, save money, and invest. 

Period. No caveats.

There is one sure-fire way to go from “being broke” to being “rich” – write a book on how to do it and sell it to broke people. (See “Broke Millennial” and “Millennial Money.”– but hey that’s capitalism and you can do it too.)

But, if investing were as easy as just sticking your money in the market, wouldn’t “everyone” be rich?

Each week we produce a chart book of the major financial markets to review whether the markets, as a whole, warrant higher levels of equity risk in portfolios or not. Stocks, as a whole, tend to rise and fall with the overall market. Therefore, if we get the short-term trend of the market right, our portfolios should perform respectively.

HOW TO READ THE CHARTS

There are three primary components to each chart:

  • The price chart is in orange
  • The Over Bought/Over Sold indicator is in gray
  • The Buy / Sell indicator is in blue.

When the gray indicator is at the TOP of the chart, there is typically more risk and less reward available at the current time. In other words, the best time to BUY is when the short-term condition is over-sold. Likewise when the buy/sell indicator is above the ZERO line investments have a tendency of working better than when below the zero line.

With this basic tutorial let’s review the major markets.

S&P 500 Index

  • Over the last couple of weeks, we noted the SPY “buy” signal in the lower panel was massively extended, which as we stated, suggested the reversal we have seen was coming.
  • We also noted: “The correction last week has set up a tradeable opportunity into June and that we were approaching our initial target of $290”
  • That target was hit and we took 1/2 of our trading positions back in.
  • SPY is not back to more extreme overbought conditions just yet, and remains on a buy signal, which suggests a bit more rally could occur next week given comments from both the Fed and the G-20 summit are on deck.
  • Short-Term Positioning: Bullish
    • Last Week: Sell 1/2 of position on any rally next week that hits our target.
    • This Week: Hold remaining position.
    • Stop-loss reamins at $280
    • Long-Term Positioning: Neutral

Dow Jones Industrial Average

  • DIA has not had as a compelling of setup as SPY.
  • Nonetheless, DIA did rally and reversed a bulk of the oversold condition but is challenging overhead resistance.
  • More importantly, DIA has registered a “sell signal.”
  • Short-Term Positioning: Neutral
    • Last Week: Hold previous position given rally reversed “sell” level.
    • This Week: Hold current positions.
    • Stop-loss moved up to $252.50
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • QQQ rallied from the oversold condition and is not overbought yet.
  • Such gives the market a chance to rally further next week into previous resistance from the August/September highs of 2018. The rally has been fairly weak.
  • QQQ is no longer oversold and the “buy signal” has been reversed. However, the “buy” signal is close to reversal suggesting the current rally may be limited to previous resistance levels.
  • Short-Term Positioning: Bullish
    • Last Week: Hold 1/2 position with a target of $185
    • This Week: Hold 1/2 position with a target of $185
    • Stop-loss moved up to $175
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • As noted several weeks ago, SLY has fallen apart as market participation has weakened. SLY, and MDY are particularly susceptible to “trade wars” and slowing economic growth.
  • The modest “buy” signal has reversed and is now on a sell signal.
  • There are a lot of things going wrong with small-caps currently so the risk outweighs the reward of a trade at this juncture.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position.
    • Stop loss violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY, like SLY, is technically not in great shape.
  • MDY did regain its 200-dma but the rally has been weak.
  • Mid-caps did rally this past week back above the 200-dma but is not overbought yet. This suggests we could see a a bit more of a rally this coming week given some positive news from the Fed or the G-20 meeting.
  • Short-Term Positioning: Neutral
    • Last Week: Look to sell any further rally this week if not already done so.
    • This Week: Use any further rally this week to sell into.
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM has failed support, broke below the 200-dma, and has continued within its longer-term downtrend.
  • Last week, a “sell signal” was triggered.
  • Short-Term Positioning: Bearish
    • Last Week: No position recommended at this time.
    • This Week: No position recommended at this time.
    • Stop-loss violated.
  • Long-Term Positioning: Neutral

International Markets

  • EFA rallied over the last couple of weeks, but remains confined to a longer-term downtrend.
  • EFA is maintaining its 200-dma which is positive but the overall trend is concerning.
  • International markets have reversed its oversold condition but is not overbought yet.
  • Short-Term Positioning: Neutral
    • Last Week: Positions sold on stop-loss violation.
    • This Week: No position.
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • A month ago, we noted the rally in oil had gotten way ahead of itself in the face of building supplies and that the risk was clearly to the downside. We also noted that if support at $60 failed, along with the 200-dma, the risk was to the mid- to low-$50’s.
  • Despite the Iran issue last week, supply builds continue to weigh on oil prices. Support is at $50/bbl. A break below that is a whole other issue and will likely indicate the onset of recession.
  • Oil remains deeply oversold, so a counter-trend bounce in oil prices will not be surprising. Such would be in conjunction with a market rally on positive news from the Fed and the G-20 meeting.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position.
    • Stop-loss violated at $60.
  • Long-Term Positioning: Bearish

Gold

  • Gold has quickly reversed its oversold condition to overbought and did break above its downtrend.
  • We also noted, that the mild sell-signal would reverse back onto a “buy” which has occurred.
  • We are maintaining our position as a hedge against a potential pick up in volatility over the summer.
  • Gold is too extended to add to positions here.. Look for a pullback to $122-123 to add.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole set at $120
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • Bonds prices on bonds have gone parabolic and are now at extremes. Even the “buy” signal on the bottom panel has reached previous extremes which suggests a reversal in rates short-term is likely.
  • With the Fed and G-20 meeting on deck for this week, look for a reversal in rates for a better trading opportunity.
  • Currently on a buy-signal (bottom panel), bonds are now back to very overbought conditions and are testing the previous highs from 2016.
  • Support held at $122 which now become extremely important support.
  • Strong support at the 720-dma (2-years) (green dashed line) which is currently $118.
  • Short-Term Positioning: Bullish
    • Last Week: Take profits and rebalance risks. A correction IS coming which will coincide with a bounce in the equity markets into the end of the month.
    • This Week: Same as last week.
    • Stop-loss is moved up to $122
    • Long-Term Positioning: Bullish

U.S. Dollar

  • Over the last couple of weeks, the dollar has pulled and has now gotten oversold and is testing the bottom of its previous uptrend.
  • USD has triggered a short-term sell signal.
  • Hold current positions but maintain stop levels.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position
    • Stop loss is set at $96


  • Review & Update
  • Understand Bear Markets, Don’t Fear Them
  • Sector & Market Analysis
  • 401k Plan Manager

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


Wednesday, June 26th from 12:30-1:30 pm.


Review & Update

This week I want to step back and talk about some misconceptions with concerning markets, cycles, and investing. However, before we get to that, let me give you a quick review and update on where we are following the “sellable rally,” we have discussed over the last couple of weeks.

In review, we said last week: 

“We remain primarily long-biased in our portfolios, but are also slightly overweight in cash, and portfolio weight in fixed income. We are also carrying some hedge by having overweighted “defensive” stocks a couple of months ago which have continued to provide outperformance. 

There is a very good possibility this rally will continue next week as momentum and short-covering levels have been breached. However, if the market fails to set a new high and turns lower, the risk of a downside break will grow as we progress into summer.”

The rally did continue on Monday and hit our initial targets. We alerted our RIA PRO subscribers (FREE 30-day trial) to this on Monday. To wit:

  • As stated last time:
    • “The correction last week has set up a tradeable opportunity into June.”
  • That tradeable rally is in process and we are approaching our initial target of $290
  • Short-Term Positioning: Bullish
    • Last Week: Hold full position with a target of $290.
    • This Week: Sell 1/2 of position on any rally next week that hits our target.
    • Stop-loss moved up to $280
    • Long-Term Positioning: Neutral

That target was hit on Monday, and we sold 1/2 of our trading positions accordingly. 



Since then, the market has languished around the 50-day moving average seemingly awaiting some catalyst to move it in one direction of the other. Fortunately, there are plenty of those on deck as next week the Fed will give us their latest musings on whether they are inclined to cut rates or not and Trump will be confronting China in the upcoming G-20 meeting. 

Pass the popcorn, please. 

As shown in the chart below, the short-term oversold condition has been reversed which limits upside, but the 50-day moving average has acted as support all week. 

The concern this coming week will continue to be adverse news from the Fed, the White House, or the economic data which has continued to take a turn for the worse. Global economic growth has plunged as well as Q2 and Q3 economic growth estimates. 

This also puts forward earnings at risk of recession, which will not play well with a market trading at rather extreme historical valuations. 

“Oh my gosh, you are so bearish. You must just be all in cash and hiding in a bunker.” 

Well, for those that are reading impaired, it must certainly sound that way.

However, in reality, we have consistently maintained long exposure to the markets, but continue to control our risks to protect against sudden losses of capital.

That brings us to today’s missive.



Understand Bear Markets, Don’t Fear Them

I am a value-oriented investor and prefer to buy assets when they are fundamentally cheap based on several factors including price to sales, free cash flow yield, and high return on equity. However, being a strict value investor can also lead to a variety of investment mistakes, primarily emotional, when markets become both highly correlated and driven by speculative excess.

Currently, there is little value available to investors in the market today as prices have been driven higher by repeated Central Bank interventions and artificially suppressed interest rates. 

What we do know is that despite these interventions, the markets will eventually mean revert to the point that “value” is once again present. 

The problem for investors is two-fold:

  1. Knowing when to sell excessively valued markets which seemingly will not stop rising, and;
  2. Knowing when to buy back into markets which seeming will not stop falling.

This is why a good portion of our investment management philosophy is focused on the control of “risk” in portfolio allocation models through the lens of relative strength and momentum analysis. 

The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise, or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as “greed” and “fear” overtake logical analysis.

I have discussed previously the effect of full market cycles” as shown in the chart below.

What is also important to note is that these full market cycles are ultimately driven by the economic cycle. As shown in the next chart, the sector rotation appears to lead the economic cycle.

Importantly, it should be noted that investment styles also shift during the broader cycle.

  • During recessionary bottoms, when assets are truly selling at “bargain basement” prices, deep discount value strategies tend to perform the best as investors are panic selling to find safety over risk.
  • As markets begin to recover, investor’s begin to cautiously re-enter the markets and begin to seek some risk with a degree of safety. Value oriented investment strategies will still work during while these early recovery cycles and growth strategies began to gain momentum.
  • During the latter stages of the economic cycle, growth and value give way to pure momentum as investor “greed” and “exuberance” began to view “value” as “out of favor.” 

It is during this last stage of the cycle that “fundamentals appear not matter” as the fundamentally worst stocks lead the markets higher.

In other words, we begin hearing discussions of why “This Time Is Different (TTID),“The Fear Of Missing Out FOMO),” and “There Is No Alternative (TINA).” 



Complacency Lives

For now, complacency lives. Despite geopolitical turmoil, slowing economic data, weak corporate profitability, tariffs, and “trade wars,” the markets remain astonishingly close to their all-time highs. Furthermore, volatility, remains amazingly close to its historical lows despite a market that has gone nowhere for eighteen months.

Moreover, complacency also in how much investors are willing to pay for each dollar of profits from owning stocks relative to overall economic growth. As shown below, investors are paying much more for every dollar’s worth of profits than what the economy should actually generate. (Profits are a reflection of economic activity, not the other way around.)

Clearly, paying excess valuations is not uncommon throughout history. However, so are the eventual reversions are investors reprice values during economic slowdowns and recessions.

But the driving force behind today’s multiple expansion has been the relentless expansion of global central bank balance sheets since the outbreak of the financial crisis nearly a decade ago. Overall, global central bank balance sheets have expanded from just over $5 trillion prior to the crisis in 2007 to nearly $22 trillion today.

There is little doubt we are currently in a bull market. But as with all things, despite hopes from the mainstream media to the contrary, they do come to an end. This should be of no real surprise to anyone that has managed money for any length of time.

But here is the most important point for investors.

The speculative asset chase over the last decade, which is a direct result of Central Bank activity, has locked investors into a period of near zero prospective total returns in virtually in every asset class for the coming decade.

Read that again.

  • The 1999-2000 Dot.com bubble was about technology stocks. (7-Years to breakeven)
  • The 2007-2008 debacle was centered around real estate and subprime debt. (7-years to breakeven)
  • The 2020, or whenever it occurs, scenario will involve multiple bubbles in stocks, corporate debt, and real estate.

There is little doubt that we are in both the late stages of an economic cycle and a momentum driven market. Therefore, investment focus must be adjusted to current market dynamics that requires a focus on relative strength and momentum as opposed to valuation-based strategies.

There have been many studies published that have shown that relative strength momentum strategies, in which as assets’ performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results. This is the basic application of Newton’s Law Of Inertia, that states “an object in motion tends to remain in motion unless acted upon by an unbalanced force.”

The chart below shows a simple example of a strategy using the 12-month moving average. The theory is you are long equities when the S&P 500 is above the 12-month moving average, and in cash when below it.

Momentum strategies, which are trend following strategies by nature, have been proven to work well across extreme market environments, multiple asset classes and over historical time frames.

Unfortunately, few investors can actually use such a system for the following reasons:

  • Investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late cycle stages.
  • Investors are ultimately driven by the “herding” effect. A rising market leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.
  • Lastly, as the markets turn, the “disposition” effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. 

The end effect is not a pretty one.

By applying momentum strategies to fundamentally derived investment portfolios it allows the portfolio to remain allocated during rising markets while managing the inherent risk of behavioral dynamics.

It is just really hard to do because of the “psychological pull” from the markets and the media.

However, this is why, despite the fact that I write like a “bear,” the portfolio model has remained allocated like a “bull” during the market’s advance. Our job is simple, make money for our clients when markets are rising and avoid potentially catastrophic losses when trends change.

Maintaining your portfolio through a disciplined investment process will reduce risk and increase long-term profitability. With markets currently hovering near all-time highs, despite a continuing erosion of underlying fundamental and technical strength, the risk/reward ratio remains out of favor.

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

Eventually, this cycle does end, and the reversion process back to value has historically been a painful one. 

But the important point is that you shouldn’t “fear” bear markets. 

They are just part of the investment cycle and are required for the next “great bull market” to begin. 

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

See you next week.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet

 


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels

Sector-by-Sector

Improving – None

We have recently discussed that relative performance of Staples and Financials were improving as the outperformance lead of Technology, Discretionary and  Communications were weakening. That performance rotation continues this week with Financials and Staples rotating into the outperformance quadrant.

Current Positions:

Outperforming – Technology, Discretionary, Communications, Financials, Staples

As noted above Technology, Discretionary and Communications are on the verge of turning from outperformance to underperformance of the S&P 500 on a relative basis. While the rally in the market, as we discussed last week, continued for a second week in a row, it has been defensive positioning continuing the outperformance. 

Take profits and rebalance across sectors accordingly. 

Current Positions: 1/2 weight XLY, Reduced from overweight XLK, Overweight XLP, Target weight XLF.

Weakening – Real Estate and Industrials

Real Estate has continued to attract buyers particularly as interest continue to weaken. Performance improved again this past and Real Estate will likely move back into outperformance next week. We continue to carry our current weight in Real Estate, we also added to agency REIT’s to out equity portfolio last week. We continue to looking for opportunities to overweight the sector. Industrials bounced this past week, but their relative performance continues to drag. We remain underweight industrials currently. 

Current Position: XLRE, 1/2 XLI

Lagging – Healthcare, Materials, Energy, and Utilities

While these sectors are currently lagging the performance of the S&P 500, on a short-term basis, that performance continues to improve, with the strong exception of energy, as defensive continues to attract capital flows. 

As noted, we have slightly overweighted healthcare and utilities to go along with our overweight positioning in staples and financials. While we are maintaining a 1/2 position in XLE, it is not performing well and we may be required to “cut it loose” if performance doesn’t improve soon. 

IMPORTANT: Two weeks ago we noted that:

“All sectors are VERY OVERSOLD currently. Look for a rally in the next week to begin rebalancing risks and weightings accordingly. This could be your best, last chance, for the rest of the summer.”

That oversold condition has been almost fully reversed. Take action if you have not done so.

We may have some follow through rally this week, but use any further rise to take action accordingly. 

Current Positions: 1/2 XLB, 1/2 XLE, Overweight XLV, Overweight XLU

Market By Market

The rally this past week was very concentrated and has all the earmarks of a short-term “short-covering” rally. 

Small-Cap and Mid Cap – Small-cap and Mid-cap previously both failed to hold above their respective 50- and 200-dma which keeps us from adding a position in portfolios. Last week, Midcap rallied back to its 200-dma but ran into a lot of resistance. We will need to patient to see if there is any follow through. As noted, these sectors are mostly tied to the domestic economy and their lack of performance is concerning relative to the economic backdrop. 

Current Position: No position

Emerging, International & Total International Markets 

As noted two weeks ago:

The re-institution of the “Trade War” kept us from adding weight to international holdings. We are keeping a tight stop on our 1/2 position of emerging markets but “tariffs” are not friendly to the international countries. 

Last week, we were stopped out of our emerging market position. We have no long exposure to international markets currently. However, industrialized international is challenging its 50-dma once again. It is too soon to take on exposure as the current trend remains concerning. However, we are watching for an opportunity to add exposure if the technicals warrant the risk.

Current Position: No Position

Dividends, Market, and Equal Weight – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with respect to economic growth and inflation. Currently, the short-term bullish trend is positive and our core positions are providing the “base” around which we overweight/underweight our allocations based on our outlook.

The rally over the last two weeks has almost fully reversed the previous oversold condition. Make sure and rebalance weightings in portfolios if you have not done so already.

Current Position: RSP, VYM, IVV

Gold – As noted last week, with rates dropping sharply and deflationary pressures on the rise, Gold finally got a bid over the last couple of week. Gold is now challenging its highs from February of this year and failed to breakout to highs. Gold has provided a good hedge in our portfolios against the recent decline and a breakout above current levels would suggest substantially higher prices. 

Current Position: GDX (Gold Miners), IAU (Gold)

Bonds 

Bonds tested cycle highs and pulled back slightly before attempting a retest of highs this week. Bonds are extremely overbought, take some profits and rebalance weightings but remain long for now.

Current Positions: DBLTX, SHY, TFLO, GSY, IEF

High Yield Bonds, representative of the “risk on” chase for the markets rallied sharply with the market this week as “shorts” were forced out of their holdings. Not surprisingly, the “junk” rally has taken the market from oversold back to fairly overbought. Given the deteriorating economic conditions, this would be a good opportunity to reduce “junk rated” risk and improve credit quality in portfolios. 

IMPORTANT: Two weeks ago we noted that:

“All sectors are VERY OVERSOLD currently. Look for a rally in the next week to begin rebalancing risks and weightings accordingly. This could be your best, last chance, for the rest of the summer.”

That oversold condition has been almost fully reversed. Take action if you have not done so.

Sector / Market Recommendations

The table below shows thoughts on specific actions related to the current market environment. 

(These are not recommendations or solicitations to take any action. This is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

 

Portfolio/Client Update:

As noted at the beginning of May. we have shifted our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

There are indeed some short-term risks in the market as we head into summer, so any positions added to portfolios in the near future will carry both tight stop-loss levels and will be trading positions initially until our thesis is proved out. 

  • New clients: Our onboarding indicators are “risk off” currently, so new accounts will remain in cash for the time being. Positions that were transferred in are on our global review list and will be monitored for an opportunity to liquidate to raise cash to transition into the specific portfolio models.
  • Equity Model: We sold MU last week as the position was simply not performing despite the fact the company is extremely cheap at 3x earnings. We will buy this position back in the future when technicals improve. We are also publishing a report this week on a “bullish steepener” in rates as short-term rates fall faster than long term (think recession). Therefore we starting buying two agency REIT’s, NLY and AGNC, to benefit from the uninversion of the yield curve. In the meantime we will collect at near 13% yield on both. 
  • ETF Model: We overweighted our exposure to defensive areas by adding Real Estate and overweighting Staples and Utilities. We are looking at adding an agency REIT ETF (REM) to our portfolios in the coming week as we did with the equity portfolio. 

Note for new clients:

It is important to understand that when we add to our equity allocations, ALL purchases are initially “trades” that can, and will, be closed out quickly if they fail to work as anticipated. This is why we “step” into positions initially. Once a “trade” begins to work as anticipated, it is then brought to the appropriate portfolio weight and becomes a long-term investment. We will unwind these actions either by reducing, selling, or hedging, if the market environment changes for the worse.


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.

