Monthly Archives: September 2017

Charlie Munger, Warren Buffett’s right-hand man at Berkshire Hathaway, made an interesting comment this morning on CNBC that echos what I’ve been saying about U.S. wealth and income inequality:

Recently, some lawmakers have been pushing for higher taxes on the wealthy, especially Rep. Alexandria Ocasio-Cortez, D-N.Y. Ocasio-Cortez has proposed a 70 percent marginal tax on incomes over $10 million in an effort to bridge the growing wealth gap between the rich and the poor.

But Munger thinks the divide will slowly bridge itself as interest rates are unlikely to go “much lower” from current levels. By slashing rates and implementing quantitative easing measures a decade ago, the Federal Reserve inadvertently bailed out the rich to help the poor during the financial crisis by boosting asset prices, Munger said.

“Nobody was doing that because they love the rich; they just didn’t have any other tools in the kit,” he said. The inequality that came from that “wasn’t malevolent and it was an accident and it probably won’t happen again.”

As I’ve been explaining, U.S. household wealth is currently experiencing an unsustainable bubble that is the main reason for growing U.S. wealth and income inequality. This bubble is largely driven by bubbles in stocks and bonds. The asset bubbles behind the U.S. wealth bubble are going to burst and cause a severe economic crisis. Therefore, I believe that our society should be worrying more about these bubbles rather than the temporary inequality that they create. When the U.S. wealth bubble bursts, the wealth and income inequality gap is going to shrink, which supports Charlie Munger’s assertion that the gap will “bridge itself.”

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Do you want to own a business with a serious competitive advantage? You’re probably thinking of something with a name brand, preferably with cutting edge technology, that has a lot of market share. Maybe Apple. Or Google. Or if you’re a little older school, and just want the name brand without the tech, maybe Colgate, Procter & Gamble, and CocaCola.

But there’s a company that you may haven’t heard of in an industry you’ve probably never thought about that has incredible market share and profitability. That company is Italian eyeglass maker Luxottica (LUXTY).

Luxottica makes frames for many designers with whom it has contracts. The designers include Prada, Chanel, Dolce & Gabbana, Versace, Burberry, Ralph Lauren, Tiffany, Bulgari, Coach, DKNY, Armani, Kors, Oakley, and Ray-Ban. If you’ve ever wanted to own those brands, you can at least own a piece of all their eyeglass business if you own Luxottica.

But Luxottica’s advantage doesn’t end with its designer contracts. It also owns major eyeglass retail outlets such as Sunglass Hut, LensCrafters, Oliver Peoples, Pearle Vision and the optical departments at Target, Sears, JC Penney, and Macy’s. If you’re buying prescription glasses or sunglasses, it’s hard to avoid Luxottica. Making the product, and owning a major part of the distribution gives Luxottica a kind of vertical monopoly. In this 60-minutes expose, the firm estimated that nearly half a billion people around the world wore its eyeglasses.

Granted, Luxottica has rehabilitated at least one big brand it owns – Ray-Ban. The iconic sunglasses were originally made by Bauch & Lomb for the U.S. Army. But it had fallen on hard times, and Ray-Bans were available in drug stores for $29. Now, with some “brand rehabilitation,” Ray-Ban is the top-selling sunglass brand in the world, and many styles retail for more than $150.

But Luxottica doesn’t only do friendly rehabilitations. In a bare-knuckles battle with Oakley, another sunglass maker, Luxottica wound up buying Oakley after Oakley accused Luxottica of copying its styles and selling its knockoffs for less. When Luxottica bought Sunglass Hut, Luxottica threatened to drop Oakley from its stores, a move that could have destroyed Oakley’s business. Eventually Oakley had to sell out.

Here’s an exchange in the 60-Minutes segment with Lesley Stahl, Andrea Guerra of Luxottica, and Brett Arends, then of SmartMoney.

Brett Arends: Yeah, there was a dispute about pricing, and they dropped Oakley from the stores, and Oakley’s stock price collapsed. How is Oakley going to reach the consumer if they can’t get their sunglasses in Sunglass Hut?

Andrea Guerra: There were some issues between the two companies in the beginning of the 2000s. But both of them understood that it was better to go along.

Lesley Stahl: Better to let you buy them?

Andrea Guerra: I wouldn’t say this. We merged with Oakley in 2007.

Lesley Stahl: You bought Oakley. They tried to compete and they lost and then you bought them.

Andrea Guerra: I understand your theory, but they understood that life was better together.

All of this means Luxottica can sell a pair of eyeglasses that costs the firm $30 for ten times that or more. The result is that Luxottica has achieved consistent operating profit margins of 15% and returns on assets of 10%.