401k-PlanManager-AllocationShift

Week Two Of The Bounce 

As noted last week:

“As reiterated in the main missive above this week, the “risks” still outweigh the “rewards” as we head deeper into the summer months. Importantly, don’t mistake an oversold, short-covering, rally as a bullish sign. More often than not, it is a trap.

We have remained patient over the last several weeks which has helped minimize some of the volatility.”

While the rally over the last couple of weeks was certainly welcomed, it was not impressive in terms of breadth or strength. Our suspicion is it will fail sooner than later UNLESS the Federal Reserve cuts rates and Trump inks a deal with China.

Given the unknowns, and the potential volatility of a “surprise” coming to fruition, continue following the same rules and guidelines from the last couple of weeks. 

  • If you are overweight equities – take some profits and reduce portfolio risk on the equity side of the allocation. Raise some cash and reduce equities to target weights. 
  • If you are underweight equities or at target – rebalance risks, look to increase cash rather than buying bonds at the moment, and rotate out of small, mid-cap, emerging, international markets. 

As noted last week, with week two of the rally now in the books and the markets back to very oversold, it is time take some action this coming week.

If you need help after reading the alert; don’t hesitate to contact me.

401k Plan Manager Coming Soon

Thank you for all the emails of plans. We have been imputing them into the 401k plan manager (we are going to roll out the beta shortly with a few samples for testing purposes.)  We are currently covering more than 10,000 mutual funds initially, and will add ETFs and Stocks in the coming updates.

We are also adding some retirement planning and savings tools to keep you on track.

Our “live” 401k plan manager which will soon be available to RIA PRO subscribers. You will be able to compare your portfolio to our live model, see changes live, receive live alerts to model changes, and much more. 

We are building models specific to company plans. So, if you would like to see your company plan included specifically, send me the following:

  • Name of company
  • Plan Sponsor
  • A print out of your plan choices. (Fund Symbol and Fund Name)

I have gotten quite a few plans, so keep sending them and I will include as many as we can. 

If would like to offer our service to your employees at a deeply discounted corporate rate please contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principle. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)

Ray Dalio is the thoughtful, somewhat controversial founder of the world’s largest hedge fund, Bridgewater Associates, which he started in 1975.

While much of his writing is private, I (and many others) peruse every word we can of his and the Bridgewater team’s thinking. I find it to be some of the most interesting market commentary I read.

Lately, Ray has been far more open with his thinking, posting books and essays. He posted on LinkedIn rather controversial stories: Why and How Capitalism Needs to Be Reformed, Parts 1 and 2 and a follow-up piece titled It’s Time to Look More Carefully at ‘Monetary Policy 3 (MP3)’ and “Modern Monetary Theory.

On first reading those, I will admit to thinking, “Ray Dalio is kinda, sorta wrong.” I agreed with much of Part 1, with a few quibbles. Ditto for Part 2. But when I read the third piece I found myself thinking, “Ray Dalio is really, really wrong.”

In that essay he basically endorses Modern Monetary Theory (MMT).

Socialism Is Back

Coming from someone of Ray’s stature, and knowing that others like Bill Gross are beginning to endorse MMT either obliquely or directly, I found myself wanting to shout, “Stop! This is dangerous!”

He is clearly a generous man. And watching him in interviews and on stage, he is both disarming and comes across rather warmly. Definitely not dangerous. But ideas have consequences…

Ray has done us all a service by pointing out the elephants in the room (some tinged with pink), which are rarely mentioned in public discourse. We discuss various parts of the elephant, but seldom the entire creature.

By that, I mean the rapidly growing potential for left-of-center “progressive” control of both Congress and the White House. Part of that growth stems from an increasing frustration over the perceived differences between haves and have nots.

As The Economist reported recently, 51% of those polled between ages 18–29 have a positive view of socialism. That should scare you.

A growing number of that generation are taking that view into the voting booth. Democratic presidential candidates are all burnishing their “progressive” credentials.

I have zero insight into who might win that nomination fight, but there is a more than reasonable chance it will be the most left-leaning presidential nominee in a very long time, since at least George McGovern (for whom I voted).

And given the potential for recession between now and the election, they have a reasonable chance of winning.

Tough Choices

Just as Trump figured out how to energize the frustration of enough voters to win the presidency, it is likely we will see a populist nominated on the Democratic side.

A Democratic president and Congress will give us higher spending and taxes, and if that election happens amid recession, there will be an increasing drumbeat to “do something” radical.

The already-huge $2-trillion deficit we will have by then could easily swell even more.

Dalio, to his credit, recognizes that would be a negative outcome. He proposes dealing with the increasing deficit and debt via Modern Monetary Theory (MMT) or directly printing money. He also hopes it would help equalize the increasing income and wealth disparities.

I agree that we have a problem. The current situation could easily become a series of crises that would in fact be “existential,” as seen from today’s relatively benign world.

We are being forced into difficult choices, both political and economic, and the longer we kick the proverbial can down the road, not dealing with the real fundamental issues, the more difficult and starker those choices will be.

We are rapidly approaching a time in which there will be no good choices, only extremely difficult, controversial and/or bad choices, none of which resolve the fundamental problems.

That said, we need to make sure our choices don’t exacerbate the problems.

Is Capitalism the Problem?

Dalio talks about wealth and income disparity as a failure of capitalism. He argues that capitalism is not achieving its goal of more equitably distributing the fruits [read: profits] of capitalism.

To his point, my good friend Ben Hunt of Epsilon Theory notes that the S&P 500 companies have the highest earnings relative to sales in history.

Let me push back with what is admittedly a small quibble in the grand scheme of things. I think of capitalism more in the context of property rights, rule of law, and free markets.

Properly understood, it provides a level playing field for entrepreneurs to offer goods and services that produce incomes and profits. I don’t think equitably distributing those profits is capitalism’s role.

Ensuring that all participants are treated fairly and, to some extent, regulating these personal and corporate endeavors is the role of society in general and government in particular.

So when you say that capitalists are not very good at sharing profits, I would say that capitalism is not designed to do so. That is the role of society and government.

The Great Reset: The Collapse of the Biggest Bubble in History

New York Times best seller and renowned financial expert John Mauldin predicts an unprecedented financial crisis that could be triggered in the next five years. Most investors seem completely unaware of the relentless pressure that’s building right now. Learn more here.

We know you get busy and don’t check on our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything that you might have missed.

The Daily Blog

The Best Of “The Lance Roberts Show”

Podcast Interview Of The Week

Our Best Tweets Of The Week

Our Latest Newsletter

What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

See you next week!

While most people – including mainstream economists – seem to believe that our bubble problems ended when the U.S. housing bubble burst in 2008, the reality is that there are even more bubbles forming today than before the Great Recession. I listed the bubbles that I am warning about in a detailed piece that I wrote last week called “Why You Should Not Underestimate The Severity Of The Coming Recession.” I believe that the bursting of these numerous bubbles is likely to cause another recession that may be even more severe than the Great Recession was. In the current piece, I will discuss the bubble that is currently forming in U.S. commercial real estate and how it is likely to burst.

In order to understand the bubble that is currently forming in U.S. commercial real estate, it is important to first understand the extremely unusual monetary environment that the U.S. has been in since the Great Recession. After the U.S. housing and credit bubble burst in 2008, the Federal Reserve was desperate to stimulate the economy by slashing borrowing costs. The Fed cut and held interest rates at virtually zero percent (i.e., zero interest rate policy or “ZIRP”) for seven years and has been gradually increasing those rates since late-2015. Unfortunately, dangerous economic bubbles form during low interest rate periods and burst when rates rise once again. The dot-com and housing bubbles formed in this manner and so are numerous other bubbles in the current cycle, including commercial real estate. Commercial real estate is particularly sensitive to interest rates, and benefits when rates are low and suffers when rates are high.

In addition to ZIRP, the Fed utilized an unconventional monetary policy known as quantitative easing or QE, which pumped $3.5 trillion dollars worth of liquidity into the U.S. financial system from 2008 to 2014. When conducting QE, the Fed creates new money digitally for the purpose of buying bonds and other assets, which helps to suppress interest rates and boost asset prices. The chart below shows the growth of the Fed’s balance sheet since QE started in 2008: 

As a result of the Fed’s ZIRP and QE programs in the past decade, virtually all types of assets soared in value: stocks, bonds, art, classic cars, farmland, residential real estate, and commercial real estate. On average, U.S. commercial real estate prices have surged by 111%, or more than double, since their 2009 low. Interestingly, most people don’t realize that U.S. commercial real estate also experienced a bubble from 2004 to 2008 at the same time as the U.S. housing bubble. This early bubble inflated for many of the same reasons as the housing bubble, which were ultra-low borrowing costs and loose lending standards. From 2004 to 2008, commercial real estate prices rose 66%, but crashed by nearly 40% during the 2008 financial crisis. Commercial real estate prices have increased even more in the current bubble (111% vs. 66%), which means that the coming commercial real estate bust is likely to be even worse than the 2008 bust.

As discussed earlier, low interest rate environments often cause dangerous bubbles to develop by encouraging borrowing booms. Like the U.S. commercial real estate bubble of 2004 to 2008, commercial real estate lending has flourished during the current bubble. Since 2012, total commercial real estate loans at U.S. banks have increased by an alarming $700 billion or 50%.

Similar to the last U.S. commercial real estate bubble, the MSCI U.S. REIT Index has quadrupled in value during the current bubble. REITs or real estate investment trusts are publicly-traded companies that own income-producing real estate and are, therefore, one way of tracking the performance of the commercial real estate industry. The MSCI U.S. REIT Index lost approximately three-quarters of its value during the 2008 crisis; a repeat performance may be in the cards when the current commercial real estate bubble bursts.

Over the past two decades, U.S. commercial real estate prices have risen at a much faster rate than rents, which has caused capitalization rates (or “cap rates”) to plummet to record lows. The capitalization rate is the rate of return that is expected to be generated on real estate investments. It is calculated by dividing the property’s net operating income (NOI) by the current market value. Unusually low cap rates are an indication that commercial real estate prices are excessively inflated and at risk of a correction. Cap rates in the current commercial real estate bubble are even lower than they were at the peak of the commercial real estate bubble in 2007.

One of the major risks that will help to pop the commercial real estate bubble is the coming tech startup bust. As I have been warning, there has been an explosion of interest and activity in the tech startup arena since the Great Recession. Tens of thousands of tech startups have been founded in recent years and there are now over three hundred new “unicorn” startups that have valuations of $1 billion or more. The creation of tens of thousands of tech startups has generated a tremendous amount of demand for office space, which has benefited the commercial real estate industry.

The venture capital boom of the past several years can be seen in the chart of the monthly count of global VC deals that raised $100 million or more:

Today’s tech startup mania is the byproduct of ultra-low interest rates and QE, just like the commercial real estate bubble. Sadly, the majority of today startups – including today’s hottest unicorns – are burning copious amounts of cash. Startups in today’s bubble are playing the same role that dot-com companies were playing in the late-1990s. I strongly believe that a devastating bust is ahead that is going to wipe out thousands, if not tens of thousands, of non-economically viable tech startups as investors lose their appetite for such pie in the sky investments. As tech startups fold by the thousands (along with other businesses in the coming recession), office space vacancies are going to soar.

The ongoing “retail apocalypse” is another trend that will help cause the U.S. commercial real estate bubble to burst. According to UBS, retailers have closed more than 15,000 stores since 2017, and will close an incredible 75,000 more stores by 2026. In addition, there has been a massive restaurant boom in the past decade, which is likely to experience a bust of its own in the coming recession as unprofitable restaurants get culled. It’s just a matter of time before investors wake up and realize that the prospects for commercial real estate are terrible going forward and that today’s high prices are a fantasy. When that happens, expect to see a commercial real estate crash like 2008 or even worse.

Last week, I discussed the Fed’s recent comments suggesting they might be closer to cutting rates and restarting “QE” than not.

“In short, the proximity of interest rates to the ELB (Effective Lower Bound) has become the preeminent monetary policy challenge of our time, tainting all manner of issues with ELB risk and imbuing many old challenges with greater significance.  

“Perhaps it is time to retire the term ‘unconventional’ when referring to tools that were used in the crisis. We know that tools like these are likely to be needed in some form in future ELB spells, which we hope will be rare.”

After a decade of zero interest rates and floods of liquidity by the Fed into the financial markets, it is not surprising the initial “Pavlovian” response to those comments was to push asset prices higher.

However, as I covered in my previous article in more detail, such an assumption may be a mistake as there is a rising probability the effectiveness of QE will be much less than during the last recessionary cycle. I also suggested that such actions will drive the 10-year interest rate to ZERO. 

Not surprisingly, those comments elicited reactions from many suggesting that rates will rise sharply as inflationary pressures become problematic. 

I disagree.

First, there is no historical evidence that is the case. The chart below shows that each time the Fed embarks upon a rate reduction campaign, interest rates have fallen by 3.15% on average.

Of course, we need to add some context to the chart above. Historically, the reason the Fed cuts rates, and interest are falling, is because the Fed has acted in response to a crisis, recession, or both. The chart below shows when there is an inversion between the Fed Funds rate and 10-year Treasury it has been associated with recessionary onset.

Secondly, after a decade of QE and zero interest rates inflation, outside of asset prices, (as measured by CPI), remains muted at best. The reason that QE does not cause “inflationary” pressures is that it is an “asset swap” and doesn’t affect the money supply or the velocity of money. QE remains confined to the financial markets which lifts asset prices, but it does not impact the broader economy.

Since 2013, I have laid out the case, repeatedly, as to why interest rates will not rise. Here are a few of the most recent links for your review:

As I said, I have been fighting this battle for a while as “everyone else” has remained focused on the wrong reasons for higher interest rates. As I stated in Let’s Be Like Japan:”

This is the same liquidity trap that Japan has wrestled with for the last 20 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The lynchpin to Japan, and the U.S., remains interest rates. If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken, and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.”

This last bolded sentence is the most important and something that Michael Lebowitz discussed in “Pulling Forward:”

“Debt allows a consumer (household, business, or government) to pull consumption forward or acquire something today for which they otherwise would have to wait. When the primary objective of fiscal and monetary policy becomes myopically focused on incentivizing consumers to borrow, spend, and pull consumption forward, there will eventually be a painful resolution of the imbalances that such policy creates. The front-loaded benefits of these tactics are radically outweighed by the long-term damage they ultimately cause.”

Unfortunately, the Fed is still misdiagnosing what ails the economy, and monetary policy is unlikely to change the outcome in the U.S., just as it failed in Japan. The reason is simple. You can’t cure a debt problem with more debt. Therefore, monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever growing void in the future that must be filled. Eventually, the void will be too great to fill.

Doug Kass made a salient point as well about the potential futility of Fed actions at the wrong end of an economic cycle.

“Pushing on a string is a metaphor for the limits of monetary policy and the impotence of central banks.

Monetary policy sometimes only works in one direction because businesses and household cannot be forced to spend if they do not want to. Increasing the monetary base and banks’ reserves will not stimulate an economy if banks think it is too risky to lend and the private sector wants to save more because of economic uncertainty.

This cycle is much different than previous cycles as there are a host of anomalous conditions that will work against the likely rate cuts that lie ahead.

What has occurred in the last decade? 

  • $4 trillion of QE
  • $4 trillion of corporate debt piled up
  • $4 trillion of corporate buybacks
  • A Potemkin-like expansion in earnings per share as the share count drops to a two decade low. (h/t Rosie)
  • Meanwhile, capital spending has failed to revive (leading to negative productivity growth).

While this is not a short term call for an imminent drop in the equity market, if my concerns are prescient and fully realized we will likely see more than the process of a market making a broad and important top.

The Fed is pushing on a string.”

Monetary policy is a blunt weapon best used coming out of recession, not going into one.

Unfortunately, as Caroline Baum penned for MarketWatch recently, the Fed has little to work with at this juncture.

“No one is disputing the idea that the Fed needs additional tools at a time when the benchmark rate (2.25%-2.5%) is already low and offers little room for traditional stimulus. Historically, the fed funds rate has been reduced by 5 percentage points, on average, to combat recessions, according to Harvard University economist Lawrence Summers.

As Eberly, Stock and Wright note in their paper, when the policy rate is close to zero, it ‘imposes significant restraints on the efficacy of Fed policy, and our estimates suggest that those constraints are only partially offset by the new slope policies.’

I am not disputing that dropping rates and restarting QE won’t work at temporarily sustaining asset prices, but the reality is that such measures take time to filter through the economy. The impact of hiking rates 240 basis points over the last couple of years are still working their way through the economic system combined with the impact of tariffs on exports and consumption.

The real concern for investors, and individuals, is the real economy. We are likely experiencing more than just a “soft patch” currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get out of the “liquidity trap” they have gotten themselves into without cratering the economy, and the financial markets, in the process.

Should we have an expectation that the same monetary policies employed by Japan will have a different outcome in the U.S? This isn’t our first attempt at manipulating cycles. (H/T Doug)

“Governor Eccles: ‘Under present circumstances, there is very little, if anything, that can be done.’

Congressman T. Alan Goldsborough: ‘You mean you cannot push a string.’

Governor Eccles: ‘That is a good way to put it, one cannot push a string. We are in the depths of a depression and…, beyond creating an easy money situation through reduction of discount rates and through the creation of excess reserves, there is very little, if anything that the reserve organization can do toward bringing about recovery.’

– House Committee on Banking and Currency (in 1935)

More importantly, this is no longer a domestic question – but rather a global one since every major central bank is now engaged in a coordinated infusion of liquidity. The problem is that despite the inflation of asset prices, and suppression of interest rates, on a global scale there is scant evidence that the massive infusions are doing anything other that fueling asset bubbles in corporate debt and financial markets. The Federal Reserve is currently betting on a “one trick pony” which is that by increasing the “wealth effect” it will ultimately lead to a return of consumer confidence and a fostering of economic growth?

Currently, there is little real evidence of success.

Nonetheless, we can certainly have some fun at the Fed’s expense. My colleague Mike “Mish” Shedlock did a nice summation of the “Powell’s Pivot.” 

Bubbles B. Goode from Mike “Mish” Shedlock on Vimeo.

HOW TO READ THE CHARTS

There are four primary components to each chart:

  • The price chart is contained within the shaded area which represents 2-standard deviations above and below the short-term moving average.  
  • The Over Bought/Over Sold indicator is in orange at the top.
  • The Support/Resistance line (green) is the longer-term moving average which also acts as a trailing stop in many cases.
  • The Buy / Sell is triggered when the green line is above the red line (Buy) or vice-versa (Sell).

LONG CANDIDATES

BMY – Bristol Meyers

  • This is not a great long-term set up but for a short-term trade there is an opportunity.
  • BMY is very oversold and is close to registering a short-term buy signal.
  • Buy BMY at current levels.
  • Target is $52
  • Stop-loss is at recent lows of $45.

CVS – CVS Health Corp.

  • We had an unsuccessful trade in CVS previously. We stated that while we like the fundamentals and the business model, the price was simply not cooperating.
  • CVS is now extremely oversold and has been basing for almost 3-months.
  • Buy 1/2 position at current levels.
  • Buy the second 1/2 position on a buy signal and break above $58
  • Stop-loss is set at $52.

DEO – Diegeo PLC

  • We previously recommended a long-position in DEO back in January.
  • The trade has gotten crazy overbought
  • Take profits and reduce overall weight to 1/2 position and wait for a correction to add back into it.
  • Stop-loss is $155

INTC – Intel Corp.

  • INTC had a very sharp correction following earnings and the company has been basing along important support.
  • The “sell signal” and the stock are very oversold.
  • This is a decent trade setup on INTC with a target of $52-54
  • Buy position at current levels with a very tight stop at $43

JNJ – Johnson & Johnson

  • JNJ took a previous hit due to their settlement over “talc.” However, as we stated then, that settlement was a non-event for the company and the stock has completely reversed the sell-off.
  • The breakout from the consolidation is bullish and sets JNJ up for a further advance. We remain long the position in our equity portfolio.
  • Look to buy, or add to, JNJ on a break above resistance at $142.
  • Stop loss on new positions is $135

SHORT CANDIDATES

AMTD – TD Ameritrade Holding Corp.

  • AMTD is not looking good.
  • With a sell signal being triggered and the downtrend holding firm, it looks like AMTD is going to break to the downside of this consolidation pattern.
  • Look to short AMTD on a break below $50
  • Stop-loss is set at $54
  • Target for trade is $40.