The firm isn’t cheap. It trades at an enterprise value/EBIT of around 20. But, then again, you’d expect that from a company with such a competitive advantage and the profitability to prove it. With a 2% dividend yield, at least investors are getting paid to wait. The recent merger with French lens-maker Essilor should help. Essilor owns 40% of the U.S. prescription lens market. There goes Luxottica again – tying up another player that can help it increase its dominance in this otherwise unremarkable, but necessary (at least for prescription lenses) product segment.

It is often said that one should never discuss religion or politics as you are going to wind up offending someone. In the financial world it is mentioning the “R” word.

The reason, of course, is that it is the onset of a recession that typically ends the “bull market” party. As the legendary Bob Farrell once stated:

“Bull markets are more fun than bear markets.”

Yet, recessions are part of a normal and healthy economy that purges the excesses built up during the first half of the cycle.

economic_cycle-2

Since “recessions” are painful, as investors, we would rather not think about the “good times” coming to an end. However, by ignoring the risk of a recession, investors have historically been repeatedly crushed by the inevitable completion of the full market and economic cycle.

But after more than a decade of an economic growth cycle, investors have become complacent in the idea that recessions may have been mostly mitigated by monetary policy.

While monetary policy can certainly extend cycles, they cannot be repealed.

Given that monetary policy has consistently inflated asset prices historically, the reversions of those excesses have been just as dramatic. The table below shows every economic recovery and recessionary cycle going back to 1873.

Importantly, note that the average recessionary drawdown historically is about 30%. While there were certainly some recessionary drawdowns which were very small, the majority of the reversions, particularly from more extreme overvaluation levels as we are currently experiencing, have not been kind to investors.

So, why bring this up?

“In the starkest warning yet about the upcoming global recession, which some believe will hit in late 2019 or 2020 at the latest, the IMF warned that the leaders of the world’s largest countries are ‘dangerously unprepared’ for the consequences of a serious global slowdown. The IMF’s chief concern: much of the ammunition to fight a slowdown has been exhausted and governments will find it hard to use fiscal or monetary measures to offset the next recession, while the system of cross-border support mechanisms — such as central bank swap lines — has been undermined.” – David Lipton, first deputy managing director of the IMF.

Despite recent comments that “recession risk” is non-existent, there are various indications which suggest that risk is much higher than currently appreciated.  The New York Federal Reserve recession indicator is now at the highest level since 2008.

Also, as noted by George Vrba recently, the unemployment rate may also be warning of a recession as well.

“For what is considered to be a lagging indicator of the economy, the unemployment rate provides surprisingly good signals for the beginning and end of recessions. This model, backtested to 1948, reliably provided recession signals.

The model, updated with the January 2019 rate of 4.0%, does not signal a recession. However, if the unemployment rate should rise to 4.1% in the coming months the model would then signal a recession.”

John Mauldin also recently noted the same:

“This next chart needs a little explaining. It comes from Ned Davis Research via my friend and business partner Steve Blumenthal. It turns out there is significant correlation between the unemployment rate and stock returns… but not the way you might expect.

Intuitively, you would think low unemployment means a strong economy and thus a strong stock market. The opposite is true, in fact. Going back to 1948, the US unemployment rate was below 4.3% for 20.5% of the time. In those years, the S&P 500 gained an annualized 1.7%.”

“Now, 1.7% is meager but still positive. It could be worse. But why is it not stronger? I think because unemployment is lowest when the economy is in a mature growth cycle, and stock returns are in the process of flattening and rolling over. Sadly, that is where we seem to be right now. Unemployment is presently in the ‘low’ range which, in the past, often preceded a recession.

The yield spread between the 10-year and the 2-year Treasury yields is also suggesting there is a rising risk of a recession in the economy.

As I noted previously:

“The yield curve is clearly sending a message that shouldn’t be ignored and it is a good bet that ‘risk-based’ investors will likely act sooner rather than later. Of course, it is simply the contraction in liquidity that causes the decline which will eventually exacerbate the economic contraction. Importantly, since recessions are only identified in hindsight when current data is negatively revised in the future, it won’t become ‘obvious’ the yield curve was sending the correct message until far too late to be useful.

While it is unwise to use the ‘yield curve’ as a ‘market timing’ tool, it is just as unwise to completely dismiss the message it is currently sending.”

We can also see the slowdown in economic activity more clearly we can look at our RIA Economic Output Composite Index (EOCI). (The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

With the exception of the yield curve, which is “real time,” the rest of the data is based on economic data which has a multitude of problems.

There are many suggesting currently that based on current economic data, there is “no recession” in sight. This is based on looking at levels of economic data versus where “recessions” started in the past.

But therein lies the biggest flaw.