CAT – Caterpillar

  • CAT is a casualty of the trade war with China ultimately.
  • The break below the consolidation pattern combined with the onset of a sell-signal suggests lower prices.
  • The current bounce is likely a decent short set up.
  • Short CAT at current levels.
  • Stop-loss is $132.50
  • Target is $100

CRM – Salesforce.com

  • CRM is just stupidly overvalued and is ultimately going to be one of the great shorts.
  • The current topping process continues combined with a current sell-signal following a bounce.
  • Short on a break of support at $150
  • Stop-loss is $160
  • Downside target is $120

EIX – Edison Intl., Inc.

  • The Utility space has been a clear winner but not so much for EIX
  • EIX is close to triggering a sell signal and remains modestly overbought.
  • Short EIX below $59
  • Target for trade is $52
  • Stop-loss is $63

EMN – Eastman Chemical Co.

  • The trade war has not been kind to basic material companies and EMN is no exception.
  • On a newly issued sell signal following a brief bounce, more downside is currently likely.
  • Short on a break of previous support at $67.50
  • Stop-loss is $75
  • Target for trade is $60
  • The short has now hit our previous targets and is oversold.
  • Close out the short-position and look to re-enter on a failed rally to $14.

Last week, I wrote a detailed piece in which I explained that U.S. recession risk was rising quite rapidly and that the coming recession is likely to be far more severe than most economists expect because there are so many dangerous new bubbles inflating currently and because the global debt burden is much worse today than it was before the Great Recession. In the current piece, I will show more warning signs of the coming recession as well as discuss reliable recession indicators to keep an eye on as we get closer to the recession.

The first chart is of the New York Fed’s recession probability model, which is warning that there is a 27% probability of a U.S. recession in the next 12 months. The last time that recession odds were the same as they are now was in early-2007, which was shortly before the Great Recession officially started in December 2007. This recession indicator has underestimated the probability of recessions in the past several decades (it never rose higher that 42% in 2008, when we were already in a recession), so the probability of a U.S. recession in the next 12 months is likely even higher than 27%.

The New York Fed’s recession probability model is based on the 10-year and 3-month Treasury yield spread, which is the difference between 10-year and 3-month Treasury rates. In normal economic environments, the 10-year Treasury yield is higher than the 3-month Treasury yield. Right before a recession, however, this spread inverts as the 3-month Treasury yield actually becomes higher than the 10-year Treasury rate – this is known as an inverted yield curve. As the chart below shows, inverted yield curves have preceded all modern recessions. The 10-year and 3-month Treasury spread inverted in May, which started the recession countdown clock.

The Leading Economic Index (LEI), which is comprised of economic indicators that lead the overall economy, has been slowing down quite rapidly in recent months. When the year-over-year growth rate of this index drops into negative territory, recessions typically occur shortly after. While the current LEI slowdown hasn’t dipped into negative territory yet, anyone who is interested in monitoring the risk of a recession should keep an eye out for that scenario.

The Chicago Fed National Activity Index (CFNAI), which is comprised of 85 indicators of national economic activity, has been contracting in recent months. Sharp contractions of the CFNAI’s 3-month moving average typically signal imminent recessions. The CFNAI’s contraction isn’t quite at recessionary levels just yet, but if it drops to -0.5 or even lower, that will provide further confirmation that a recession is imminent.

In May, the U.S. Manufacturing Purchasing Managers’ Index fell to its lowest level since September 2009:

South Korean exports, which are seen as a barometer for the health of the global economy, have been falling in recent months:

It’s not surprising that South Korea’s exports are falling as global trade plummets:

Major appliance shipments collapsed 17% in April, which is a recession warning sign:

One popular indicator that is used to monitor recession risk, the University of Michigan Consumer Expectations Index, shows no sign of an imminent recession – quite the opposite, actually. Just beware when it starts to drop very sharply like it did before the last several recessions.

U.S. building permits and housing starts are popular economic indicators that are used to monitor recession risk. Right now, they are not warning of an imminent recession, thankfully. But if building permits and housing starts weaken significantly in the near future, it will provide further confirmation that a recession is near.

One of the most basic recession indicators is the stock market itself. When the stock market experiences a bear market (a decline of 20% or more), that is typically a sign that the economy is rolling over into a recession. For now, the stock market is not warning of a recession, but beware that it can unravel very quickly due to how inflated it currently is.

Corporate earnings growth is another valuable recession indicator to watch. Corporate earnings growth drops significantly and turns negative when the economy rolls over into a recession. After growing at a nearly 20% annualized rate in 2017 and 2018, Q1 2019 earnings growth hit a wall, growing only 1.5%. If corporate earnings start to contract in the next few quarters, that would confirm that a recession is near.

As I have explained in the past, sub-4% unemployment is a sign that the economic cycle is quite mature and that a recession is not far off. The U.S. unemployment rate has been under 4% since early-2018. When the unemployment rate abruptly increases from such low levels, that is a tell-tale sign that a recession has started.

Though technically not a recession indicator, it is worth paying attention to the high-yield bond spread as a measure of how much stress there is in the credit market. The spread tends to increase leading up to and during recessions as investors jettison riskier high-yield bonds in favor of less risky Treasury bonds. Credit market stress is still low at the moment, but can change on a dime.

In the past year or so, Goldman Sachs’ Bear Market Risk Indicator has been at its highest level since the early-1970s:

The high probability of a recession and bear market in the next year or so is very concerning because of how inflated the U.S. stock market currently is. The Fed’s aggressive inflation of the U.S. stock market in the past decade caused stocks to rise at a faster rate than their underlying earnings, which means that the market is extremely overvalued right now. Whenever the market becomes extremely overvalued, it’s just a matter of time before the market falls to a more reasonable valuation again. As the chart below shows, the U.S. stock market is nearly as overvalued as it was in 1929, right before the stock market crash that led to the Great Depression.

Another indicator that supports the “higher volatility ahead” thesis is the 10-year/2-year Treasury spread. When this spread is inverted, it leads the Volatility Index by approximately three years. If this historic relationship is still valid, we should prepare for much higher volatility over the next few years. A volatility surge of the magnitude suggested by the 10-year/2-year Treasury spread would likely be the result of a recession and a bursting of the massive asset bubble created by the Fed in the past decade.

While several reliable indicators are giving recession warnings and are worth paying attention to, the U.S. economy is still in the early stages of slowing down and rolling over into a recession. Even if the recession begins in a year or two, that is still too close for comfort considering the tremendous risks that have built up globally during the past decade of extremely stimulative monetary policies. As I have explained in last week’s piece, bubbles are forming in global debtChinaHong KongSingapore, emerging markets, CanadaAustraliaNew ZealandEuropean real estatethe art marketU.S. stocksU.S. household wealthcorporate debtleveraged loansU.S. student loansU.S. auto loanstech startupsshale energyglobal skyscraper constructionU.S. commercial real estatethe U.S. restaurant industryU.S. healthcare, and U.S. housing once again. I believe that the coming recession is going burst those bubbles, which may cause a crisis that is even worse than the 2008 Global Financial Crisis was.

We have discussed yield curves in quite a few commentaries and articles over the last few months. The reason we stress the topic is that yield curve inversions are not only uncommon, but their occurrence is highly correlated with recessions.

Typically, when people use the phrase “the yield curve,” they are referring to the 10 year/2 year Treasury curve spread. While that curve is important, there are other curves that are predictive of future Fed rate policy as well as the prospects of a coming recession.

For example, the graph below shows the 6month/3month Treasury bill curve. Because the maturities making up this curve are so short, its usefulness is in providing an outlook for what the Fed might do and how soon they might do it.

As shown above, the 6m/3m curve now sits at negative 13 basis points, meaning 6 month T-bills now yield .13% less than 3 month T-bills. The 3 month bill is currently priced at a yield of 2.26 which is about 14 basis points below where it traded earlier this year prior to when the market thought the Fed would ease in 2019.  

Given the yield decline, the timing of the Fed’s meetings, and the term to maturity, the current 3 month bill implies nearly a 100% chance that the Fed will reduce rates by 25 basis points at the July 31st meeting. The yield on the 6 month bill implies the same rate cut plus a 50% chance of another rate cut at the September 18th meeting which is the next meeting after the July 31st meeting.

Essentially the graph highlights that the last two recessions occurred shortly before or after the T-bill market implied a greater than 50% chance of consecutive rate cuts by the Fed, as it is now.

The bond markets for the moment are signaling that a recession is imminent as the chances of Fed rate cuts becomes more likely by the day. At the same time, the stock market appears to think that easier Fed policy will protect the value of the stock market. Based on historical precedence and current valuations in stocks and bonds, we would argue they cannot both be right.

Six of the last seven times the Fed has lowered rates a recession followed. August of 1998, the one instance it did not occur, was Fed action to minimize the effect of the failure of Long Term Capital Management, one of the world’s largest hedge funds at the time. It is worth noting, their actions, along with Y2K spending, likely forestalled the recession which followed two years later. 

The table below shows the previous seven times the Fed reduced rates by 75 basis points or more and the maximum drawdowns that occurred in the S&P 500 over various time frames.  Needless to say, heed the message of the bond market and trade with care.

In, The Lowest Common Denominator, we quantified the extent to which growth of consumer, corporate, and government debt has greatly outstripped economic growth and our collective income. This dynamic has made the servicing of the debt and the ultimate pay back increasingly more reliant on more debt issuance.

Fortunately, taking on more debt for spending/consumption and to service older debt has not been a problem. Over the past twenty years there have been willing lenders (savers) to fund this scheme, even as their reward, measured in yield, steadily declined.

Unfortunately, two of the largest buyers/holders of U.S. Treasury debt (China and the Federal Reserve) are no longer pulling their weight. More concerning, this is occurring as the amount of Treasury debt required to fund government spending is growing rapidly. The consequences of this drastic change in the supply and demand picture for U.S. Treasury debt are largely being ignored.

Foreign Bond Holders

In our article, Triffin Warned Us, we provided a bit of history on the Bretton Woods Agreement. This pact from 1944 essentially deemed the U.S. dollar the world’s reserve currency. As a result of the agreement, foreign nations rely heavily on U.S. dollars for all types of international trade. For instance, if Uruguay sells widgets to Australia, Australia will most likely pay Uruguay in U.S. dollars. Because of the reliance on dollars for trade, Uruguay, Australia and almost every other nation holds reserves of dollars.

Foreign entities with dollar reserves maximize the interest they earn on reserve accounts with the objective of taking as little risk as feasible. Think of reserve accounts as savings accounts.  As such, foreign reserves are most often invested in “safe” U.S. Treasuries. As world trade has grown over the years, the need for dollar savings has grown in step and has resulted in more lending to the U.S. Treasury by foreign governments.

Recently the incremental appetite from foreign buyers, both private investors and governments, has declined. Prior to the last two years, the last instance with flat to negative growth over a two-year period was 1999-2000. During that period, the amount of U.S. Treasury debt outstanding was shrinking, and despite a decline in foreign ownership, foreign ownership as a percentage of bonds outstanding rose.

The graph below charts the amount and percentage of foreign holdings of public U.S. Treasury debt outstanding (excluding intra-governmental holdings such as social security administration investments), and total public debt outstanding. As highlighted, the divergence occurring over the past few years is without comparison in the last forty years. As a point of reference, the last time foreign entities meaningfully reduced their holdings (1979-1983) the ratio of U.S. Treasury debt to GDP was less than 40% (currently 105%). Needless to say, the implications of a buyers strike today are quite different.

Data Courtesy St. Louis Federal Reserve

Federal Reserve QE

During the financial crisis and its aftermath, government spending and debt issuance increased sharply. From 2008 through 2012, Treasury debt outstanding increased by over $8 trillion. This was three times as much as the $2.6 trillion increase during the five years preceding the crisis. 

Faced with restoring economic growth and stabilizing financial markets during the crisis, the Federal Reserve took the unprecedented step of lowering the target for the Fed Funds rate to a range of 0-0.25%. When this proved insufficient to meet their objectives, they introduced Quantitative Easing (QE). The implementation of QE had the Fed purchase U.S. Treasury securities and mortgage-backed securities (MBS) in open market operations. By reducing the amount of bonds held publicly they reduced Treasury and MBS yields which had the knock-on effect of lowered yields across a wide spectrum fixed-income securities. After three rounds of QE, the Fed had purchased over $1.9 trillion Treasuries and over $1.7 trillion MBS. At its peak, the Fed owned 19% of all publicly traded U.S. Treasury securities.

In October 2017, the Fed began balance sheet normalization, the process by which they reduce their holdings of U.S. Treasuries and MBS, in what is colloquially known as Quantitative Tightening (QT). Since then, they have reduced their Treasury holdings by over $200 billion. Although they have been shedding $50 billion a month between U.S. Treasuries and MBS, they intend to reduce and halt all reductions by the end of September. The following graph shows the size of the Fed’s balance sheet as well as its expected decline.

Data Courtesy St. Louis Federal Reserve

The Fed and Foreigners are MIA

As discussed, the Fed is reducing their U.S. Treasury holdings and foreign entities are not adding to their Treasury holdings. This reduced demand is occurring as the U.S. Treasury is ramping up issuance to fund a staggering $1 trillion+ annual deficit. The CBO forecasts the pace of heavy Treasury debt supply will continue for at least four more years.

Because foreign entities and the Fed are not buying, domestic investors are left to fill the gap. The graph below charts the change in U.S. Treasury debt issuance along with the net amount of domestic investor purchases (Total debt issuance less net purchases of foreign entities and the Fed.)

Data Courtesy St. Louis Federal Reserve

As highlighted in the yellow box, domestic purchases have indeed taken up the slack. The graph below shows investor breakout of net purchases from 2000 to 2015.  

Data Courtesy St. Louis Federal Reserve

Note that domestic investor demand accounted for roughly a quarter of the Treasury’s issuance. Now consider the period from 2016 to current as shown below.

Data Courtesy St. Louis Federal Reserve

Quite a stark difference! Domestic investors have bought over 100% of Treasury issuance.  

This leads to two important consequences worth considering.

  1. Given the amount of debt that is expected to be issued, will interest rates need to rise further to attract domestic buyers?
  2. If domestic investors are forced to buy 100% net Treasury issuance plus that which is sold by the Fed and foreigners where will the money will come from?   

Now, before answering those questions here is the punch line. According the Office of Management and Budget (OMB), Treasury debt is expected to increase by $1.086 trillion in 2019. As the Fed modifies their balance sheet reduction but does not resume buying, and foreign entities remain neutral, domestic savers will still be on the hook to purchase at least the entire $1.086 trillion in U.S. Treasury securities in 2019 alone. Looking beyond 2019, net debt issuance over the next ten years is expected to average $1.2 trillion per year, and that forecast by the CBO, OMB and primary dealers does not include a recession which could easily double the annual estimate for a few years.  

It is probable that, barring deflation or a notable stock market decline, higher interest rates will be required to attract marginal domestic investors to purchase U.S. Treasuries. It is also fair to say that the onus of buying more U.S. Treasuries that is falling on domestic investors will likely result in a higher savings rate which negatively effects consumption.

The bottom line is that investors will need to consume less and shift from other assets into U.S. Treasuries to match the growing supply. This presents a big problem for equity investors that are buying assets at record high valuations and are unaware of, or unconcerned with, this situation.

Summary

Just because something has gone on for what seems to be “forever” does not mean it will continue.

Deficits do indeed matter. The post Bretton Woods agreement formalizing a fiat currency global system had the support of all major developed world nations. Against better judgement and a lack of understanding about the implications, monetary policy was fashioned towards ever larger debt burdens. The story plays a bit like an old Monty Python skit:

Cleese: “The amount of debt we owe is creating a problem, sir.”

Palin: “Don’t be ridiculous! That’s pure horse hockey! It’s just a bloody flesh wound.”

Cleese: “But the amount of debt outstanding can no longer be described using numbers and we have no way of paying the interest.”

Gilliam: “Are you an idiot, man? We’ll issue more debt to pay the current debt we owe, of course!

Cleese: “But we’ve been doing that and the problem keeps getting worse and you say the same thing!

Chapman: “Is that a penguin on the telly?”

Now that we actually have to fund our debt, the reality is hitting home and diverting attention to “penguins on the telly” will do us no good. If foreign investors remain uninterested and the Fed avoids restarting QE, this situation will become much more obvious. Regardless, history is chock full of warnings about countries that continuously spent more than they had. Simply, it is completely unsustainable and the investment implications across all assets are meaningful.

Each week we produce a chart book of 10 of the current positions we have in our equity portfolio. Specifically, we are looking at the positions which warrant attention, or are providing an opportunity, or need to be sold.

While the portfolios are designed to have longer-term holding periods, we understand that things do not always go the way we plan. This monitoring process keeps us focused on capital preservation and long-term returns.

HOW TO READ THE CHARTS

There are four primary components to each chart:

  • The price chart is contained within the shaded area which represents 2-standard deviations above and below the short-term moving average.  
  • The Over Bought/Over Sold indicator is in orange at the top.
  • The Support/Resistance line (green) is the longer-term moving average which also acts as a trailing stop in many cases.
  • The Buy / Sell is triggered when the green line is above the red line (Buy) or vice-versa (Sell).

When the price of a position is at the top of the deviation range, overbought and on a buy signal it is generally a good time to take profits. When that positioning is reversed it is often a good time to look to add to a winning position or looking for an opportunity to exit a losing position.

With this basic tutorial let’s get to the sector analysis.

AAPL – Apple Corp.

  • AAPL sold off recently with the rest of the tech sector, but held important support at previous support.
  • We previously sold 20% of our holdings at the beginning of May and are looking to add back to our position.
  • It is too early to do so and we need some confirmation the current rally is somewhat sustainable. We are not there yet.
  • We will continue to hold our reduced position and look for the right entry point.
  • Stop remains at $145

CMCSA – Comcast Corp.

  • After breaking out to new highs, CMCSA is pulling back towards support and is in the early stages of working off some of its overbought condition.
  • The current buy signal is very extended and CMCSA may trigger a short-term sell signal.
  • Look for an opportunity to add to positions that hold support at $40.50
  • Stop-loss is moved up to $39

COST – Costco Wholesale

  • We previously took profits in COST and after a breakout to all-time highs, and confirmed, we can look for an opportunity to increase our holdings.
  • COST is currently overbought but on a buy signal. We will be patient for now and wait for the right opportunity to add to our current position.
  • Look to add around $240 if support holds
  • Stop-loss remains at $230 for now.

GDX – Gold Miners

  • GDX was added to our portfolios to hedge against potential volatility and rate risk in portfolios.
  • The hedge worked well in the recent sell-off and is testing overhead resistance.
  • We continue to hold our position for now and will look for a break above $23 to add to our holdings.
  • Our stop is set at $20

IAU – Gold

  • Like GDX, we are using gold as a hedge against volatility and risk in the market.
  • During the recent sell-off our positions acted appropriately by rising and hedging off some of the downside risk in our portfolios.
  • We remain long IAU for now and will only look to add to the position on a breakout above $13.
  • Stop-loss remains at $12.20 for now.

JNJ – Johnson & Johnson

  • JNJ recently plunged on worries about the settlement over issues with their “talc powder.” As we noted at the time, that plunge was far overdone relatively to the size of the settlement and we held our position.
  • The market came to agree with us and JNJ has now rallied back to the top of its consolidation pattern.
  • JNJ needs to breakout above $140 which should confirm a substantial move higher.
  • We remain long our position currently and are moving our stop-loss up to $130

MU – Micron Technologies

  • MU continues to be our “problem child” in our portfolio. It simply isn’t performing and while it recently held support the risk/reward simply doesn’t work right now.
  • With a P/E of 3x, the company is simply CHEAP.
  • We are giving MU a bit of room, but not much, and we are very close to selling the position for now and putting it back on our watch list.
  • Stop-loss is set at $32.50.

UTX – United Technologies

  • UTX sold off this past week due to the announced merger with Raytheon (RTN). This merger will make UTX one of the largest defense contractors on the planet and will broaden their income streams and their government contracts for high-end defense and aerospace.
  • The pullback is a buying opportunity for long-term investors, but it is too early to start buying just yet.
  • Our target to add to our exposure is at $118 given previous support levels. However, it is feasible we could see UTX trade a lower levels over the summer.
  • Defensive sectors continue to get a bid from investors looking for safety and yield so we like our positioning for now.
  • We are adjusting our stop-loss down to $105 for now to accommodate for added holdings.