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are ‘best guesses’ about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

The issue with a statement of “there is no recession in sight,” is that it is based on the “best guesses” about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

“The Federal Reserve is not currently forecasting a recession.”

In hindsight, the NBER called an official recession that began in December of 2007.

But this is almost always the case. Take a look at the data below of real (inflation-adjusted)economic growth rates:

  • September 1957:     3.07%
  • May 1960:                 2.06%
  • January 1970:        0.32%
  • December 1973:     4.02%
  • January 1980:        1.42%
  • July 1981:                 4.33%
  • July 1990:                1.73%
  • March 2001:           2.31%
  • December 2007:    1.97%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.  In 1957, 1973, 1981, 2001, 2007 there was “no sign of a recession.” 

The next month a recession started.

So, what about now?

“The recent decline from the peak in the market, is just that, a simple correction. With the economy growing at 3.0% on an inflation-adjusted basis, there is no recession in sight.” 

Is that really the case or is the market telling us something?

The chart below is the S&P 500 two data points noted.

The green dots are the peak of the market PRIOR to the onset of a recession. In 8 of 9 instances, the S&P 500 peaked and turned lower prior to the recognition of a recession. The yellow dots are the official recessions as dated by the National Bureau of Economic Research (NBER) and the dates at which those proclamations were made.

At the time, the decline from the peak was only considered a “correction” as economic growth was still strong.

In reality, however, the market was signaling a coming recession in the months ahead. The economic data just didn’t reflect it as of yet. (The only exception was 1980 where they coincided in the same month.) The chart below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

The problem is in waiting for the data to catch up.

Today, we are once again seeing many of the same early warnings. If you have been paying attention to the trend of the economic data, the stock market, and the yield curve, the warnings are becoming more pronounced. In 2007, the market warned of a recession 14-months in advance of the recognition. 

So, therein lies THE question:

Is the market currently signaling a “recession warning?”

Everybody wants a specific answer. “Yes” or “No.

Unfortunately, making absolute predictions can be extremely costly when it comes to portfolio management.

There are three lessons to be learned from this analysis:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

As Doug Kass noted on Tuesday there are certainly plenty of risks to be aware of:

  1. Domestic economic growth weakens, Chinese growth fails to stabilize and Europe enters a recession
  2. U.S./China fail to agree on a trade deal
  3. Trump institutes an attack on European Union trade by raising auto tariffs
  4. U.S. Treasury yields fail to ratify an improvement in economic growth
  5. The market leadership of FANG and Apple (AAPL) subsidies
  6. Earnings decline in 2019 and valuations fail to expand
  7. The Mueller Report jeopardizes the president
  8. A hard and disruptive Brexit
  9. Crude oil supplies spike and oil prices collapse, taking down the high-yield market
  10. Draghi is replaced by a hawk

While the call of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000, or 2007, either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

Pay attention to the message markets are sending. It may just be saying something very important.

Each week we produce a chart book of 5 to 10 stocks which have hit our watch list for potential additions to our long-short equity trading portfolio.

We have broken down the list into two sections – Long and Short and have provided targets for potential actions.

Importantly, these equities are not part of our long-term investment themes and are far trading purposes only. We may, or may not, implement any of the ideas on this list. They are simply for consideration.

This week we used our NEW SCAN TOOL (Click on SCAN in the menu bar above) to screen for our candidates. We recently added several new screening parameters to include both fundamental factors (Piotroski Score) and momentum factors (Mohanram Score) along with Zack’s rankings.

I have included a clip of the screen at the beginning of each section below.

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

BA – Boeing Co.

  • BA has rallied sharply since the December lows. However, the fundamentals of the company remain very strong. The recent breakout to new highs makes BA very attractive currently.
  • BA has also recently triggered a buy signal but is extremely overbought short-term. Look for a pullback to the $380-400 for an entry.
  • Stop-loss is at $350

BLFS – BioLife Solutions

  • BLFS broke above the longer-term resistance and is close to triggering a buy signal.
  • There is currently upside to $24-25 with a very tight stop directly below so risk/reward for a trade is good.
  • Stop-loss is currently $15.50

MRCY – Mercury Systems, Inc.

  • MRCY recently broke out to all-time highs after triggering a buy signal. 
  • Currently, MRCY is extremely overbought so some correction is needed to warrant an entry.
  • Short-Term Positioning: Bullish
    • Buy on pullback to support @ $55-57.50
    • Stop-loss is currently $50 after “buy”

RNG – RingCentral, Inc.

  • RNG has also just recently broken out to a new high and has triggered a buy signal.
  • Currently RNG is extreme\ly overbought so wait for a pullback.
  • Short-Term Positioning: Bullish
    • Buy on pullback to support at $95-100
    • Stop-loss is tight at $95 after “buy”

VCEL – Vericel Corp.

  • VCEL is currently attempting a breakout to all-time highs. 
  • It is also, close to triggering a “buy” signal within a strong uptrend.
  • Short-Term Positioning: Bullish
    • Buy at current levels.
    • Stop-loss is currently $17

SHORT CANDIDATES

APC – Anadarko Petroleum

  • APC has failed to gain any traction at all during a strong rally. 
  • Currently on a deep sell signal, and oversold, look for a failed rally to short APC.
  • Recommendation is to short on a rally to $47.50 that fails.
    • Sell 1/2 position at $47.50
    • Sell 1/2 position on break below $41
    • Stop-loss is at $50

ARMK – Aramark 

  • ARMK had a sharp rally but failed at resistance. 
  • Sell-signal still in place and position is currently oversold.
  • Short-Term Positioning: Bearish
    • Short at current levels or on any rally to $32.50
    • Stop-loss is currently $33.50

DWDP – Dow Dupont

  • DWDP has failed to rally with much of the basic materials sector and earnings were less than optimal.
  • DWDP is currently working on a triple bottom that looks to be broken.
  • Look to sell short DWDP on a break of $50-52 which would suggest a decline into the $40’s.
  • Stop-loss is currently $58

MCD – McDonalds, Inc.

  • MCD just triggered a “sell signal” and is threatening to break support at $172.50
  • Short-Term Positioning: Bearish
    • Short on break below $172.50
    • Stop-loss is currently $175

M – Macy’s 

  • M has failed to rally, at all, with the recent recovery in the market. This makes the stock more vulnerable to a decline if the market sells off. 
  • M is very oversold and is also on a deep sell signal, so downside is somewhat limited currently. 
  • Short-term positioning: Bearish
    • Short at current levels
    • Target to cover is $18-19
    • Stop-loss is currently $28.
That is some crazy talk” – Bill Gates on the topic of MMT

In our article, MMT Sounds Great in Theory… But, we dove into the latest and greatest of economic thinking, Modern Monetary Theory (MMT). This theory is crucially important for investors and citizens to understand as its popularity is spreading like wildfire. The theory promises to be a strong force in the coming election and a challenge to the popular Keynesian policies that are widely adhered to by most governments and central banks.

Free healthcare and higher education, jobs for everyone, living wages and all sorts of other promises are just a few of the benefits that MMT can provide. At least, that is how the theory is being sold. Regardless of the apparent unreasonableness of such promises, it’s not hard to imagine presidential and congressional candidates running and winning on such a “free lunch” economic platform. Bear in mind, this was done with some success in 2016 as Stephanie Kelton, Bernie Sander’s chief economic advisor, is a leading advocate of MMT.

Given the importance of this new thinking, we will analyze various bits and pieces of the theory in the coming months. In this article, we discuss a crucial aspect of the theory, inflation. MMT theory essentially believes the government spending can be funded by printing money. Currently, government spending is funded by debt and not the Fed’s printing press. MMT disciples tell us that when the shackles of debt and deficits are removed, government spending can promote economic growth, full employment and public handouts galore. MMT does, however, have a discipline that regulates spending, and that is inflation.

Inflation

Inflation is impossible to calculate. Inflation is impossible to calculate. No, that is not a typo. For emphasis, let us put it another way. Inflation is impossible to calculate.

The point that inflation is impossible to calculate cannot be overstated.

Economists will say the Consumer Price Index (CPI), for instance, does a good job of telling us whether prices are rising or falling and to the precision of a tenth of a percent. As background, CPI measures how a select basket of goods changes in price from month to month.

In regards to CPI and its purported accuracy think about these questions:

  • Do the specific goods and amount of goods in the CPI basket match what you buy?
  • Are prices of goods the same in Nevada as they are in Maine?
  • Do you substitute apples for oranges when oranges rise in price?
  • Does a 75-year-old retired couple consume the same basket of goods as a single 20-year-old in college or a 50-year-old couple with three teenagers?
  • Are value hedonic adjustments fair and reflective of the value you receive from the goods? (Hedonic adjustments attempt to change the price of goods based on perceived improvements in value. For instance, the decline in computer prices as measured within CPI is greater than what we observe at the store because they deliver more power today than in the past. We expanded on this concept in the MMT article mentioned earlier.)

We now get personal because this point is crucial. Michael Lebowitz, a partner at Real Investment Advice, is 50 years old, married, with three teenagers. He pays for his own health care and has one kid in college. He lives near Washington D.C. where real estate and many of the goods and services he consumes are more expensive than the national average. CPI, as reported by the BLS, is running annually at +1.9%. Do you think Michael’s personal CPI is only 1.9%? Based on a simple and reliable personal budget analysis, his price index has been running in the double digits for the last few years.