PG – Proctor & Gamble

  • PG continues to get a bid from investors looking for “defensive” positions amid the current rally and slowing economy.
  • We took profits in PG previously and have been looking for a pullback to add to our position longer-term.
  • There is a short-term sell signal close at hand which may give us an opportunity. Given we have already taken profits we are running a larger than normal stop-loss so we can add to our current holdings.
  • We would like to see PG hold support and consolidate a bit.
  • Stop loss is currently set at $95

PEP – Pepsico, Inc.

  • PEP continues to power higher after breaking out to all-time highs.
  • The chase for defensive income stocks continues and has accelerated after talks by the Fed of lowering interest rates.
  • PEP is grossly overbought so a pullback to old highs and a bit of consolidation is needed to add to our holdings.
  • Stop-loss is moved up to $117.50
The Green New Deal (GND) is a plan to drastically change the American economy and improve social conditions for its people. It was put forth in March by Rep. Alexandria Ocasio-Cortez (D-N.Y.) and Sen. Ed Markey (D-Mass.) but stalled in Congress after a Senate defeat. However, the GND still is a topic of wide debate and already has spawned various copycat proposals – and its underlying movement still will have a significant effect on the economy and investors going forward.

Modeled after FDR’s New Deal in 1933 but focusing on fighting climate change, the Green New Deal is controversial for several reasons, including its enormous cost and rapid timetable.

I am not going to argue politics today. But while some, most or even all of the proposal may never be passed into law, there is no denying that the trend toward a more Earth-friendly economy is in place. A few states already have long-term 100% renewable-energy mandates in places, and literally hundreds of mayors and several governors have expressed support in 100% goals.

With or without the GND, some technologies – such as electric vehicles, solar power and ocean-friendly packaging – will develop into viable industries.

This presents many opportunities for investors. The question is where should they put their money, assuming that at least the underlying concepts within the Green New Deal materialize?

Why Go Green?

Again, without even discussing whether the GND is possible, viable or even desirable, we can at least stipulate that being more environmentally friendly is desirable. Being a better shepherd to the planet, protecting ecosystems and using natural resources wisely make sense for the simple reason that clean air, water, food and even recreational facilities are good for all of us.

The No. 1 “green” issue for most people is climate change caused by emissions of carbon dioxide and other so-called greenhouse gasses. In the atmosphere, these gases trap heat and raise the average temperature around the world.

According to the United Nations’ World Meteorological Organization, the average global temperature is on track to increase by 5.4 to 9.0 degrees Fahrenheit through the end of the century.

That doesn’t sound like much, especially when the average high and low temperatures in a city such as New York vary 57 degrees from winter to summer and can swing from single to triple digits at their extremes. But that seemingly little range is all it takes to drastically shift weather patterns, causing stronger storms and altering crops, sea levels and rainfall.

With the public now increasingly aware of climate change and roughly three-quarters of Americans “somewhat” or “very worried” about it, according to a poll from Yale University, George Mason University and Climate Nexus, investors should be mindful of the companies that will directly benefit from fighting it.

The Basics of the Green New Deal

In a nutshell, the GND seeks to:

  1. Shift 100% of national power generation to renewable source within 10 years. Initially, it sought a zero-emission target but it has since been changed to “net zero.” That means carbon emissions from natural sources, such as the decay of organic materials, would be harnessed to provide power first before being emitted. In 2017, only 11% of the nation’s energy consumption came from renewables, according to the Energy Information Administration. Another 9% is generated by nuclear power. Although not renewable, nuclear doesn’t emit carbon dioxide.
  2. Upgrade all buildings to make them energy-efficient. This means replacing all building infrastructure to eliminate heating oil and natural gas. It also means replacing all electric air conditioners that use HFC refrigerants (hydrofluorocarbons), which are 2,000 times more potent than carbon dioxide as greenhouse gasses.
  3. Decarbonize manufacturing and agricultural industries. Infrastructure would be required to “scrub” emissions to remove carbon. It also is where “cow emissions” can be captured to provide energy.
  4. Decarbonize and upgrade the nation’s infrastructure, especially transportation, specifically shifting nonessential individual transportation to mass transit. While high-speed rail was suggested as a preferred method for domestic travel, it was not true that the plan called for rail travel on overseas routes.
  5. Fund massive investment in the drawdown and capture of greenhouse gases. Technology to recapture carbon from the air would have to be developed.
  6. As a byproduct, the U.S. could become a major exporter of green technology, products and expertise.
  7. Guarantee jobs for those who are vocationally displaced by these changes
  8. Guaranteed minimum income and universal healthcare.

Surprisingly, the Green New Deal does not include a carbon tax or a cap-and-trade program. These programs, which essentially shift the cost of polluting from one organization to another, raise the cost of carbon fuels, such as gasoline. That could hurt lower-income families more, especially those in rural areas who rely on an automobile.

(more…)

Over the past couple of weeks, we have been discussing a “sellable rally” following the sell-off during the month of May. To wit:

This week we are going to look at the recent sell-off and the potential for a short-term ‘sellable’ rally to rebalance portfolio risks into.

The markets only need some mildly positive news at this point to spur a ‘short-covering’ rally. I would encourage you to use it to reduce risk, rebalance holdings, and raise cash until the ‘trade war smoke’ clears.

The market did indeed rally last week. While the initial sell-off in the market was attributed to potential tariffs on Mexico, which were indefinitely suspended on Friday, the real reason was the dismal employment report of just 75,000 jobs.”

As I said, there was more room to go on the upside, and yesterday the market continued its rally to start the week.

“In the very short-term the markets are oversold on many different measures. This is an ideal setup for a reflexive rally back to overhead resistance. The markets have only reversed about half of the previously oversold condition which leaves some ‘fuel in the tank’ for a continuation of the rally this coming week.”

But here is the real question for this week:

Is it still just a “sellable rally” or “is the bull market back?”

That’s the answer we all want to know.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes.

(See an unlocked version here. We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and long-short ideas. You can try RIA PRO free for 30-days)

  • Last week we noted that SPY had corrected the overbought condition and is testing the 200-dma.
  • The “buy” signal in the lower panel was massively extended, as noted several weeks ago, which as we stated, suggested the reversal we have seen was coming. The signal is almost fully reversed.
  • As stated last time:
    • “The correction last week has set up a tradeable opportunity into June.”
  • That tradeable rally is in process and we are approaching our initial target of $290
  • Short-Term Positioning: Bullish
    • Last Week: Hold full position with a target of $290.
    • This Week: Sell 1/2 of position on any rally next week that hits our target.
    • Stop-loss moved up to $280

On Monday, our initial target was hit which, for traders, suggests trimming positions and reaping some decent short-term profits. However, the current momentum of the rally does suggest the rally could be sustained through the end of the month with previous highs attainable.

With the markets back to very overbought levels, as noted above, there are reasons to remain cautious as there are signs the current rally is likely not sustainable longer-term.

Let’s Review Some Important Charts

Dow Theory

Dow Theory suggests that when the Transportation index does not confirm the Industrial components, rallies should be treated with caution. Since the Dow Jones Industrial Average is really no longer just industrial companies, I compare the industrials the S&P 500 for some measure of confirmation. Currently, transportation stocks continue to suggest the economy is weaker than the markets currently believe and the current rally is likely somewhat limited.

Notice the vertical red lines correspond with a non-confirmation of transportation to the S&P 500. In most cases, that non-confirmation resulted in lower market prices. While this is not an absolute signal, it does suggest some caution with respect to excessive risk taking.

Yields

Yields also continue to suggest that investors should proceed with at least of a modicum of caution.

As noted this past weekend, the yield spreads across various maturities have continued to invert. These inversions are not just a theoretical market indicator but rather has real world impacts on a variety of areas which affect real economic growth such as lending, capital investment, and financially engineered products.

“Interest rates are the best predictor of the economic strength, and the yield curve has been screaming both ‘deflation’ and ‘economic weakness’ for months. (We have repeatedly warned on this issue – see here)”

Importantly, as shown in the chart below, yields typically fall 2-3% on average during periods of economic weakness and recessions.

The important thing to notice is that during each period of falling rates, going back to 1980, each successive low has been lower along with the subsequent high during each cycle. With yields currently at just a bit more than 2%, as of this writing, the next low in interest rates, most likely coincident with a recession, will be close to zero.

Corporate Profits

Ultimately, the market is a “weighing machine,” to quote Warren Buffett, based on the expected cash flows and profits from companies in the future. While in the short-term prices can, and do, deviate from the underlying value, ultimately prices will revert to the underlying fundamentals. Since the December 24th lows, prices have risen sharply while earnings, and subsequently corporate profits, have deteriorated. The chart below shows corporate profits before and after tax.

It is important to note that investors are paying a very high price for earnings which have not risen since 2011 on a pre-tax basis. (Also, the effective tax rate rose in the last quarter.)

With the risk of a recession on the rise, the risk to profits, and ultimately valuation multiples, is worth carefully considering. As David Rosenberg noted on Monday:

“It’s not like risks have not been on the rise either, as the New York Fed’s recession model increased again in May hitting its highest level in 12-years. Odds of a recession ticked higher to 29% from just 11% last year and 8% two years ago. Putting it all together means there is now more downside risk than upside potential in the stock market as investors have already overpriced equities for whatever good news there has been in the first 5-months of the year.”

(Importantly, the recession indicator is based on LAGGING economic data which is subject to very large revisions. It is for the reason that readings of 20-30% are indicative of recessions.)

Monthly Signals Remain Bearish

Given that monthly data is very slow moving, longer-term signals can uncover changes to the trend which short-term market rallies tend to obfuscate.

I can’t believe I actually have to write the next sentence, but if I don’t I invariably get an email saying “but if you sold out, you missed the whole rally.”

What should be obvious is that while the monthly “sell” signals have gotten you out to avoid more substantial destructions of capital, the reversal of those signals were signs to “get back in.” Investing long-term is about both deployment of capital and the preservation of it.

Currently, the monthly indicators have all aligned to “confirm” a “sell signal” which since 1950 has been somewhat of a rarity. The risk of ignoring the longer-term signal currently is the risk of a loss of what has been gained during the current reflexive rally. Yes, while waiting for the signal to reverse will equate to short-term underperformance, the long-term risk-adjusted returns have been more than enough to satisfy retirement planning goals which is why we invest to begin with.

The following chart is one of my favorites because it combines a litany of confirming signals all into one monthly chart. Despite the recent rally, which has pushed prices back above their longer-term moving average, the longer-term trends of the signals remain “non-confirming” of the recent rally.

The technical signals, which do indeed lag short-term turns in the market, have not confirmed the bullish attitude. Rather, and as shown in the chart above, the negative divergence of the indicators from the market should actually raise some concerns over longer-term capital preservation.

What This Means And Doesn’t Mean

What this analysis DOES NOT mean is that you should “sell everything” and “hide in cash.”

As always, long-term portfolio management is about “tweaking” things over time.

At a poker table, if you have a “so so” hand, you bet less or fold. It doesn’t mean you get up and leave the table altogether.

What this analysis DOES MEAN is that we need to use this rally to take some actions to rebalance portfolios to align with some the “concerns” as discussed above.

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 a bounce, they are going to 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 are aggressively weighted in 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.

Could I be wrong? Absolutely.

If we are, and the market rallies and confirms new highs, and a resurrection of the bullish trend, then we will adjust our allocation models up and take on more equity risk.

But as I have asked before, what is more important to you as an individual?

  1. Missing out temporarily on the initial stages of a longer-term advance, or;
  2. Spending time getting back to even, which is not the same as making money.

For the majority of investors, the recent rally has simply been just recovery of previous losses from 2018.

Currently, there is not a great deal of evidence supportive of a longer-term bull market cycle. The Fed talking about cutting rates is “NOT” bullish, it actually correlates to much more negative long-term outcomes in the market.

If I am right, however, the preservation of capital during an ensuing market decline will provide a permanent portfolio advantage going forward. The true power of compounding is not found in “the winning,” but in the “not losing.”

As I quoted in our post on trading rules:

Opportunities are made up far easier than lost capital.” – Todd Harrison

Each week we produce a chart book of the S&P 500 sectors to review where money is flowing within the market as whole. This helps refine not only decision making about what to own and when, but what sectors to overweight or underweight to achieve better performance.

HOW TO READ THE CHARTS

There are three primary components to each chart:

  • The price chart is in orange
  • The Over Bought/Over Sold indicator is in gray
  • The Buy / Sell indicator is in blue.

When the gray indicator is at the TOP of the chart, there is typically more risk and less reward available at the current time. In other words, the best time to BUY is when the short-term condition is over-sold. Likewise when the buy/sell indicator is above the ZERO line investments have a tendency of working better than when below the zero line.

With this basic tutorial let’s get to the sector analysis.

Basic Materials

  • The bounce we discussed previously has occurred and XLB has gone from extreme oversold back to extreme overbought.
  • As noted previously, XLB rallied sharply and we suggested using the rally to reduce exposure accordingly.
  • XLB is back to very overbought conditions and is testing both previous resistance and the downtrend line. Use this opportunity to trim back holdings is still at target weight or more.
  • Short-Term Positioning: Neutral
    • Last Week: Hold balance for rally to $55 to $55 1/2
    • This Week: Sell down positions to 1/2 weight and hold for now.
    • Stop-loss moved up to $55
  • Long-Term Positioning: Bearish

Communications

  • As noted previously, XLC broke support and failed at a rally turning support into resistance. Support is holding at current levels but just barely and XLC is now testing important overhead resistance.
  • We stated last week, that the “stop-loss” was violated, look for a bounce to $47 to $47 1/2 to sell position. We are there now.
  • Short-Term Positioning: Neutral
    • Last Week: Sell on rally to $47-47 1/2
    • This Week: Sell remaining positions.
    • Hard Stop set at $45
  • Long-Term Positioning: Bearish

Energy

  • Three weeks ago, I stated that XLE was currently at a critical juncture. A failure below the 200-dma was going to bring the low-$60’s into focus. That break happened and XLE tested the $59 level.
  • The previous “buy signal” has reversed putting more pressure on the sector currently. Use any rally to reduce exposure to the sector for now.
  • Short-Term Positioning: Neutral
    • Last week: Stop violated, sell on rally to $61-63
    • This week: Reduce exposure on this rally, initial target of $61 hit, $63 is likely max.
    • Stop-loss adjusted to $59
  • Long-Term Positioning: Bearish

Financials

  • XLF has rallied over the last couple of trading sessions and is now testing previous resistance.
  • XLF remains on a “buy” signal currently and the overbought condition was reversed to provide for the bounce. XLF is not back to overbought levels as of yet.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position, add on a pullback to $25 that holds.
    • Stop-loss moved up to $25.00
  • Long-Term Positioning: Bearish

Industrials

  • XLI has put in a “triple top” at recent highs which makes that resistance level critically important.
  • As stated two weeks ago:
    • For now, the buy signal in lower panel is reversing and industrials are now oversold. With “trade war” rhetoric ramping up, watch for a break below support. XLI must hold $72.
  • Our stop level has held for now and XLI is rallying back to overhead resistance. There is a potential “had and shoulder” pattern being formed short-term so remain cautious.
  • Short-Term Positioning: Neutral
    • Last week: Hold remaining 1/2 position
    • This week: Look to sell on failed rally to $75-76
    • Stop-loss moved up to $72
  • Long-Term Positioning: Neutral

Technology

  • XLK reversed nicely off of the short-term oversold condition as expected.
  • The break above resistance, which has been driven by just AMZN, MSFT, AAPL, and GOOG, is set to test old highs at best.
  • Since we previously took profits, continue to hold the remaining positions for now.
  • Short-Term Positioning: Bullish
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss remains at $70
  • Long-Term Positioning: Neutral

Staples

  • XLP rallied sharply as money sought “safety” and “defense” once again.
  • XLP’s “buy” signal (lower panel) is still in place and extended. We continue to recommend taking some profits if you have not done so.
  • XLP was oversold and we stated additional gains were likely. $56.50 was initial resistance which was taken out with new all-time highs.
  • Short-Term Positioning: Bullish
    • Last week: Holding full position, take profits and rebalance.
    • This week: Add to current holdings if needed. We are currently carrying an overweight position.
    • Profit stop-loss moved up to $55.50
  • Long-Term Positioning: Bullish

Real Estate

  • XLRE, like XLP, has broken out to all-time highs as “defense” continues to catch the majority of the rally.
  • We previously recommended taking profits and rebalancing risk. That is still advisable.
  • Buy signal is being reduced along but XLRE is back to overbought.
  • We recently added to our XLRE position and are now carrying a full weight.
  • Short-Term Positioning: Bullish
    • Last week: Holding full position.
    • This week: Hold position.
    • Stop-loss adjusted to $35.50
  • Long-Term Positioning: Bullish

Utilities

  • XLU, like XLRE and XLP above, continue to advance from the “defensive” shift in allocations.
  • Long-term trend line remains intact and the recent test of that trend line with a break to new highs confirms the continuation of the bullish trend.
  • Buy signal worked off some of the excess. (bottom panel) but the sector is back to overbought once again.
  • Short-Term Positioning: Bullish
    • Last week: Hold overweight position
    • This week: Hold overweight position
    • Stop-loss moved up to $56.
  • Long-Term Positioning: Bullish

Health Care

  • Sell-signal (bottom panel) remains intact currently but previous support is holding.
  • While Healthcare is holding up for now, there is a downtrend forming in the sector. Keeps stops in place.
  • XLV has been in a consolidation for the last 18-months. So whichever direction healthcare breaks out to will be a big move.
  • XLV is back to overbought so $92 is important resistance.
  • Short-Term Positioning: Neutral
    • Last week: Hold current position (overweight)
    • This week: Hold current position (overweight)
    • Stop-loss set $86
  • Long-Term Positioning: Neutral

Discretionary

  • With AMZN and AAPL now considered discretionary stocks, it is not surprising to see XLY rise and fall with XLK and XLC as those two major stocks rallied last week and on Monday.
  • The “buy” signal has been reduced and is potentially threatening a reversal.
  • XLY was oversold and is now approaching overbought as the previously expected rally has occurred.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 of position.
    • This week: Hold 1/2 position with stops in place.
    • Stop-loss adjusted to $107.50 after sell of 1/2 position.
  • Long-Term Positioning: Neutral

Transportation

  • XTN has continued to lag the overall market and continues to suggest there is “something wrong” economically.
  • XTN has reversed its buy signal (bottom panel) and while the sector is bouncing off of an oversold condition, there is a lot going wrong. Look for a failed rally to $60 to sell into if you are still long positioning..
  • As we have been saying for several weeks, our “sell stop” was triggered previously. No real need to rush back into adding a new position. We will watch and see what happens.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Each week we produce a chart book of the major financial markets to review whether the markets, as a whole, warrant higher levels of equity risk in portfolios or not. Stocks, as a whole, tend to rise and fall with the overall market. Therefore, if we get the short-term trend of the market right, our portfolios should perform respectively.

HOW TO READ THE CHARTS

There are three primary components to each chart:

  • The price chart is in orange
  • The Over Bought/Over Sold indicator is in gray
  • The Buy / Sell indicator is in blue.

When the gray indicator is at the TOP of the chart, there is typically more risk and less reward available at the current time. In other words, the best time to BUY is when the short-term condition is over-sold. Likewise when the buy/sell indicator is above the ZERO line investments have a tendency of working better than when below the zero line.

With this basic tutorial let’s review the major markets.