Washington, DC provides one good example as a city, but it is not a leap to say that major metropolitan and urban areas impose a higher cost of living than rural areas. Furthermore, according to the 2010 United States Census, over 71% of the population live in “urbanized areas”, which the Census Bureau defines as “densely developed residential, commercial and other nonresidential areas.” Does measurement of CPI or any other inflation metric properly account for such complexities? How can they?

The bottom line is that inflation varies widely by demographic, region and individual needs and desires and a host of other differences that cannot possibly be accounted for in one number.

That is problem number one with applying a “CPI-for-all” mentality and using it to make important policy decisions.

Inflation Manipulation

There is a bigger and more nefarious problem with inflation measurements and how they can be manipulated. To reiterate, MMT states that government spending and money printing can occur as long as inflation is limited.

If inflation regulates government spending and by default the health of the economy, then won’t leaders, who will do anything to retain their power, suppress inflation readings to allow greater spending?

Sadly, that question is rhetorical. We know the rate of inflation is already being suppressed for political reasons. As an example, the Federal Reserve uses Core CPI, a derivative of CPI that excludes food and energy, as prices on those two components are unusually volatile. They do tend to be volatile, but they are also two of the biggest expenses of the population. That is like measuring a quarterback’s accuracy without considering passes that occur further than ten yards from the line of scrimmage.

As for the government, they routinely take steps to manipulate how CPI and other inflation data are calculated and published.

Before continuing with what some may call a conspiracy theory, we think a little background on the Boskin Commission is appropriate. Per Wikipedia:

The Boskin Commission, formally called the “Advisory Commission to Study the Consumer Price Index”, was appointed by the United States Senate in 1995 to study possible bias in the computation of the Consumer Price Index (CPI), which is used to measure inflation in the United States. Its final report, titled “Toward A More Accurate Measure Of The Cost Of Living” and issued on December 4, 1996, concluded that the CPI overstated inflation by about 1.1 percentage points per year in 1996 and about 1.3 percentage points prior to 1996.

The report was important because inflation, as calculated by the Bureau of Labor Statistics, is used to index the annual payment increases in Social Security and other retirement and compensation programs. This implied that the federal budget had increased by more than it should have, and that projections of future budget deficits were too large. The original report calculated that the overstatement of inflation would add $148 billion to the deficit and $691 billion to the national debt by 2006.

The Boskin Commission was formed, and their recommendations enacted, to reduce reported inflation. Inflation is costly to the government due to higher borrowing rates, cost of living wage adjustments, and social security expenses. Said differently, by lowering measured inflation they reduced governmental expenses and allowed for more spending. Our opinion on the government’s motives is not a result of our cynical nature; it is based on the illogic of some of the adjustments that have occurred since the commission was formed.

The best example to highlight this is housing prices and their contribution to CPI. In 1998, the Bureau of Labor Statistics (BLS) changed the way they calculated real estate prices within CPI. The BLS replaced an index based on actual home prices with what is now called owner’s equivalent rent (OER). OER is a rental equivalence which calculates the price at which an owned house would rent. It is important to note that rents were then and continue to be a part of the CPI calculation.

The graph below compares the compounded growth rates of the OER index and the widely recognized leader in home price indexing, Case-Shiller U.S. National Home Price Index.

Data Courtesy St. Louis Federal Reserve

It is clear from the graph that OER is a great substitute for actual home prices if the goal is to reduce reported inflation. However, if you are a citizen and in the market for a house, OER represents wishful thinking.

Based on the data above, CPI has been suppressed by an average of 0.40% per year since 1998 due to the OER calculation. That may not seem material, but this one modification accounts for 20% of the CPI growth over the period.

Even more concerning, the graph below shows that OER understates CPI by much more than 0.40% when the decline in house prices during the financial crisis is excluded. Since the crisis, OER has underestimated CPI by 0.75% annually, meaning that a truer inflation rate over the period from 2010 to current was 2.37% not 1.62%. Annual compounding implies CPI understated the rate of inflation by approximately 7%.

Data Courtesy St. Louis Federal Reserve

To put a final point on MMT and home prices, consider the following: If house prices in California are rising rapidly while falling in New York, should the same fiscal and monetary policy be applied to both situations? MMT would benefit both New York and California but is that what is truly best for Californians, a state notorious for pricing many out of the housing market? In either case, those most severely impacted are the lower and middle classes struggling to maintain their standard of living.

Summary

The problems described above are symptomatic. In this article we only touched on a few of the flaws with the government’s preferred inflation calculation and how it is being manipulated. There are a plethora of other adjustments that are made to adjust inflation to accommodate the preferences of policy-makers. Given the relative ease with which inflation can be hidden, we should assume politicians, especially those that embrace MMT, will lobby for more “adjustments” when inflation rises and threatens their campaign promises. Those promises are, after all, the basis upon which they assume power.