S&P 500 Index

  • Last week we noted that SPY had corrected the overbought condition and is testing the 200-dma.
  • The “buy” signal in the lower panel was massively extended, as noted several weeks ago, which as we stated, suggested the reversal we have seen was coming. The signal is almost fully reversed.
  • As stated last time:
    • “The correction last week has set up a tradeable opportunity into June.”
  • That tradeable rally is in process and we are approaching our initial target of $290
  • Short-Term Positioning: Bullish
    • Last Week: Hold full position with a target of $290.
    • This Week: Sell 1/2 of position on any rally next week that hits our target.
    • Stop-loss moved up to $280
    • Long-Term Positioning: Neutral

Dow Jones Industrial Average

  • Last week, we noted the setup for DIA wasn’t as compelling as the S&P 500.
  • DIA did rally and reversed a bulk of the oversold condition but is challenging overhead resistance.
  • More importantly, DIA has registered a “sell signal.”
  • Short-Term Positioning: Neutral
    • Last Week: Sell holdings on any rally that fails to get above $250.
    • This Week: Hold previous position given rally reversed “sell” level.
    • Stop-loss remains $250
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • QQQ rallied from the oversold condition and is not overbought yet. Such gives the market a chance to rally further next week into previous resistance from the August/September highs of 2018.
  • QQQ is no longer oversold and the “buy signal” has been reversed. However, the “buy” signal is close to reversal suggesting the current rally may be limited.
  • Support at $185 failed which is now resistance. The tradeable opportunity we suggested last week is in process.
  • Short-Term Positioning: Bullish
    • Last Week: Buy 1/2 position with a target of $185
    • This Week: Hold 1/2 position with a target of $185
    • Stop-loss moved up to $175
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • As noted several weeks ago, SLY has fallen apart as market participation has weakened. SLY, and MDY are particularly susceptible to “trade wars” and slowing economic growth.
  • The modest “buy” signal has reversed and is now on a sell signal.
  • There are a lot of things going wrong with small-caps currently so the risk outweighs the reward of a trade at this juncture.
  • Short-Term Positioning: Bearish
    • Last Week: Stops violated. Sell position.
    • This Week: No position.
    • Stop loss violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY, like SLY, is technically not in great shape.
  • MDY failed to hold its 200-dma, failed at support from the lows of early 2018, and remains in a downtrend.
  • As noted last week, Mid-caps were oversold and the extremely extended “buy” signal had reversed and is about to turn into an outright sell signal.
  • The rally this past week did get MDY back above the 200-dma and is not overbought yet which suggests we could see a further rally this coming week.
  • Short-Term Positioning: Neutral
    • Last Week: Sell any rally this week
    • This Week: Look to sell any further rally this week if not already done so.
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM has failed support, broke below the 200-dma, and has continued within its longer-term downtrend.
  • Last week, a “sell signal” was triggered.
  • Short-Term Positioning: Bearish
    • Last Week: Closed all positions.
    • This Week: No position recommended at this time.
    • Stop-loss violated.
  • Long-Term Positioning: Neutral

International Markets

  • EFA broke below important support previously which negated previous recommendations.
  • EFA is maintaining its 200-dma.
  • EFA is has reversed its oversold condition and is not overbought yet. The “buy signal” is being reversed.
  • Short-Term Positioning: Neutral
    • Last Week: Stop loss violated. Sell any rally.
    • This Week: Sell current holdings this week if not already done.
    • Stop-loss at $64 has been violated.
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • A month ago, we noted the rally in oil had gotten way ahead of itself in the face of building supplies and that the risk was clearly to the downside.
  • We also noted that if support at $60 failed, along with the 200-dma, the risk was to the mid- to low-$50’s.
  • We tagged $51/bbl and WTIC got very oversold so the modest bounce last week was not surprising.
  • Look for a further rally this week along with the equity market but this is likely an opportunity to reduce exposure if you are still long.
  • WTIC is oversold and the “buy signal” is continuing to be reversed.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position.
    • Stop-loss violated at $60.
  • Long-Term Positioning: Bearish

Gold

  • As noted last week, “Finally, Gold popped last week as Trump launched a trade war with Mexico along with China.”
  • Gold quickly reversed its oversold condition to overbought and did break above its downtrend.
  • We also noted, that the mild sell-signal would reverse back onto a “buy” which has occurred.
  • We noted last week that we were maintaining our position as a hedge against a potential pick up in volatility over the summer. That worked well again this past week.
  • Gold is too extended to add to positions here.. Look for a pullback to $122-123 to add.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole set at $120
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • Bonds rallied again this week as “trade war” continued to rattle the equity markets sending money searching for “safety.” Prices on bonds have gone parabolic and are now at extremes.
  • As we stated last week: “We should see a counter-trend rally in stocks next week and a reversal of rates back to $126”
  • Currently on a buy-signal (bottom panel), bonds are now back to very overbought conditions and are testing the previous highs from 2016.
  • Support held at $122 which now become extremely important support.
  • Strong support at the 720-dma (2-years) (green dashed line) which is currently $118.
  • Short-Term Positioning: Bullish
    • Last Week: Take profits and rebalance risks. A correction IS coming which will coincide with a bounce in the equity markets into the end of the month.
    • This Week: Same as last week.
    • Stop-loss is moved up to $122
    • Long-Term Positioning: Bullish

U.S. Dollar

  • The dollar finally pulled back last week from the more extreme overbought level.
  • USD is testing the uptrend support level and is on a buy signal.
  • Hold current positions but maintain stop levels.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position
    • Stop loss is set at $96

There is little denying the rise of “socialistic” ideas in the U.S. today. You can try and cover the stench by calling it “social democracy” but in the end, it’s still socialism.

Since 1775, millions of Americans have given their lives in defense of the American “idea.” The tyranny and oppression which arise from communism, socialism, and dictatorships have been a threat worthy of such sacrifice. I am sure those patriots who died to ensure the “American way of life” would be disheartened by the willingness of the up and coming generations adopt such ideals.

But such shouldn’t be a surprise. It is the cycle of all economic civilizations over time as we “forget our history” and become doomed to repeat. it.

Scottish economist Alexander Tytler, who, in 1787, was reported to have commented on the then-new American Republic as follows:

“A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship.

The average age of the world’s greatest civilizations has been about 200 years. These nations always progressed through this sequence:

  • From Bondage to Moral Certitude;
  • from Moral Certitude to Great Courage;
  • from Great Courage to Liberty;
  • from Liberty to Abundance;
  • from Abundance to Selfishness;
  • from Selfishness to Complacency;
  • from Complacency to Apathy;
  • from Apathy to Dependency;
  • from Dependency to Bondage.”

Since Tytler’s time, we’ve been able to witness many formerly free countries slide inexorably into their final stages of decline. For example, the countries in the EU are further gone than the countries in North America, and Venezuela is, well, just gone.

Currently, it is fairly evident that the U.S. has moved from complacency to apathy, given the lack of will by any political party to tackle the debts, deficits, and underfunded pension system. Then there are the calls for more government support in everything from absolving student loan debt to government guaranteed employment. As we discussed recently in “MMT – Sounds Great In Theory:”

“While MMT sounds great at the conversational level, so does ‘communism’ and ‘socialism.’ In practice, the outcomes have been vastly different from the theory. The real crisis lies between the choices of ‘austerity’ and continued government ‘largesse.’ One choice leads to long-term economic prosperity for all, the other doesn’t.”

But, here we are, almost 243 years after the United States was founded, and only 36 percent of Americans are satisfied with the current state of the country, according to a recent Gallup poll. Of the 61 percent that are unsatisfied, many believe the social, economic, and cultural issues plaguing the country will lead to its downfall.

The reasoning can be clearly seen in study after study of the finances of American households

“Some 23 percent of Americans have to use their credit cards to cover basic necessities, including rent, utilities and groceries, according to a new survey. An additional 12 percent of Americans say that medical bills account for the largest share of their debt, according to the survey of 2,200 U.S. adults by CNBC Make It and Morning Consult.

In addition, Americans have an average of $6,506 in credit card debt, according to a separate report out this week by the Experian credit agency. Just 49 percent of Americans say their job income alone is enough to pay the bills.”

We have discussed this problem previously:

“Assuming a ‘family of four’ needs an income of $58,000 a year to just ‘make it,’ such becomes problematic for the bottom 80% of the population whose wage growth falls far short of what is required to support the standard of living, much less to obtain ‘happiness.’ 

The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living, so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $3200 annual deficit that cannot be filled.”

This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.

The Rise Of Socialism (Dependency To Bondage)

How did a country which was once the shining beacon of “capitalism” become a country on the brink of “socialism?”

Changes like these don’t happen in a vacuum. It is the result of years of a burgeoning divide between the wealthy and everyone else. It is also a function of a 40-year process of capitalism morphing an entire population into “debt slaves” to sustain economic prosperity. 

It is a myth that the economy has grown by roughly 5% since 1980. In reality, economic growth rates have been on a steady decline over the past 40 years, which has been supported by a massive push into deficit spending by consumers.

Look closely at the chart above. From 1950-1980 the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span rising from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily in production and manufacturing which has a high multiplier effect on the economy.  This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980.

As we have discussed previously in “The Breaking Point,” beginning in 1980 the shift of the economic makeup from a manufacturing and production based economy to a service and finance economy, where there is a low economic multiplier effect, is partially responsible for this transformation. The decline in economic output was further exacerbated by increased productivity through technological advances, which while advancing our society, plagued the economy with steadily decreasing wages.  Unlike the steadily growing economic environment prior to 1980; the post-1980 economy has experienced by a steady decline. Therefore, a statement that the economy has been growing at 5% since 1980 is grossly misleading. The trend of economic growth, wages, and productivity (5-year averages) show the real problem.

This decline in economic growth has kept the average American struggling to maintain their standard of living. It is from that perspective the rise of socialistic ideas should be of no surprise. As wages declined, families were forced to turn to credit to fill the gap in maintaining their current standard of living. This demand for credit became the new breeding ground for the financed based economy. Easier credit terms, lower interest rates, loose lending standards and less regulation fueled the continued consumption boom. 

While America on the surface was the envy of the world for its apparent success and prosperity; the underlying cancer of debt expansion and lower personal savings was eating away at its core.

Here is another way to look at it. 

What would the economic growth rate be WITHOUT the debt. Instead of $18 Trillion (inflation-adjusted) it would be a negative $50 Trillion.

This chart shows why “socialism” is now “a thing.”

The massive indulgence in debt, what the Austrians refer to as a “credit induced boom”, has now reached its inevitable conclusion. The unsustainable credit-sourced boom, which leads to artificially stimulated borrowing, seeks out diminishing investment opportunities. Ultimately these diminished investment opportunities lead to widespread malinvestments. Not surprisingly, we clearly saw it play out “real-time” in everything from subprime mortgages to derivative instruments which was only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk.

When credit creation can no longer be sustained the markets must began to clear the excesses before the cycle can begin again.  It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses.  This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE to tax cuts, only delay the clearing process. Ultimately, that delay only potentially worsens the inevitable clearing process.

The clearing process is going to be very substantial. The economy is currently requiring roughly $3 of total credit market debt to create $1 of economic growth. A reversion to a structurally manageable level of debt would involve a nearly $30 trillion reduction of total credit market debt. The economic drag from such a reduction will be dramatic while the clearing process occurs.

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns, and a stagflationary environment as wages remain suppressed while costs of living rise. However, only by clearing the excess can the personal savings return to levels which can promote productive investment, production, and ultimately consumption.

Does this mean that all is doomed? Of course, not. However, we will likely remain constrained in the current cycle of “spurt and sputter” growth cycle we have witnessed since 2009. Such will be marked by continued volatile equity market returns, and a stagflationary environment, as wages remain suppressed while costs of living rise. 

The end game of three decades of excess is upon us, and we can’t deny the weight of the debt imbalances that are currently in play. The medicine that the current administration is prescribing is a treatment for the common cold; in this case a normal business cycle recession. The problem is that the patient is suffering from a “debt cancer,” and until the proper treatment is prescribed and implemented; the patient will most likely continue to suffer.

If I am wrong, then a rising percentage of Americans wouldn’t be supporting the idea of “socialism?”


  • Is The Sellable Rally Done?
  • Some Comments On The Fed Cutting Rates
  • Sector & Market Analysis
  • 401k Plan Manager

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


Are YOU: Age 60 and over. • Concerned about retirement health care expenses. •Recently retired, or planning to retire soon. • Wanting to understand how to begin making important Medicare decisions. 

Then this “Lunch & Learn” is for you. Class size is very limited so register now


Is The Sellable Rally Done?

In last weeks missive, I noted the oversold condition of the market and the likelihood of a bounce:

“This week we are going to look at the recent sell-off and the potential for a short-term ‘sellable’ rally to rebalance portfolio risks into.

The markets only need some mildly positive news at this point to spur a ‘short-covering’ rally. I would encourage you to use it to reduce risk, rebalance holdings, and raise cash until the ‘trade war smoke’ clears.” 

The market did indeed rally last week. While the initial sell-off in the market was attributed to potential tariffs on Mexico, which were indefinitely suspended on Friday, the real reason was the dismal employment report of just 75,000 jobs. 

“The economy added only 75,000 jobs in May, about 100,000 fewer than expected, a sign that the slowing that is showing up in other parts of the economy is now affecting the job market.” – CNBC

A couple of months ago, I warned of the potential for weaker employment as the “household” survey had already dropped sharply. It is likely, that without some major natural disasters which spurred a temporary bump in hiring in 2018, that official employment rates are going to play catchup. 

If we just use a simple 12-month moving average of the non-seasonally adjusted data, we get a better picture about what is actually happening in the economy. (NOTE: the official BLS measure consistently OVERSTATES employment during expansions and plays catchup during recessions.)

“So, why are the markets rallying?” 

Two words – Rate. Cuts.



With employment weakening, along with a wide swath of economic data, stocks rallied sharply on Friday as the bond market priced in a certainty of a rate cut by the Federal Reserve. 

“Stocks initially sold off on the report but then moved higher as the market took the news as a sign the Fed would cut interest rates. In the Treasury market, yields, already in steep decline this week, fell further. The 2-year yield closely reflects expectations for Fed policy, and it fell to 1.77% from an intraday high of 1.89%. The 10-year yield, which influences mortgages and other loans, fell to a low of 2.059%.” – CNBC

There is a very important misconception at play here. 

What the report implies is that the “economy” is just a reflection of whatever the stock market does. However, that is inaccurate. Given that corporate profits are driven by the products they sell, and the price of stocks is based upon future expectations of the cash flows and earnings, ultimately the price of the market is slave to the direction of the economy. 

Interest rates are the best predictor of the economic strength, and the yield curve has been screaming both “deflation” and “economic weakness” for months. (We have repeatedly warned on this issuesee here)

But more importantly, is the inversion of the Fed Funds rate to the 10-year Treasury. 

Here is the MOST important point of both charts above. Recessions don’t kick in until these inversions are reversed. 

This is why David Rosenberg was absolutely correct last week when he stated:

“You don’t go long the first rate cut, you go long on the last one.”

This is because by the time the Fed quits cutting rates, the recession will be near its trough and the corresponding bear market in equities is almost complete. 



As I stated, the rally this past week was expected. In fact, we alerted our RIA PRO subscribers (FREE 30-day trial) to a “trading opportunity” in the market on Monday. To wit:

  • SPY has corrected the overbought condition and is testing the 200-dma.
  • The “buy” signal in the lower panel was massively extended, as noted several weeks ago, which as we stated, suggested the reversal we have seen was coming.
  • The correction last week has set up a tradeable opportunity into June.
  • Short-Term Positioning: Bullish
    • Add 1/2 position with a target of $290.
    • Stop-loss remains at $275

The question to answer this week, is whether there is more left to this rally before the next decline?

More To Go

I think the answer to that question is “yes.”

I recently interviewed Charles Nenner who is a practitioner/forecaster of long-term stock market cycles. As he correctly predicted in our discussion, this current rally would start at the end of May and last into July before the next more serious decline begins. (Forecast begins around 1:30)



His comments align much with ours from last week:

“In the very short-term the markets are oversold on many different measures. This is an ideal setup for a reflexive rally back to overhead resistance.”

Chart updated through Friday’s close:

The markets have only reversed about half of the previously oversold condition which leaves some “fuel in the tank” for a continuation of the rally this coming week. 

However, that doesn’t mean the “bull is back” and you should be complacent about your portfolio. The market remains on an important SELL signal as shown below. The last two times the S&P 500 has triggered a similar sell signal, there were sharp, aggressive, rallies which were fully reversed just a few weeks later. The current market action is extremely similar to those previous events. 

The difference this time, is that many of the supports which drove the recoveries previously are either a) not present, or b) have already been priced in. As I said, while I think there is more to go in the short-term, it is highly likely the current rally will fail.

  • While it’s good that “potential” tariffs on Mexico were delayed, they were only a threat. Tariffs are still in play with China and there has been NO progress on a trade deal.
  • Earnings estimates are still far too high going into the end of 2019 and 2020. Read This
  • Economic data has turned markedly weaker both globally and domestically. 
  • Expectations for a positive effect from more QE and rates cuts are likely misplaced. Read This.
  • At the end of September, Congress will face a debt ceiling and potential Government shutdown. The subsequent $4 Trillion continuing resolution will likely undermine confidence in economic sustainability as the deficit surges will past $1.5 Trillion. 
  • There are no current supportive tailwinds (disaster recovery, tax cuts, etc.) to support economic growth. 

We remain primarily long-biased in our portfolios, but are also slightly overweight in cash, and portfolio weight in fixed income. We are also carrying some hedge by having overweighted “defensive” stocks a couple of months ago which have continued to provide outperformance. 

There is a very good possibility this rally will continue next week as momentum and short-covering levels have been breached. However, if the market fails to set a new high and turns lower, the risk of a downside break will grow as we progress into summer. The weekly chart below, is also suggestive the recent rally is likely unsustainable as with a “sell signal” in place, and our volume signal back at extremely low levels, suggesting a lack of commitment from traders, and volatility still at elevated levels and rising, have marked the last two tops.

Remain cautious for now. The market is still at the same level as it was 18-months ago, and it is quite likely it will be at these levels, or lower, by the end of the summer. 

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

See you next week.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet

  


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels

Sector-by-Sector

Improving – Financials and Staples

As we have noted over the last couple of weeks, the “defensive” rotation continues for now. We recommended previously to use weakness in the defensive areas to add exposure accordingly. We previously overweighted in staples, heaalthcare, and utilities. 

It is too late to add further exposure here as the sectors are back to very overbought. Be patient as wait for a pullback over the next couple of months. 

Current Positions: Overweight XLP, Target weight XLF.

Outperforming – Technology, Discretionary, Communications

While these sectors rallied sharply this past week, their outperformance over the market is waning quickly. Over the last several weeks, we have recommended taking profits and rebalancing portfolio risks accordingly. That remains the same recommendation this week given the reflexive rally we discussed last week when we stated:

“This should be done on a counter-trend rally back towards the 2800 level on the S&P index.” 

Current Positions: 1/2 weight XLY, Reduced from overweight XLK

Weakening – Real Estate and Industrials

As noted two weeks ago, Real Estate has continued to attract buyers particularly as interest rates have fallen. That performance has improved this past week as yields have collapsed towards 2% on Treasuries. We continue to carry our current weight in Real Estate and are looking for some opportunities to overweight the sector. Industrials bounced this past week, but their relative performance continues to drag. We remain underweight industrials currently. 

Current Position: XLRE, 1/2 XLI

Lagging – Healthcare, Staples, Financials, Materials, Energy, and Utilities

While these sectors are currently lagging the performance of the S&P 500, on a short-term basis, longer-term they have been strong winners. Importantly, that performance lag in Staples, Financials, Utilities, and Healthcare, have improved markedly over the last week.

As noted, we have slightly overweighted staples and utilities to go along with our overweight healthcare positioning currently.  where relative performance is improving as a “risk off” rotation occurs. While we are maintaining a 1/2 position in XLE, it is not performing well and we may be required to “cut it loose” if performance doesn’t improve soon. 

Importantly, let me reiterate our closing statement from last week:

All sectors are VERY OVERSOLD currently. Look for a rally in the next week to begin rebalancing risks and weightings accordingly. This could be your best, last chance, for the rest of the summer.

We may have some follow through rally this week, but use any further rise to take action accordingly. 

Current Positions: 1/2 XLB, 1/2 XLE, XLF, Overweight XLV, Overweight XLP,  Overweight XLU

Market By Market

The rally this past week was very concentrated and has all the earmarks of a short-term “short-covering” rally. 

Small-Cap and Mid Cap – Small-cap and Mid-cap previously both failed to hold above their respective 50- and 200-dma which keeps us from adding a position in portfolios. Last week, Midcap rallied above the 200-dma but is heading into a lot of resistance. We will need to patient to see if there is any follow through. As noted, these sectors are mostly tied to the domestic economy and their lack of performance is concerning relative to the economic backdrop. 

Current Position: No position

Emerging, International & Total International Markets 

As noted two weeks ago:

The re-institution of the “Trade War” kept us from adding weight to international holdings. We are keeping a tight stop on our 1/2 position of emerging markets but “tariffs” are not friendly to the international countries. 

Last week, we were stopped out of our emerging market position. We have no long exposure to international markets currently. However, industrialized international is challenging its 50-dma once again. It is too soon to take on exposure as the current trend remains concerning. However, we are watching for an opportunity to add exposure if the technicals warrant the risk.