My concerns about the U.S. automobile bubble are being confirmed. As Bloomberg reports:

More Americans than ever are at least three months behind on their auto loans, a sign that the U.S. economy may have little growth left in the tank.

The number of loans at least 90 days late exceeded 7 million at the end of last year, the highest total in the two decades the Federal Reserve Bank of New York has kept track. Expressed as a percentage of total debt, the delinquency rate is the highest since 2012, as overall borrowing has also increased.

The data show not all Americans are benefiting from the strong labor market, New York Fed economists say. Consumers with the weakest credit have driven deteriorating performance of auto debt: The share of subprime borrowers who fell well behind on car payments the last three months of the year was the highest since the second quarter of 2010.

As I’ve been warning for the past couple years, the U.S. automobile sales boom is a byproduct of a bubble in auto loans:

The auto sales and auto loan bubble is a byproduct of ultra-cheap credit conditions in the past decade since the Great Recession. Interest rates are now rising, which threatens the auto bubble:

It’s only a matter of time before the U.S. auto sales and loan bubble experiences a serious bust. Rising delinquencies are just the start, I’m afraid. Booms fueled by cheap credit always end the same way – in a terrible bust. Ignore the voices that say “this time will be different!”

Please follow me on LinkedIn and Twitter to keep up with my updates.

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Last night the following Reuters headlines hit the wires. The report is from a speech given by Cleveland Federal Reserve Governor Loretta Mester.

Mester’s comments and similar remarks from other Fed Governors occur within two weeks of a very strong BLS employment report. Over the last two months payrolls have increased by 526,000 jobs, a pace greater than any two month period since July of 2016. Providing further evidence of a strong jobs market, yesterday the BLS released the JOLTS (Job Openings and Labor Turnover Summary) report which confirmed the labor situation is not only healthy but at some of the strongest levels in recent history.

Here are the facts:

  • The unemployment rate is only 0.3% above the lowest level in nearly 50 years
  • Jobless claims are at levels last seen in 1969
  • JOLTS just reported the highest number of job openings since they began reporting on the data in 2000. 

These and other signs of a strong labor market point to the growing possibility that wages, and with it inflation, will rise in the coming months.

Maximizing employment is one of  two Federal Reserve congressionally chartered mandates. The second is stable prices and moderate long term interest rates. Inflation is stable and interest rates are among the lowest in recorded history. The BLS reported this morning that the Fed’s preferred measure of CPI inflation, Core CPI (CPI less food and energy) is running at a 2.2% annual rate. The Fed considers stable inflation to be 2.0%.

To be fair, not everything is rosy. Slowing global growth, further dollar strength, and the ongoing trade debate pose the potential to hamper US economic growth.

Bottom line: there are some clouds gathering on the global economic horizon, but the sun is still shining brightly in the U.S.

With that backdrop, we come back to the question we asked in two articles published two weeks ago. On January 30th and February 1st, we summarized and commented on the recent Federal Reserve FOMC policy meeting. Of importance, we were trying to figure out why the Fed made such an abrupt policy U-turn from the prior meeting on December 19, 2018. Here are the articles.

Quick Take: January 30, 2019 Fed Meeting

Additional Thoughts: Quick Take January 30, 2019 Fed Meeting

Our initial take was that the 20% stock market decline was to blame for the change in policy. It didn’t help that President Trump was calling for Fed action and at the time Powell’s head seemingly daily. In the “Additional Thoughts” article we posited the following:

What Does the Fed Know?

During the press conference, the Chairman was asked what has transpired since the last meeting on December 19, 2019, to warrant such an abrupt change in policy given that he recently stated that policy was accommodative, and the economy did not require such policy anymore. In response, Powell stated “We think our policy stance is appropriate right now. We do. We also know that our policy rate is now in the range of the committee’s estimates of neutral.” As we discussed in the original article, Powell’s response was incomplete and failed to address the question directly. Given his weak answer, we wonder if Powell knows something we don’t. Could China’s economy be rolling over at a much more concerning pace than anyone thinks? Are trade discussions with China a no-go, therefore resulting in eminent tariffs? Is a bank in trouble?

The possibilities are endless, but given Powell’s awkward response and unsatisfactory rationale to a simple and obvious question, it is possible that he is hiding something that accounts for the policy U-turn.

Our Current Take

The market has largely recovered from the fourth quarter swoon, as such the Fed should be resting more comfortably. Economic data remains strong, and if anything it is slightly better than December when the Fed was ready to raise rates three times and put balance sheet reduction on “autopilot.”