Current Position: Sold EEM

Dividends, Market, and Equal Weight – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with respect to economic growth and inflation. Currently, the short-term bullish trend is positive and our core positions are providing the “base” around which we overweight/underweight our allocations based on our outlook. 

As we stated last week:

That correction has continued for a second week, and all of our core positions are oversold. We should see a bounce in the markets next week and we will decide how to hedge our core positions.” 

Current Position: RSP, VYM, IVV

Gold – With rates dropping sharply and deflationary pressures on the rise, Gold finally got a bid over the last couple of week. Gold is now challenging its highs from February of this year. Gold has provided a good hedge in our portfolios against the recent decline and a breakout above current levels would suggest substantially higher prices. 

Current Position: GDX (Gold Miners), IAU (Gold)

Bonds 

As the beginning of May, we said bonds were setting up for a nice entry point to add additional bond exposure. Bonds bounced off the 50-dma holding important support last week. Bonds are now back to overbought, take some profits and rebalance weightings but remain long for now.

Current Positions: DBLTX, SHY, TFLO, GSY

High Yield Bonds, representative of the “risk on” chase for the markets rallied sharply with the market this week as “shorts” were forced out of their holdings. Not surprisingly, the “junk” rally has taken the market from oversold back to fairly overbought. Given the deteriorating economic conditions, this would be a good opportunity to reduce “junk rated” risk and improve credit quality in portfolios. 

As we concluded last week:

All equity markets are VERY OVERSOLD currently. Look for a rally in the next week to begin rebalancing risks and weightings accordingly. This could be your best, last chance, for the rest of the summer.

That advice remains this week. 

The table below shows thoughts on specific actions related to the current market environment. 

(These are not recommendations or solicitations to take any action. This is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

 

Portfolio/Client Update:

From last week:

“We have continued to rebalance our risks and more to a more defensive positioning the short-term and are carrying additional cash in our portfolios.”

As noted three weeks ago, we have shifted our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

There are indeed some short-term risks in the market as we head into summer, so any positions added to portfolios in the near future will carry both tight stop-loss levels and will be trading positions initially until our thesis is proved out. 

  • New clients: Our onboarding indicators are “risk off” currently, so new accounts will remain in cash for the time being. Positions that were transferred in are on our global review list and will be monitored for an opportunity to liquidate to raise cash to transition into the specific portfolio models.
  • Equity Model: After taking profits recently, we are well positioned for the current volatility and rotation into defensive positioning. We are looking at adding selected exposure and are evaluating positions currently. 
  • ETF Model: We overweighted our exposure to defensive areas by adding Real Estate and overweighting Staples and Utilities. We are evaluating opportunities in some other areas of opportunity but are likely to hold flat into next week. 
  • In both the Equity and ETF Models: We increased the duration of bond portfolio by adding in 7-10 year duration holdings and hedge our risk with an increased weighting in IAU. Both bonds and gold are very overbought so we are looking for pullbacks to support to increase exposures.

Note for new clients:

It is important to understand that when we add to our equity allocations, ALL purchases are initially “trades” that can, and will, be closed out quickly if they fail to work as anticipated. This is why we “step” into positions initially. Once a “trade” begins to work as anticipated, it is then brought to the appropriate portfolio weight and becomes a long-term investment. We will unwind these actions either by reducing, selling, or hedging, if the market environment changes for the worse.


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.

401k-PlanManager-AllocationShift

Short-Covering Rally As Expected

As noted last week:

“With the market deeply oversold short-term we are expecting a bounce which we can rebalance into and remain defensive.

I would again encourage you to read the commentary above, the bulls, along with the media, are betting on things which have a very low probability of actually occurring. The increasing ‘trade war’ will only succeed in advancing the next recession.”

As reiterated in the main missive above this week, the “risks” still outweigh the “rewards” as we head deeper into the summer months. Importantly, don’t mistake an oversold, short-covering, rally as a bullish sign. More often than not, it is a trap.

We have remained patient over the last several weeks. Last week we stated:

“Should get a bounce next week. On that bounce look to take the following actions.”

  • If you are overweight equities – take some profits and reduce portfolio risk on the equity side of the allocation. Raise some cash and reduce equities to target weights. 
  • If you are underweight equities or at target – rebalance risks, look to increase cash rather than buying bonds at the moment, and rotate out of small, mid-cap, emerging, international markets. 

It is time take some action this coming week.

If you need help after reading the alert; don’t hesitate to contact me.

Thank You, 401k Plan Manager Is Almost Ready

Over the last couple of weeks, we have discussed the launch of our “live” 401k plan manager which will soon be available to RIA PRO subscribers. You will be able to compare your portfolio to our live model, see changes live, receive live alerts to model changes, and much more. 

We are building models specific to company plans. So, if you would like to see your company plan included specifically, send me the following:

  • Name of company
  • Plan Sponsor
  • A print out of your plan choices. (Fund Symbol and Fund Name)

I have gotten quite a few plans, so keep sending them and I will include as many as we can. 

If would like to offer our service to your employees at a deeply discounted corporate rate please contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principle. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)

We know you get busy and don’t check on our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything that you might have missed.

The Daily Blog

The Best Of “The Lance Roberts Show”

Podcast Interview Of The Week

Our Best Tweets Of The Week

Our Latest Newsletter

What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

See you next week!

The financial world has been buzzing nervously about the rapidly rising risk of a recession as warning signs mount. Though many mainstream economists and commentators are finally starting to concede that a recession in the next year or two is likely, almost all of them downplay the likely severity of the coming recession by saying “but it will be short-lived!” and “we’re due for a healthy slowdown after a ten year expansion!” (economists were saying the same thing in 2006 and 2007 too). My view, however, is that virtually everyone is underestimating the tremendous economic risks that have built up globally during the past decade of extremely stimulative monetary policies. I believe that these unknown risks are going to rear their ugly heads with a vengeance in the coming recession and that heavily indebted governments will have far less firepower with which to rescue their economies like they did during the 2008 to 2009 Global Financial Crisis.

According to the New York Fed’s very accurate yield curve-based recession probability model, there is a 27% probability of a U.S. recession in the next 12 months. The last time that recession odds were the same as they are now was in early-2007, which was shortly before the Great Recession officially started in December 2007 – talk about too close for comfort!

The New York Fed’s recession probability model is based on the 10-year and 3-month Treasury yield spread, which is the difference between 10-year and 3-month Treasury rates. In normal economic environments, the 10-year Treasury yield is higher than the 3-month Treasury yield. Right before a recession, however, this spread inverts as the 3-month Treasury yield actually becomes higher than the 10-year Treasury rate – this is known as an inverted yield curve. As the chart below shows, inverted yield curves have preceded all modern recessions. The 10-year and 3-month Treasury spread inverted in May, which started the recession countdown clock.

The coming recession is likely to be far more severe than the majority of economists expect because global interest rates have been held at record low levels for a record period of time since the Great Recession, which has completely distorted the global economy and created many dangerous bubbles that most people have no clue even exist (and that includes most professional economists!). Bubbles form during periods of relatively low interest rates and burst when rates rise – that’s why most modern financial crises and recessions have occurred, as the chart below shows. The dot-com and housing bubbles both formed during low interest rate periods and burst when rates started to rise.

Make no mistake: numerous bubbles have formed during the low interest rate period of the past decade and there is no way of escaping their ultimate popping. These bubbles are forming in global debt, China, Hong Kong, Singapore, emerging markets, Canada, Australia, New Zealand, European real estate, the art market, U.S. stocks, U.S. household wealth, corporate debt, leveraged loans, U.S. student loans, U.S. auto loans, tech startups, shale energy, global skyscraper construction, U.S. commercial real estate, the U.S. restaurant industry, U.S. healthcare, and U.S. housing once again. There are likely even more bubbles than I listed – we just won’t know until they all burst. As Warren Buffett once said “only when the tide goes out do you discover who’s been swimming naked.” I believe that the current bubble situation, when looked at globally, is even worse than it was before the 2008 Global Financial Crisis – that’s why the coming crisis is actually likely to be far worse than 2008. How’s that for an unpopular opinion?!

The global bubbles that have formed in the past decade have been exacerbated by an unconventional central bank policy called quantitative easing or QE. QE basically entails creating new money for the purpose of pumping liquidity into the financial system and boosting asset prices. The chart below shows how the U.S. Federal Reserve’s balance sheet grew with each QE program in the past decade (the Fed’s balance sheet grows as it buys assets like bonds to pump more money into the financial system). Of course, the Fed wasn’t the only central bank that conducted QE programs in the past decade – most major central banks did as well, which created a tremendous ocean of liquidity that helped to inflate the numerous bubbles around the world.

As a result of the Fed’s ultra-low interest rates and QE programs, the U.S. stock market (as measured by the S&P 500) surged 300% higher in the past decade:

The Fed’s aggressive inflation of the U.S. stock market caused stocks to rise at a faster rate than their underlying earnings, which means that the market is extremely overvalued right now. Whenever the market becomes extremely overvalued, it’s just a matter of time before the market falls to a more reasonable valuation again. As the chart below shows, the U.S. stock market is nearly as overvalued as it was in 1929, right before the stock market crash that led to the Great Depression.

The Fed’s aggressive inflation of U.S. stocks, bonds, and housing prices has created a massive bubble in household wealth. U.S. household wealth is extremely inflated relative to the GDP: since 1952, household wealth has averaged 384% of the GDP, so the current bubble’s 535% figure is in rarefied territory. The dot-com bubble peaked with household wealth hitting 450% of GDP, while household wealth reached 486% of GDP during the housing bubble. Unfortunately, the coming household wealth crash will be proportional to the run-up, which is why everyone should be terrified of the coming recession. 

Not only have more bubbles inflated around the world than in the mid-2000s, but governments are far more indebted now (government debt is now at 80% of global GDP), which means that they have much less firepower with which to rescue their economies in the coming crisis. In the case of the U.S., federal debt as a percent of GDP has never been so high before a recession (it’s currently at 100% of the GDP vs. 62% before the Great Recession), so we are truly in unprecedented times.

Though interest rates have been at ultra-low levels for the past decade, the sheer amount of U.S. federal debt (over $22 trillion) is the reason why interest payments have spiked over the past couple years. To make matters worse, this debt will eventually need to be refinanced at higher interest rates, which means that interest payments will rise even more. Another recession combined with another ramp-up of federal debt and ensuing debt downgrades will cause these payments to rise even more. This is how sovereign debt crises happen.

Though the Great Recession was essentially caused by a debt crisis, both public and private U.S. debt have continued to grow since then. The so-called U.S. economic “recovery” didn’t occur in spite of the post-Great Recession debt growth – it occurred because of that very debt growth. What most people don’t understand is that debt creates temporary economic growth by borrowing from the future. We’re making the same mistakes that we made before 2008, yet expecting different results. Unfortunately, the outcome will be the same as in 2008, if not worse, due to the even higher debt load we now have.

The world has been on an unprecedented debt binge in the past several decades. Global debt is up by $150 trillion since 2003 and $70 trillion since 2008. As bad as the 2008 crisis was, we now have an addition $70 trillion worth of debt to contend with in the coming crisis.

In virtually every major economy, debt has grown at a much faster rate than the underlying GDP in the past several decades:

As a result of debt growing faster than the underlying economies themselves, global debt as a percent of GDP has increased quite substantially in the last several decades. The global economy is now saturated with debt, which will make it much harder to grow out of the coming recession by taking on even more debt like we did in the past.

In particular, China has binged harder on debt than any other country since the Great Recession. China’s gigantic debt mania of the past decade greatly helped to boost its economic growth, which made it one of the most important global engines of economic growth in turn. Essentially, China’s debt bubble helped to carry the global economy for the last ten years. Unfortunately, China is nearly tapped out and is heading for a bust of its own, which will drag down the entire global economy with it. There will be no “new Chinas” to binge on debt and carry the global economy after the next global financial crisis – no other country has the capacity to throw such a wild debt party.

To summarize, the vast majority of economists and commentators are assuming that the coming recession will be a garden-variety recession – a mere ebb of the business cycle. They’re expecting a walk in the park relative to the massive debt and bubble tsunami that I see on the horizon. Remember, this is the exact same crowd who downplayed or completely missed the warning signs of the U.S. housing bubble and global financial crisis as well. Apparently, this group still has not learned their lesson, so they will be taught it once again – and we’re all going to suffer as a result of their ignorance. If you are not terrified by the thought of the coming recession, you have no clue about the tremendous risks that have built up in the past decade. The risk of a full-blown global depression cannot be discounted.

Parts One through Three of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

In Part One, the introduction to our Value Your Wealth series, we documented how recent returns for investors focused on growth companies have defied the history books and dwarfed returns of investors focused on value stocks. In particular: “There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.”

In this, the fourth part of the Value Your Wealth series, we focus on growth and value mutual funds and ETFs. Our purpose is to help determine which professional value and growth fund managers are staying true to their stated objectives.

Fund Analysis

A large part of most investor’s investment process starts with the determination of an investment objective. From this starting point, investors can appropriately determine the asset classes and investment strategies that will help them achieve or even exceed their objectives. 

Once an investor decides upon an objective, strategy, and asset class, they must select individual securities or funds. This article focuses singularly on assessing growth and value mutual funds and ETFs. In particular it shows how an investor focused on growth or value can choose funds that are managed properly to meet their goals.

Investors usually key on the following factors when selecting a mutual fund or ETF: 

  • Declared fund strategy (Growth or Value in this case)
  • Prior period returns
  • Fee and expense structure
  • Reputation of the fund family and possibly the manager

These four factors provide valuable information but can be misleading.

For instance, prior returns provide a nice scorecard for the past but can be deceptive. As an example, if we are currently scanning for value funds based on performance, the highest ranking funds will more than likely be those that have leaned most aggressively toward growth stocks. While these funds may seem better, what we believe is more important the fund managers adherence to their objectives.  Given we are looking forward and believe value will outperform growth, we want fund managers that we can trust will stick with value stocks.

It is also important not to shun funds with the highest expenses and/or gravitate towards those with the lowest. We must be willing to pay up, if necessary, to achieve our objectives. For instance, if a fund offers more exposure to value stocks than other comparable value funds, it may be worth the higher fee for said exposure. Conversely, there are many examples where one can gain more exposure to their preferred strategy with cheaper funds. 

Most investors check the fund strategy, but they fail to determine that a fund is being effectively and cost efficiently managed towards their stated strategy. 

We now compare the largest growth and value mutual funds and ETFs to assess which funds offer the most value, so to speak. 

Mutual Fund/ETF Analysis

In order to limit the population of value and growth mutual funds and ETFs to a manageable number, we limited our search to the largest funds within each strategy that had at least 85% exposure to U.S. based companies. We further restricted the population to those funds with a stated strategy of growth or value per Bloomberg.

In prior articles of this series, we have used Bloomberg growth and value factor scores and our own growth and value composite scores. While we would prefer to use our own computations, the large and diverse holdings of the mutual funds and ETFs make it nearly impossible for this exercise. Accordingly, Bloomberg growth and value factor scores provide us the most accurate description of where the respective funds lie on the growth/value spectrum. It is important to note that Bloomberg assigns every fund both a growth and a value score. We consider both scores and not just the score pertinent to growth or value.

We understand most of our readers do not have access to Bloomberg data. As such, we provide a DIY approach for investors to track growth and value exposure amongst mutual funds and ETFs.

Growth and Value Scores

The scatter plot below shows the 54 funds analyzed. Each dot represents a fund and the intersection of its respective growth (x-axis) and value scores (y-axis). The funds most heavily skewed towards value (high value scores and low growth scores) are in the upper left, while heavily growth oriented funds are in the bottom right (high growth score and low value scores).  Information about the funds used in this report and their scores can be found in the tables below the graph. Certain funds are labeled for further discussion.   

A few takeaways:

  • VIVAX (Growth -.60, Value +.37): While this value fund is farthest to the left, there are other funds that offer more value exposure. However, this fund has the lowest growth score among value funds.
  • DFLVX (Growth -.43, Value +.68): This value fund offers an interesting trade off to VIVAX sporting a higher value score but a less negative growth score.
  • AIVSX (Growth +.10, Value -.05): Despite its classification as a value fund, AIVSX has a slight bias towards growth. Not surprisingly, this fund has recently outperformed other value funds but would likely underperform in the event value takes the lead.
  • FDGRX (Growth +.88, Value -.64): This growth fund offers both the highest growth score and lowest value score. For investors looking for an aggressive profile with strong growth exposure and little value exposure, this fund is worth considering.
  • VPMCX (Growth -.04, Value +.16): Despite its classification as a growth fund, VPMCX has a slight bias towards value.
  • In our opinion, the six funds with growth and value scores near zero (+/-.20) in the red box do not currently have a significant growth or strategy orientation, and as such, they are similar to a broad market index like the S&P 500.

It is important to stress that the data represents a snapshot of the fund portfolios for one day. The portfolio managers are always shifting portfolios toward a value or growth bias based on their market views.

 (CLICK on the tables to enlarge)

Data Courtesy Bloomberg

The data above gives us potential funds to meet our strategic needs. However, we also need to consider fees.  

Fees

The scatter plots below isolate growth and value funds based on their respective growth or value score and fees charged.

We circled three groupings of the growth funds to help point out the interaction of fees and growth scores. The four funds in the blue circle have average or above average fees versus other growth funds yet provide a minimal bias towards growth. The yellow circle represents a sweet spot between low fees and a good exposure to growth stocks. Lastly, the red circle shows funds where  heavy exposure to growth comes with above average fees.

This graph circles three groupings of value funds to help point out the interaction of fees and growth scores. The blue circle contains funds with little to no bias towards value. The yellow circle represents a good mix of value and cheap fees. The red circle, our sweet spot in this graph, shows that heavy exposure to value can be had with fees near the group average.

Alpha and Bad Incentives 

Alpha is a measure that calculates how much a portfolio manager, trader, or strategy over or underperforms an index or benchmark. From a career perspective, alpha is what separates good fund managers from average or bad ones.

We mention alpha as we believe the current prolonged outperformance of growth over value is pushing professional fund managers to stray from their stated objectives. As an example, a value based fund manager can add exposure to growth stocks to help beat the value index he or she is measured against.

Adding growth to a value fund may have proven to be alpha positive in the past, but we must concern ourselves with how well the fund manager is adhering to the fund’s objective Simply put, we are trying to find managers that are staying true to their objectives not those who have benefited from a deviation from stated strategy in the past.

It is important to note that positive alpha can be attained by sticking to the stated objective and finding stocks that outperform the index. This is the type of alpha that we seek.

DIY

As discussed, growth and value factors can change for funds based on the whims of the portfolio manager. Therefore, the data provided in this article will not age well. If you do not have access to Bloomberg to track value and growth scores we offer another approach.

Morningstar provides a blunt but effective style analysis tool.  To access it, go to www.morningstar.com and select your favorite fund. Then click on the tab labeled Portfolio and scroll down to Style Details.

The following screen print shows Morningstar’s style analysis for value fund DFLVX.

The box in the top right separates the fund’s holdings by market capitalization and value growth classifications. We can use this data to come up with our own scores. For instance, 59% (46+13) of DFLVX is biased toward value (red circle) while only 6% (5+1) is in growth companies (blue circle). To further demonstrate how a fund compares to its peers, the Value & Growth Measures table on the bottom left, compares key fundamental statistics. As shown by three of the first four valuation ratios, DFLVX has more value stocks than the average for funds with similar objectives.

Summary

The word “Value” in a fund name does not mean the fund takes on a value bias at all times. As investors, we must not rely on naming conventions. This means investors must do some extra homework and seek the funds that are truly investing in a manner consistent with the funds, and ultimately the investor’s, objective.

As we have mentioned, we are at a point in the economic and market cycles where investors should consider slowly rotating towards value stocks. Not only is the style historically out of favor, many of the names within that style are unjustifiably beaten down and due for mean reversion to more favorable levels. We hope this article provides some guidance to ensure that those who heed our advice are actually adding value exposure and not value in name only.

Passive funds have come a long, long way from their humble beginnings. Having started as small and scrappy and distinctly out-of-consensus investment options, they have grown impressively over the last ten years and now are often considered the defaults for many investing activities.

As passives have grown, however, an important dynamic has changed. When passive funds comprised only a small part of the total market, it didn’t matter much that they allocated capital according to criteria that were entirely unrelated to economic fundamentals. As a much larger (and still growing) mass of funds, this quirk is having a progressively greater effect on market prices.