Today the Fed has all but put the kibosh on further rate hikes and, per Mester’s comments, will end balance sheet reduction (QT) in the months ahead.

It is becoming more suspect that the Fed knows something the market does not. What this is, one can only guess. Recent Fed comments are not “measured” nor commensurate with economic data. They fly in the face of their claim that policy will be “data dependent.”

The stock market may continue to march higher on dovish Fed-speak. In doing so, it will ignore the elephant in the room, and that is why the Fed is battening down the hatches on such a calm and sunny day.

When the market discovers the reason for the pivot, volatility may suddenly pick up and the gains resting on the back of a dovish Fed tilt may quickly be erased. Until then enjoy the rally but keep both eyes on the horizon.

 

 

 

 

President Trump often tweets about the strength and health of the U.S. economy, and two weeks ago, he tweeted that the U.S. economy was the Gold Standard throughout the World.

The fact that Trump capitalized the words “Gold Standard” may have piqued the interest of those who believe in sound money principles.  Trump has in fact spoken in the past about a return to the Gold Standard, and some of the issues surrounding this are summarized in an October 2018 article: Trump Puts Gold Standard On The Table.

A simple interpretation of Trump’s tweet means that the U.S. economy is the envy of the world, the benchmark by which other economies measure themselves.

Nevertheless, Trump’s tweet can be viewed as valid in another way, whether this interpretation was intended or not.  When the U.S. dollar was de-linked from the value of gold in 1971, the U.S. dollar and its economy became the Gold Standard.  The U.S. dollar is the primary reserve currency throughout the world, and therefore almost everything bought or sold in the world has a reference point to the value of the dollar.

The value of the dollar is related to the health of the U.S. economy, and the U.S. economy, absent a “real” gold standard, IS the monetary standard throughout the world.

We are not suggesting that Trump will help navigate the world back to a Gold Standard, and any political, strategic or tactical discussions on that point are above our pay grade.  In fact, we prefer to summarize our understanding of the gold market by way of two children’s stories.

Fables and Fairy Tales

Everyone loves a good story.  Good stories can give us hope and fill us with courage.  Good stories can teach us what is “good” and what is “evil.”  Good stories give us examples to follow and mistakes to avoid.   Good stories resonate with us and even help frame our understanding of reality.

Simple stories can the most entertaining ones, and great stories are replayed again and again in many different ways.  A common, mistreated and honorable girl falls in love and marries the prince (i.e. Cinderella).  The swashbuckling hero takes from the rich and gives to the poor (i.e. Robin Hood).  The wayward and shame-stricken son finds his way to become the king of the jungle (i.e. The Lion King).

Two well-known fables that summarize our understanding the gold market: Rumpelstiltskin and The Boy Who Cried Wolf.

Rumpelstiltskin

In the story of Rumpelstiltskin, a goblin-like creature appears to help a girl turn straw into gold for a king.  The girl’s father had promised the king that the girl herself could accomplish this task.  Her ultimate reward is marriage, but her punishment is death if she cannot.  Rumpelstiltskin has increasing demands for the girl in exchange for his magical feat of doing what she could not – turning straw into gold.

Without getting into the finer details, let’s take a step back and consider the power that someone would have if they could turn common straw into gold, whether they are a king, a girl or a goblin.  If you could turn paper into gold, then money would literally grow on trees, just for you.

It is not a stretch of the imagination to see that the turning-straw-into-gold ability exists for those who sell paper derivative gold of all kinds.  A large amount of investors demand for gold exists primarily in paper or electronic forms – whether such demand is for gold-backed ETFs or gold futures contracts.  The banks and brokers who satisfy this demand have a license to create “gold” from paper (or electronic promissory notes).

Gold selling banks and brokers usually sell paper “gold” without necessarily acquiring more physical gold reserves.  Spoken plainly – they often sell gold they do not have.  It is easy to imagine how this scheme can distort price discovery in the gold market.

The paper-derivative gold supply scheme is an accomplishment that should make even Rumpelstiltskin proud.

The Boy Who Cried Wolf

This story is about a shepherd boy who repeatedly issues a false alarm to nearby villagers, claiming that wolves are attacking his flock. When a wolf actually does appear and the boy again calls for help, the villagers believe that it is another false alarm and the sheep are eaten by the wolf.

There are many well-intentioned shepherd boys in the gold market (and some not so well-intentioned), who on regularly highlight problems with the worldwide monetary system.  The “wolf” in this case might be characterized as a form of worldwide monetary reset, perhaps with physical gold as a benchmark, rather than the U.S. dollar.