Although few would be surprised that passive funds have been gaining share at the expense of active funds, the extent of that progress is not often highlighted. This makes the recent Morningstar Direct Fund Flows Commentary from April 2019 (h/t Almost Daily Grants) all the more newsworthy. The report noted that:

“A $39 billion inflow in passively-managed assets in April pushed the total to $4.3 trillion, within $6 billion of eclipsing the total assets invested in active management”.

Kevin McDevitt, who authored the report noted, “This is a milestone that has been a long time coming as the trend toward low-cost fund investing has gained momentum.” Further, almost all the growth in passives has been funded by flows out of active funds. As McDevitt highlighted, “active U.S. equity managers have seen funds decrease in every year since 2006”.

Coincident with the passive share milestone, a couple of studies appeared in the recent Financial Analysts Journal that speak to some increasingly visible problems with passive investing. The first, entitled, “The revenge of the stock pickers“, focuses on the awkward and often inefficient ways in which ETFs discount thematic news:

“When an exchange-traded fund (ETF) trades heavily around a theme, correlations among its constituents increase significantly. Even some securities that have little to no exposure to the theme itself begin to trade in lock-step with other ETF constituents. In other words, because ETF investors are agnostic to security-level information, they often ‘throw that baby out with the bathwater’.”

Of course, this is the type of thing that causes active investors to salivate at the opportunity. Indeed, the authors confirm, “When high-volume selloffs occur, ETF investors may be leaving as much as 200-300 bps of alpha on the table for stock pickers to capture over the following 40 days.” The opportunity for the active investor is conditioned on only two basic questions: “Why is the ETF selling off, and should this constituent be selling off with it?”

Often the answers are not hard to find. The article outlined the example of pharmaceutical stocks in September 2015. At that time the New York Times reported Turing Pharmaceuticals had massively increased the price of a life-saving drug. The next day, presidential candidate Hillary Clinton tweeted that she would develop a plan to curtail price gouging by pharmaceutical firms. A week later, Valeant Pharmaceuticals was scrutinized by the House of Representatives in regard to drug price increases. These headlines had an interesting effect on the Health Care Select Sector SPDR ETF (XLV):

“Both these events threatened to put pressure on revenues for the pharmaceuticals sector but not necessarily for other health care stocks. Although some companies were directly in the line of fire, we find it hard to imagine how regulation aimed at human drug pricing would affect companies that make animal medicines and vaccines, such as Zoetis, or medical equipment, such as Baxter International. Yet all XLV constituents-without exception-sold off over these seven trading days.”

In other words, it very much appears as if the baby got thrown out with the bathwater. Stocks like Baxter and Zoetis should not have been affected at all by pharmaceutical headlines but were affected simply by virtue of being in the healthcare index. This shouldn’t happen when a market is effective at determines prices.

Another area in which the value proposition of passives can be less than it seems is in the area of factor investing. Factor investing (aka, smart beta) is a form of passive investing in that it foregoes security-level analysis. Rather, it identifies certain “factors” that tend to generate premium returns over time. “Value”, for example, is a well-known factor.

Another factor is “quality” and it is reviewed in the study, “What is quality?“. One of the unique aspects of this particular factor is that there are fairly disparate views as to what constitutes quality. Various funds use very different inputs to capture the essence of quality.

In the authors’ review of literature on the “quality” factor, they find that “profitability, investment (asset growth), accounting quality, and payout/dilution are all strongly related to future return.” Conversely, they also find that the commonly used metrics of “capital structure, earnings stability, and growth in profitability show little evidence of premium.”

So, one point is that the metrics for “quality” that have been demonstrably effective tend to be the same ones that any decent student of finance, or decent CFA charterholder, or decent securities analyst have been trained to identify. The main difference is that factor funds try to do so cheaply and systematically but often superficially, and analysts dig in to confirm economic reality but at a higher cost.

Another point is that at least some “quality” factor funds don’t do what they are supposed to do. Most of the “quality” funds that were examined include metrics that have no evidence of adding value. One of the funds uses only metrics that have no evidence of adding value.

As such, to a greater or lesser degree, most of the “quality” factor funds are more marketing phenomena than they are interesting investment vehicles. They lend credence to the adage that smart beta is simply the combination of smart marketing and dumb beta. They also indicate how alluring narratives and other marketing tools are increasingly tarnishing the field of passive products.

The trend in passives to more aggressively exploit marketing narratives was also revealed by Zerohedge in discussing the “Next Generation of ETFs“. In the increasingly competitive field of passive products, not only is there a need to develop new product ideas in order to keep expanding, but there is a need to raise fees from the paltry levels of the largest, most commoditized funds.

As the story highlights, “While a normal ETF collects fees of as little as $0.20 on every $1,000 invested, AI [artificial intelligence] designed ETFs can justify fees as large as $1.80 to $8 on that same $1,000 investment.” There is no small irony that increasingly aggressive and dubious marketing claims that are designed to increase fees are infecting the field of passive investing. The same types of criticisms that were used by passive funds to gain share at the expense of active funds now applies to those very same passive funds.

While the two FAJ articles highlight some pockets where things can go wrong with passive investing, they only hint at the broader impact passives can have. This broader impact can best be understood as an imbalance. When trading is dominated by active funds, the parties have economic incentives to get the transaction price as right as possible. This keeps prices anchored to economic realities.

When trading becomes dominated by passive funds, however, and passive funds gain share at the expense of active funds (as they have over the last several years), there is no mechanism to anchor prices to economic reality.

Horizon Kinetics reported on this phenomenon in its 4th Quarter 2016 commentary. They describe how “the money flows into index funds pushed up the prices of the index-centric securities”.  They add, at the same time, “the outflow from actively managed funds … has forced active managers to sell and push down the prices of that which they own.” Both trends affect prices in ways that are wholly unrelated to fundamentals.

There are two important consequences of these trends. One is that the growth in passives will slow down:

“But long before such exhaustion of the pool of actively managed equity mutual fund AUM, those outflows must decline significantly. They don’t just continue at a steady rate, then stop on a dime. Moreover, there is some significant number of investors who prefer and will maintain their actively managed assets. Is it 10%, 30%, 40%, of the total equity? So the limit is even closer. And it’s even closer than that, because to keep the perceived equilibrium going, the index fund organizers need to go beyond merely continued net inflow; they need proportionately increased flow, because the market value of everything they are buying is going up; it’s a law of large numbers dynamic. They need more and more money to hold the prices where they are, but the inflow is being drained from a shrinking pool of non-indexed AUM. That’s how all bubbles work.”

A second consequence is that market prices have become progressively more detached from underlying economic fundamentals. How far can valuations get stretched? The folks at Horizon Kinetics provide some color:

“We do not know where the tipping point is. But the minute the inflows [from passives] slow meaningfully, whether that takes three years or ten, the index will no longer set the price, the ETFs will no longer be setting the prices of the winners. At that point, the baton passes to the active managers, and they will set the marginal price.”

So, there are some fairly powerful lessons for investors here. When the baton passes to active investors and they begin setting the marginal price again, there is potential for stocks to go down significantly from current levels. The reason is that active managers set prices according to fundamentals and valuation and passive managers don’t. It is not that fundamentals and valuation have not mattered over the last nine years; it is only that they haven’t mattered to the setters of marginal prices during that period.

Another important point is that change is imminent. Now that passives comprise half of managed funds, there is little room for continued growth at the same rates. As Horizon Kinetics points out, passives “need more and more money to hold the prices where they are, but the inflow is being drained from a shrinking pool of non-indexed AUM.” It’s only a matter of time before that growth must slow.

In addition, whatever selloff might happen could be substantially magnified by a slowdown in corporate share repurchases. Just like passive funds, corporations have also been large purchases of stock and have also been largely insensitive to price in doing so. If share repurchases decline from record levels, it would exacerbate the effect of slowing passive flows.

Further, the success of passive investing has affected the active money management industry in a number of ways. Many active managers have not been able to withstand the performance pressures and have closed down. Many of those who have survived have done so by adapting their approaches to favor money flows over valuation in their analyses. Either way, much of the industry has lost its “muscle memory” for doing rigorous valuation work.

Finally, the 50% milestone creates an excellent opportunity to reflect on the value proposition of passive funds. Since that value proposition is predicated on low cost exposure to something desirable, and the desirability of risk assets depends on prices representing fair value (which translates into adequate expected returns), it also depends on the balance between active and passive investing.

The more passive funds set prices, though, the less balance there is, and the more disconnected prices can stray from economic reality. The result is that owning passive funds simply exposes investors to overvalued assets. In other words, passive funds are becoming victims of their own success by becoming too big to offer the same value proposition they once did.

As a result, the 50% milestone also serves as a warning signal to passive and active investors alike. It signals that the greatest benefits of passive investing are mostly over and are unlikely to ever be repeated to the same degree. It also signals an investment landscape featuring security and entire asset class valuations that are substantially above fair value. Indeed, the balance between passive and active investing may be a more important indicator for investors than either interest rates or economic growth. The bad news is that returns are likely to be poor for the foreseeable future. The good news is that this environment is setting up to be one in which truly active managers are well suited to outperform.

The volatility in the investment markets over the past few months has been truly astonishing. Prices are violently fluctuating and the range of traditional volatility indicators like the VIX have exploded. Just look at the daily moves of the popular U.S. stock market indices for example. While it’s generally folly to attribute specific causes to market action (there are simply too many actors with too many motives), I think it’s fair to say that the trade negotiations with China likely played a part. This got me thinking. How sound a strategy is it to trade the news, so to speak, and what makes for a good investment thesis? Upon reflection, I came to this idea of persistence; that building investments around the metaphysically given is more powerful than those built upon the man-made.

Erratic news flow created large intraday price moves in the S&P 500 and swings in the VIX

The Metaphysically Given & The Man-made

As you might know, I have a penchant for the abstract. I find exploring subjects from a first principles perspective helpful in bringing clarity to chaotic markets—overconfidence bias notwithstanding. Simply, what is should dictate the actions we ought to take. This applies to life as well as investing. Generally speaking, the better I can understand a market trend, the clearer of an investment case I can build.

Within philosophy, there’s a branch that deals with the fundamental study of “stuff.” It’s called metaphysics. Metaphysics examines the nature of the world as we know it. Broadly speaking, there two categories of stuff. The first is the metaphysically given. The second is the man-made.

The metaphysically given are things native to the natural world. Not just the objects but also the immutable laws of nature that govern them. Rocks are hard and sink in water, apples ripen and fall from trees, fish have gills and breathe and swim underwater, and people are mammals with an ability to think abstractly. The metaphysically given merely describes of world without consideration for human influences.

The man-made is the opposite. It is those objects—both physical and conceptual—that arise from human action. Cars, mathematics, and investment markets are all man-made objects; they could not exist without us.

Thus, a country’s border is an example of the man-made. Its physical land is a metaphysical fact.

The Relevance To Investing

Investing is all about information. Prices reflect that which participants currently know about the world. They change when facts change. A stock’s price might rise on account of better than expect financial performance as investors adjust their outlook for a company. The current price is deemed too low and buying bids up the price. It might also rise also due to capital inflows into the asset class as a whole, or as its price trend attracts strategies seeking such patterns. Thus, changes in information related to capital flows impacts investment performance.

Information is constantly changing. However, not all information is created equally. Some is more impactful than others, both in magnitude and duration. Certain news has lasting effects in markets while others’ are fleeting. Thus, the persistence of new information matters. Distinguishing between the metaphysically given and the man-made can provide insight into the impact that information might carry.

The Metaphysically Given & Man-made In Markets

Drawing an analogy from philosophy, we can consider the metaphysically given as the physical structures within capital markets. Similar to the natural world, these cannot be changed easily. Thus, when new information necessitates a price adjustment, the movements can be strong and hard to arrest once initiated. For example, metaphysically-related information might pertain to business cycles, capital cycles, trader positioning (like Commitment of Traders reports), algorithmic trading rules, regulatory requirements (such as risk-based capital guidelines), and changes to federal and state laws. Once new information sets the price of an investment in motion it persists until the market rebalances at the appropriate level.

Man-made information, on the other hand, can create trades with fleeting impacts. These rest upon data that are easily changeable. Those closely watching the markets of late should be familiar with such occurrences. Tweets, central bank messaging, OPEC meetings, executive orders—these circumstances lack persistence. They are reversible with a few taps of a thumb. Hence, man-made price movements can be volatile and profits temporary.

These applications are not limited to macro-level concepts. For example, the revenues associated with products on a new car are more persistent then those from launching a new flavor of yogurt. The same car model is typically sold for 3 to 5 years. Suppliers rarely change over this lifespan. Thus, one’s revenues should be reliable (so long as the vehicle sells, of course). Consumer food preferences, however, frequently change and there are few competitive barriers to entry. Fortunes can come and go in an instant. Similarly, cost savings associated with supply chain changes are likely to be lasting, while those resulting from a reduction in advertising might not.

Build On The Metaphysically Given

Not all information changes are equal when it comes to investing. Some will be more powerful and relevant than others. Understanding the persistence of such can help. A deeper knowledge of what something is can better frame what we ought to do with our trades.

In drawing this analogy I saw that investment theses built around the metaphysically given should be more persistent than those relying on the man-made. The price action tracking the flip-flopping of Trump’s trade tweets and Powell’s dovish pivot should illustrate just this. Volatility increased as information deemed relevant for market prices not only fluctuated daily—but whimsically. To be sure these were relevant for investors; however, the metaphysical persistence of the information was weak. Easy come, easy go.

While I find framing persistence using terms borrowed from philosophy insightful, there are countless ways to construct this analogy. What’s important is that the information underpinning an investment thesis is well-understood; how powerful an impact it might have and how reversible it may be.

In my opinion, it’s wiser to build one’s investment portfolio on the metaphysically given. Here, one can be more confident in—and hence more fully capitalize on—the persistence of the causal relationships underlying a given price change. Quite simply, the shape-shifting man-made is not suitable bedrock upon which to build one’s wealth.

On Tuesday, Federal Reserve Chairman Jerome Powell, in his opening remarks at a monetary policy conference in Chicago, raised concerns about the rising trade tensions in the U.S.,

“We do not know how or when these issues will be resolved. As always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective.”

However, while there was nothing “new” in that comment it was his following statement that sent “shorts” scrambling to cover.

“In short, the proximity of interest rates to the ELB has become the preeminent monetary policy challenge of our time, tainting all manner of issues with ELB risk and imbuing many old challenges with greater significance.  

“Perhaps it is time to retire the term ‘unconventional’ when referring to tools that were used in the crisis. We know that tools like these are likely to be needed in some form in future ELB spells, which we hope will be rare.”

As Zerohedge noted:

“To translate that statement, not only is the Fed ready to cut rates, but it may take ‘unconventional’ tools during the next recession, i.e., NIRP and even more QE.”

This is a very interesting statement considering that these tools, which were indeed unconventional “emergency” measures at the time, have now become standard operating procedure for the Fed.

Yet, these “policy tools” are still untested.

Clearly, QE worked well in lifting asset prices, but not so much for the economy. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

However, they have yet to operate within the confines of an economic recession or a mean-reverting event in the financial markets. In simpler terms, no one knows for certain whether the bubbles created by monetary policies are infinitely sustainable? Or, what the consequences will be if they aren’t.

The other concern with restarting monetary policy at this stage of the financial cycle is the backdrop is not conducive for “emergency measures” to be effective. As we wrote in “QE, Then, Now, & Why It May Not Work:”

“If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.

“The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the ‘norm’ are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.”

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

While Powell is hinting at QE4, it likely will only be employed when rate reductions aren’t enough. Such was noted in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In effect, Powell has become aware he has become caught in a liquidity trap. Without continued “emergency measures” the markets, and subsequently economic growth, can not be sustained. This is where David compared three policy approaches to offset the next recession:

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

This is exactly the prescription that Jerome Powell laid out on Tuesday suggesting the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

This is also why 10-year Treasury rates are going to ZERO.

Why Rates Are Going To Zero

I have been discussing over the last couple of years why the death of the bond bull market has been greatly exaggerated. To wit: (Also read: The Bond Bull Market)

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

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

It’s item #3 that is most important.

In “Debt & Deficits: A Slow Motion Train Wreck” I laid out the data constructs behind the points above.

However, it was in April 2016, when I stated that with more government spending, a budget deficit heading towards $1 Trillion, and real economic growth running well below expectations, the demand for bonds would continue to grow. Even from a purely technical perspective, the trend of interest rates suggested at that time a rate below one-percent was likely during the next economic recession.

Outside of other events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. which all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. But, given the inflation of multiple asset bubbles, a credit-driven event that impacts the corporate bond market will drive rates to zero.

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

Rates are ultimately directly impacted by the strength of economic growth and the demand for credit. While short-term dynamics may move rates, ultimately the fundamentals combined with the demand for safety and liquidity will be the ultimate arbiter.

With the majority of yield curves that we track now inverted, many economic indicators flashing red, and financial markets dependent on “Fed action” rather than strong fundamentals, it is likely the bond market already knows a problem in brewing.

However, while I am fairly certain the “facts” will play out as they have historically, rest assured that if the “facts” do indeed change, I will gladly change my view.

Currently, there is NO evidence that a change of facts has occurred.

Of course, we aren’t the only ones expecting rates to go to zero. As Bloomberg noted:

“Billionaire Stan Druckenmiller said he could see the Fed funds rate going to zero in the next 18 months if the economy softens and that he recently piled into Treasuries as the U.S. trade war with China escalated.

‘When the Trump tweet went out, I went from 93% invested to net flat, and bought a bunch of Treasuries,’ Druckenmiller said Monday evening, referring to the May 5 tweet from President Donald Trump threatening an increase in tariffs on China. ‘Not because I’m trying to make money, I just don’t want to play in this environment.’”

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade and there is rising evidence that growth is beginning to decelerate.

While another $2-4 Trillion in QE might indeed be successful in further inflating the third bubble in asset prices since the turn of the century, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. 

There is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “QE” works, great.

But as investors, with our retirement savings at risk, what if it doesn’t?Save

Save

Save

HOW TO READ THE CHARTS

There are four primary components to each chart:

  • The price chart is contained within the shaded area which represents 2-standard deviations above and below the short-term moving average.  
  • The Over Bought/Over Sold indicator is in orange at the top.
  • The Support/Resistance line (green) is the longer-term moving average which also acts as a trailing stop in many cases.
  • The Buy / Sell is triggered when the green line is above the red line (Buy) or vice-versa (Sell).

LONG CANDIDATES

AMT – American Tower

  • Our first long-recommendation for AMT was in January of this year. Since then, the stock has gone parabolic as the “yield chase” has ensued.
  • Take profits for now.
  • With the buy signal EXTREMELY extended, lower panel, a correction is going to occur at some point or at least a length consolidation as seen in 2017-2018.
  • Move stops on all positions to $190

ALE – Allete

  • We stated last week that if ALE broke out to new highs positions could be added.
  • If you are currently long ALE, hold with a stop at $78.
  • If not, you can take on a trading position with the breakout to new highs.
  • Stop-loss on new positions is currently $81

APD – Air Products

  • We previoulsy recommended a long-position in APD back in January.
  • The trade has gotten crazy overbought as APD has gone parabolic.
  • Take profits and reduce overall weight to 1/2 position and wait for a correction to add back into it.
  • Stop-loss is $200

CVS – CVS Healthcare

  • We previously took on a position in CVS but were ultimately stopped out. We like the business model and the fundamental backdrop of the company.
  • The trade setup is not yet ideal but the basing process has allowed CVS to get deeply oversold. This provides a reasonable risk/reward point to start accumulating a position.
  • Buy 1/2 position at current levels with a very tight stop at $52
  • Add second 1/2 on move about $58 that remains for more than a week.
  • Stop Loss is set tight at $52

WMT – Walmart

  • Last week we discussed adding a position in WMT on a breakout above resistance.
  • WMT has continued to push that resistance and looks to be working a breakout at recommended levels.
  • Buy above $103.50
  • Stop loss is set at $100

SHORT CANDIDATES

GOOG – Alphabet Inc.

  • Last week, we recommended taking on a short-position in GOOG.
  • The initial target was $1000 but GOOG got in the neighborhood at $1025.
  • Close out the position and look for a re-entry on a failed attempt to get above $1100

ALB – Albemarle Corp.

  • In January of this year we recommended a short-position on ALB.
  • Targets have now been reached and ALB is deeply oversold.
  • Close out the position and take profits.

APA – Apache

  • In March we recommended a short position in APA given the potential weakness in oil prices.
  • Close out short positions and take profits.

AMC – AMC Entertainment Holdings

  • In May we recommended a short position in AMC.
  • Initial targets have been reached and while AMC is oversold, it has just registered an important sell signal.
  • Close out the short position for now.
  • Look to re-enter the position on a failed rally to $14.
  • Look for a break below $50 to establish the short position.

BT – BT Group

  • We last recommended a short-position in BT Group back in April.
  • The short has now hit our previous targets and is oversold.
  • Close out the short-position and look to re-enter on a failed rally to $14.

The escalating trade war between the U.S. and China is creating numerous unintended consequences around the world and this conflict may only be in its infancy. One of those serious risks is that that the trade war may burst a massive property bubble that has been developing in Hong Kong over the past decade, as Bloomberg reports

Record high home prices in Hong Kong have prompted some economists to forecast a bursting of the bubble.

Residential property values in the city reached an all-time high last week after relentless gains over the past three months. Prices have risen by 8.6% since the beginning of the year, Centaline data show.

However with Hong Kong exposed to the trade war between China and the U.S. and the city’s stock market taking a hit, analysts say the likelihood of home prices declining is even greater now. The recent equities sell-off has been so widespread that about a third of Hang Seng Index constituents entered oversold territory last Friday — a technical indicator that traders use to evaluate whether buying or selling of a security has become too extreme — the most in almost one year.

“Sentiment is likely to turn more cautious over the next several months or probably for an even longer period,” said Tommy Wu at Oxford Economics Ltd. in Hong Kong. “If the stock market continues to come under pressure, especially if there’s no sign of U.S.-China trade tensions getting any major relief,” then home prices will fall, he said.

I have also been warning about Hong Kong’s property and credit bubble for the past several years. These bubbles have inflated because Hong Kong has held its benchmark interest rate at record low levels since the Global Financial Crisis. These interest rates were far too low for Hong Kong’s economy – this anomalous situation only occurred because Hong Kong was trying to match U.S. interest rates to keep the currency exchange rate between the two countries stable. After 2008, the U.S. was a post-bust economy that was struggling with deflationary pressures – Hong Kong was not.

Hong Kong’s housing prices have quintupled since 2003:

Similarly, total outstanding private sector loans have quintupled since 2003:

Mainland China has also been experiencing a tremendous credit bubble in the past decade that has been artificially boosting economic growth:

Hong Kong’s property and credit bubble is bound to burst violently one way or another and the trade war is just one of the potential catalysts, in addition to rising interest rates. While many American investors probably think “who cares? I don’t live or invest in Hong Kong!,” the reality is that Hong Kong’s massive property and credit bubble is one of the many ticking time bombs around the world that threaten your investments and way of life. Because we have a truly global, interconnected economy now, nobody can afford to have an insular, America or Western-centric mindset anymore.

To quote from last month’s FI Review, “The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds are becoming more obvious…

On the surface, it looks as though fixed income had another excellent month with the exception of the high yield (junk) sector. Year-to-date, total return gains range from between 3.5% (MBS, ABS, CMBS) to 7.3% (junk). With equity markets up 9-10% through May, bonds are, to use horse racing vernacular, holding pace and stalking. But the monthly total return data does not tell the whole story as we shall see.

To start with an important backdrop for all asset classes, the decline in yields during May was eye-catching and most notable was the sharp inversion of the 3-month to 10-year curve spread. The table below highlights yield changes for May and the curve inversion.

The graph below shows the yields on the 3-month T-bill and the 10-year Treasury note as well as the yield spread between the two. Past inversions of this curve have tended to signal the eventuality of a recession, so this is a meaningful gauge to watch.

To reference the lead quote above, we maintain that spread tightening has most likely run its full course for this cycle and performance will largely be driven by carry. That said, we offer caution as the risk of spread widening across all credit sectors is high, and May might be offering clues about what may yet come.

The first four months of the year highlighted excellent risk-on opportunities. However, with Treasury yields now falling dramatically, they seem to signal bigger problems for the global and domestic economy than had previously been considered. The Treasury sector handily outperformed all others in May and higher risk categories (Junk and EM) were the worst performers. This is a reversal from what we have seen thus far in 2019.

Summer winds are blowing in trouble from the obvious U.S.-China trade dispute but also from Italy, Brexit, Iran, and Deutsche Bank woes.

To highlight the relationship between the historical and recent month-over-month moves in the S&P 500 returns and those of investment grade and high yield bonds, the scatter chart below offers some compelling insight. The green marker on each graph is the month of April, and the red marker is May.

Investment grade bonds have less sensitivity to equity market moves (trendline slope 0.124) and, as we should expect, high yield bonds have return characteristics that closer mimics that of the stock market (trendline slope 0.474). The scales on the two graphs are identical to further stress the differences in return sensitivity.

Finally, when looking at the spread between 5-year Treasuries and investment-grade bonds (similar duration securities) versus the spread between 5-year Treasuries and high-yield bonds, the spread widening since the end of April has been telling.

The investment grade spread to Treasuries widened by .019% (19 bps) and .82% (82 bps) against junk. Netting the risk-free interest rate move in Treasuries for May reveals that the pure excess return for the investment grade sector was -1.39% and for high yield it was -2.49%.

The month of May offered a lot of new information for investors. Most of it is highly cautionary.

All Data Courtesy Bloomberg and Barclays

Debt allows a consumer (household, business, or government) to pull consumption forward or acquire something today for which they otherwise would have to wait. When the primary objective of fiscal and monetary policy becomes myopically focused on incentivizing consumers to borrow, spend, and pull consumption forward, there will eventually be a painful resolution of the imbalances that such policy creates. The front-loaded benefits of these tactics are radically outweighed by the long-term damage they ultimately cause.

Due to the overwhelming importance that the durability of economic growth has on future asset returns, we take a new approach in this article to drive home a message from our prior article The Death of the Virtuous Cycle. In this article, we use two simple examples to demonstrate how the Virtuous Cycle (VC) and Un-Virtuous Cycle (U-VC) have benefits and costs to society that play out over time.

The Minsky Moment

Before walking you through the examples contrasting the two economic cycles, it is important to put debt into its proper context. Debt can be used productively to benefit the economy in the long term, or it can be used to fulfill materialistic needs and to temporarily stimulate economic growth in the short term. While both uses of debt look the same on a balance sheet, the effect that each has on the borrower and the economy over time is remarkably different.

In the course of his life’s work as an economist, Hyman Minsky focused on the factors that cause financial market fragility and how extreme circumstances eventually resolve themselves. Minsky, who died in 1996, only recently became “famous” as a result of the sub-prime mortgage debacle and ensuing financial crisis in 2008. 

Minsky elaborated on his “stability breeds instability” theory by identifying three types of borrowers and how they evolve to contribute to the accumulation of insolvent debt and inherent instability.

  • Hedge borrowers can make interest and principal payments on debt from current cash flows generated from existing investments.
  • Speculative borrowers can cover the interest on the debt from the investment cash flows but must regularly refinance, or “roll-over,” the debt as they cannot pay off the principal.
  • Ponzi borrowers cannot cover the interest payments or the principal on debt from the investment cash flows, but believe that the appreciation of the investments will be sufficient to refinance outstanding debt obligations when the investment is sold.

Over the past 20 years, investors have been witness to a remarkable sequence of bubbles. The first culminated when an abundance of Ponzi borrowers concentrated their investments in the equity markets and technology stocks in particular. Technology companies, frequently with operating losses, raised capital through stock and debt offerings from investors who believed excessive valuations could expand indefinitely.

The second bubble emerged in housing. Many home buyers acquired houses via mortgages payments they could in no way afford, but believed house prices would rise indefinitely allowing them to service their mortgage obligations via the extraction of equity.

Today, we are witnessing a broader asset price inflation driven by a belief that central banks will engage in extraordinary monetary policy indefinitely to prop up valuations in the hope for the always “just around the corner” wealth effect. Equity markets are near all-time highs and at extreme valuations despite weak economic growth and limited earnings growth. Bond yields are near the lowest levels (highest prices) human civilization has ever seen. Commercial real estate is back at 2007 bubble valuations and real assets such as art, wine, and jewelry are enjoying record-setting bidding at auction houses.

These financial bubbles could not occur in an environment of weak domestic and global economic growth without the migration of debt borrowers from hedge to speculative to Ponzi status.

Compare and Contrast

The tables below summarize two extreme economic models to exhibit how an economy dependent upon “Ponzi” financing compares to one in which savings are prioritized. In both cases, we show how the respective financial decisions influence consumption, profits, and wages.

Table 1, below, is based on the assumption that consumers spend 100% of their wages and borrow an additional amount equivalent to 10% of their income annually for ten years straight. The debt amortizes annually and is therefore retired in full in 20 years.  

Assumptions: Debt is borrowed each year for the first ten years at a 5% interest rate and ten year term, corporate profits and employee wages are 7% and 3% of consumption respectively, annual income is constant at $100,000 per year. 

Table 2, below, assumes consumers spend 90% of wages, save and invest 10% a year, and do not borrow any money. The table is based on the work of Henry Hazlitt from his book Economics in One Lesson.  

Assumptions: Productivity growth is 2.5% per year, corporate profits and employee wages are 7% and 3% of consumption respectively.

Table 1 is the U-VC and Table 2 is the VC. The tables illustrate that there are immediate economic benefits of borrowing and economic costs of saving. For example, in year one, consumption in Table 1 rises as a result of the new debt ($100,000 to $108,705) and wages and corporate profits follow proportionately. Conversely, table 2 exhibits an initial $10,000 decline in consumption to $90,000, and a similar decline in wages and corporate profits as a result of deferring consumption on 10% of the income that was designated for saving and investing.

After year one, however, the trends begin to reverse. In the U-VC example (Table 1), when new debt is added, debt servicing costs rise, and the marginal benefits of additional debt decline. By year eight, debt service costs ($10,360) are larger than the additional new debt ($10,000). At that point, without lower interest rates or larger borrowings, consumption will fall below the income level.

Conversely, in the VC example (Table 2), savings and investments engender productivity growth, which drives wages, profits, and consumption higher.

The graphs below highlight the consumption and wage trends from both tables.

As illustrated in both graphs, the short term justification for promoting the U-VC is prompt economic growth. Equally important, the reason that savings and investments in the VC are admonished is that they require discipline and a period of lesser growth, profits, and wages.

Debt-fueled consumption is an expedient measure to take when economic growth stalls and immediate economic recovery is demanded. While the marginal benefits of such action fade quickly, a longer-term policy that consistently encourages greater levels of debt and lower debt servicing costs can extend the beneficial economic effects for years, fooling many consumers, economists and business leaders into believing these activities are sustainable.

In the tables above, it takes almost seven years before consumption in the VC (Table 2) is greater than in U-VC (Table 1).  However, after that breakeven point, the benefits of a VC become evident as economic growth compounds at an increasing rate, quickly surpassing the stagnating trends occurring under the U-VC.

In the real world, VC or U-VC economies do not exist. Economies tend to exhibit characteristics of both cycles. In the United States, for example, some consumers and corporations are saving, investing, and generating productive economic gains. Productivity gains from years past are still providing benefits as well.  However, over the past 30 years, consumers have increasingly opted to borrow and consume in a Ponzi-like manner and neglect savings. In other words, the U.S. economy has increasingly favored “Ponzi” debt-fueled consumption and denied the benefits of savings and the VC. Then again, U.S. leadership has only encouraged these behavioral patterns through imprudent fiscal and monetary policies.

The U.S. and many other countries are once again approaching what has been deemed the Minsky Moment.  Similar to 2008, this is the point when debt becomes unserviceable and a sharp increase in defaults is unavoidable. Will the Federal Reserve be able to once again reignite “Ponzi” borrowing to suspend that outcome?

Summary

The U.S. and many other countries are forced to deal with the consequences of economic policy actions, borrowing, and consumption behaviors from years past. While the present economic situation is troubling, leadership is obligated to reflect on past choices and move forward with changes that are in the best interest of the country and its entire population. As our title suggests, we can continue to try to pull consumption forward and further harm future growth, or we can save and reward future generations with productivity gains resulting in greater economic growth and prosperity. 

Shifting direction, and “paying forward,” via more savings and investments and the deferral of some consumption, comes with immediate negative consequences to wages, profits, and economic growth. Nothing worth having is easy, as the saying goes. However, over time, the discipline is rewarded, and the economy can be on a more sustainable, prosperous path.

These economic concepts, tables, and graphs extend an accurate diagnosis of the “Death of the Virtuous Cycle.” They are intended to help investment managers better understand the costs and benefits of saving versus borrowing from a macroeconomic perspective. If successful in that endeavor, the substance of this article will afford managers better ideas about how to navigate a very uncertain investment landscape. The implications for the sustainability of economic growth and therefore long term asset returns are profound and the bedrock of all investment decisions. 

Tesla bulls and Elon Musk fans everywhere are hoping that the decline in Tesla stock price will end soon.  After the stock breached the technically important $250 price level, the next key support level is in the $180 range, close to where the stock is trading now. 

Tesla has emotionally attached both bullish and bearish investors. Spend ten minutes on financial Twitter and the emotions from those thinking Tesla is going to zero to those thinking the right price in the 1,000’s is easily evident. Bulls certainly want Tesla to hold the $180 line, but as Toto sang in the 1970s, “Love isn’t always on time.” 

On a weekly chart, we can see that the $180 price level has served as important support and resistance since 2013.  More evidence supporting the Tesla is oversold, is that weekly RSI is as over-sold as the most recent dip below $180 in early 2016.

A linear regression of the recent TSLA downtrend on a daily chart shows price currently extended at the bottom of the range.  This linear regression has a high confidence factor over 92%.

The TSLA Options Market

The options market provides institutions and other large position holders an ability to hedge their TSLA exposure, whether the funds are invested long or short.  Since TSLA has a history of being difficult or expensive to short, liquidity is abundant in TSLA options.  I imagine that there are many retail and institutional investors who short TSLA by buying puts.

The market makers who facilitate this trade almost always hedge their exposure instantaneously and dynamically with delta-neutral portfolios.  The market makers perform combination trades to (theoretically) hedge their exposure to price while also profiting from options volatility.  The maximum profit for the market makers will occur if the price of the stock settles near the price level where their individual portfolio is delta neutral.  As a result, it can be enlightening to track neutral delta levels for Tesla as we do for many different stocks, ETFs and commodities.

TSLA Op-ex Sweet Spot

I consider the price range between Neutral Delta and Neutral Gamma to be the “sweet spot” for stock prices on or before option expiration.  On May 29th, TSLA had a sweet spot in the $207 to $225 range for the June 21st op-ex.  As such, our indicator currently considers TSLA to be over-sold near $180/share. 

Source: Viking Analytics

Additional Comments

  1. Put-call ratios in the 1.2 to 2.4 range suggest that there is potential support for TSLA in the event of a sharp decline in price.  TSLA’s put-call ratios have fallen somewhat over the past week, however. 
  2. At the closing price of $188 on May 30th, the total value of at-the-money puts in TSLA stock was $1.25 Billion greater than the total value of at-the-money calls for the next three option expirations.
  3. The basic theory behind the Neutral Delta and Neutral Gamma levels can be found by reading a quick introduction on this link: Introduction to Options Sentiment.

Price and Neutral Delta Converge

Due to order flow, contract rollover and hedge dynamics, there tends to be a convergence between stock prices and the point of delta neutral as option expiration comes nearer.  Here is TSLA stock price versus Neutral Delta and Neutral Gamma for the month of May 2019 into the June option expiration.

Gamma is a Wild Card

Extreme divergences between Neutral Gamma and price can also point towards forced-buying or forced-selling events.  I have outlined this dynamic in several articles, including: Negative Gamma and the Demise of Optionsellers.com.   Neutral Gamma is currently trending with price, which is common.  However, our data shows that Neutral Gamma may begin to spike as option expiration comes nearer.  This highlights the potential for forced selling by the put sellers as option expiration comes nearer.   

Final Thoughts

Tesla is over-sold on several metrics.  The weekly RSI is at a multi-year low, and price is currently at the bottom of an orderly downtrend channel.  The options market has priced in a modest recovery into June option expiration; however, there is potential for a forced selling event if too many puts remain in the money.  I will consider a long trade in TSLA in early to mid-June if it successfully tests the $180 price level and the forced selling potential dissipates.

Disclaimer

This is for informational purposes only and is not trading advice.

Each week we produce a chart book of 10 of the current positions we have in our equity portfolio. Specifically, we are looking at the positions which warrant attention, or are providing an opportunity, or need to be sold.

While the portfolios are designed to have longer-term holding periods, we understand that things do not always go the way we plan. This monitoring process keeps us focused on capital preservation and long-term returns.

HOW TO READ THE CHARTS

There are four primary components to each chart:

  • The price chart is contained within the shaded area which represents 2-standard deviations above and below the short-term moving average.  
  • The Over Bought/Over Sold indicator is in orange at the top.
  • The Support/Resistance line (green) is the longer-term moving average which also acts as a trailing stop in many cases.
  • The Buy / Sell is triggered when the green line is above the red line (Buy) or vice-versa (Sell).

When the price of a position is at the top of the deviation range, overbought and on a buy signal it is generally a good time to take profits. When that positioning is reversed it is often a good time to look to add to a winning position or looking for an opportunity to exit a losing position.

With this basic tutorial let’s get to the sector analysis.

ABT – Abbott Laboratories

  • As noted previously, earlier this year we made a decision to overweight healthcare in portfolios. This has proved to be defensive with healthcare holding up despite the pullback in the market.
  • ABT has been building a consolidation above previous highs. A breakout above that consolidation will allow us to add to our holdings.
  • We remain long our holding of ABT currently with stops moved up to support.
  • Stop is set at $72.50

AEP – American Electric Power

  • Defensive Utility and Real Estate stocks continue to get a bid during turmoil as well. We remain long utilities currently.
  • AEP is overbought short-term but remains on a buy signal for now.
  • While stops have been moved up to important support we will take profits on a break of $82.
  • Stop-loss is moved up to $78

BA – Boeing Corp.

  • In March we took 1/2 position in BA on the initial sell-off following the 737 MAX crash.
  • We said then we would give the stock a wide berth to find its bottom and while it did break support at $360, we continue to look for an opportunity to build out the rest of our position around $310.
  • It is still too early to take on additional holdings and with BA on a “sell” signal and not deeply oversold we will be patient.
  • Stop-loss remains at $300 for now.

DOV – Dover Corp.

  • Despite the restart of the trade war, DOV continues to hold its ground and just bounced off of support at the old highs.
  • We continue to hold our position for now and continue to keep a close eye on industrial and material sectors.
  • Our stop is set at $87.50

HCA – HCA Healthcare

  • Both HCA and UNH continue to hold critical support levels and have been working off their overbought condition.
  • As noted above, money has been rotating into healthcare which is why we continue to overweight holdings there for now.
  • Stop-loss remains at $115 for now.

MSFT – Microsoft Corp.

  • Money continues to chase technology despite the more extreme overbought conditions in the sector.
  • We remain long our position after taking profits and will look for an opportunity to increase exposure.
  • Our stop-loss is moved to $112.50

NSC – Norfolk Southern

  • Despite lackluster performance in the “transportation” sector overall, Railroads have continued to hold up much better than the market.
  • NSC is overbought but remains on a buy signal. The recent correction was not enough to allow us to add to our holdings just yet.
  • Stop-loss is set at $180.

UTX – United Technologies

  • UTX has recently pulled back from its highs and is sitting on support. Support held during the sell off which is encouraging. We will look to add to our holdings if support continues to hold this week.
  • Defensive sectors continue to get a bid from investors looking for safety and yield so we like our positioning for now.
  • Our stop-loss is moved to $125

VZ – Verizon

  • VZ sold off last week on rumors that AMZN is getting in the wireless business. This is not likely the case other than AMZN might acquire a pay-as-you-go service which will have minimal impact on VZ.
  • VZ continues to consolidate in a fairly broad range with VZ sitting on support.
  • We will add to the position when we get a corresponding buy signal. We would like to see VZ hold current support and consolidate a bit.
  • Stop loss is currently set at $54

YUM – Yum Brands

  • YUM continues to power higher along support and recently just broke out to new highs.
  • Currently, YUM is very overbought so a pullback to old highs and a bit of consolidation is needed to add to our holdings.
  • Stop-loss is moved up to $95