There is burgeoning and unsustainable debt creation worldwide.  The U.S. dollar is losing ground as the benchmark reserve currency.  There is increasing accumulation of physical gold reserves by central banks worldwide.   The BRIC nations are creating payment systems to rival the U.S. dollar-based SWIFT payment system.  There is indeed evidence that the wolf is on the prowl, and investors should consider how to protect their savings and long-term purchasing power.

On the other hand, shepherd boys have been crying, “WOLF!” for over a decade since the 2008 financial crisis, and many investors have been misled – especially those who have bought paper-derivative gold on a DATE-CERTAIN-THIS-IS-THE-BIG-ONE panic.

We believe that investors should seriously consider buying precious metals.  But investors should also prudently assess whether they MUST ACT NOW when they do so.

Here is the bottom line for the long-term: every major economy is printing more and more paper currency. The value of money, like any other commodity, rises and falls as the supply changes.  As the money supply continues to increase over time, the value of gold relative to those currencies will increase over time.  It is that simple.

Here’s why we believe The Boy Who Cried Wolf metaphor is so appropriate.  The wolf is coming.  We don’t know when, why or how, but he is coming. It could be next month, or it could be many years from now.  When he does come, it won’t matter whether you purchased gold at $1,200 or $1,500 per ounce.  Either way, your purchasing power should be protected over the long run.

Until the wolf does come – and even after he does – it might be prudent to purchase physical gold (or other precious metals) on a routine, dollar-cost-averaging basis, regardless of the headlines and whatever the shepherd boys are calling out this week.

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 – Abbot Laboratories

  • ABT rallied and broke out to a new high.
  • We are currently up nearly 10% in the position and with a “buy” signal approaching we will use weakness to add to the position accordingly.
  • Stop-loss moved up to $70.

AEP – American Electric Power

  • Like ABT, AEP has also broken out to new highs.
  • We currently only carry a 1/2 position in AEP so we will add to the position on any weakness that doesn’t violate support.
  • Currently, with a bit more than a 9% gain, we are tightening up stops.
  • Stop is currently $76 Short-Term
    • Holding 1/2 position currently
    • Looking for opportunity to increase exposure opportunistically.

DOV – Dover Corp.

  • Trade war…what trade war. Our basic materials holdings have been burning it up lately.
  • After taking profits in DOV and buying VMC, DOV has continued to rally busting out to new highs.
  • More importantly, DOV is switching back onto a buy signal which will allow us to add to the position on some weakness.
  • Stops moved up to $85
    • Looking for a suitable position to swap into.
    • Stop-loss moved up to $64

FDX – Federal Express

  • After adding FDX to the portfolio, it has rallied and we are carrying about a 12.5% gain.
  • FDX is still on a longer-term “sell” signal and is wrestling with short-term moving average resistance which keeps us cautious.
  • We like the company longer-term but stops are moved up to $170

HCA – HCA Health Care

  • HCA has rallied nicely since we added it to the portfolio. Currently we are carrying 1/2 position with a 4.75% gain in just a couple of weeks.
  • We are looking for some weakness to add to our position that doesn’t violate our stop-loss.
  • Stop-loss is at $130

MDLZ – Mondelez International

  • They say “buy what you love” and I am loving “Oreo” cookies.
  • We initially bought 1/2 postion in MDLZ hoping for an opportuntiy to build into it. The stock hasn’t given us that opportunity yet.
  • However, with MDLZ now on a buy signal, and up almost 16% since our purchase, we will wait for a bit of a consolidation or pullback to add our second half to our holdings.
  • MDLZ has broken out of a very long consolidation pattern which suggests substantial upside remains from current levels.
  • However, we are tightening up stops to protect our profits.
  • Stop is at $44

MMM – 3M Corp.

  • Following a good earnings report, MMM rallied into resistance at the long-term moving average.
  • We stated last week, MMM needed to move above resistance to add to the position. It did that this week, so we will look to add to the holding.
  • The sell signal has also reversed back to a buy so we are getting much more bullish on MMM in the short-term. 
  • Stop-loss moved up to $200

NSC – Norfolk Southern

  • NSC rallied sharply this week taking us to a 20% profit on our holding.
  • With a buy signal fast approaching we will look to add to our holding on a pullback or consolidation that doesn’t violate out stop loss.
  • Stop-loss is tight at $170 currently.

PG – Proctor & Gamble

  • PG broke out to all-time highs and gained traction which is very bullish.
  • We are currently only carrying 1/2 position with a and will look to add on a pullback to support that doesn’t violate our stop.
  • Stop-loss moved up to $94

UNH – United Health Care

  • This past week we added 1/2 position of UNH to the portfolio.
  • You will notice we like health care a lot in our portfolio.
  • UNH had pulled back to support and bounced nicely off of it yesterday.
  • Currently on a sell-signal (bottom panel) but is beginning to improve.
  • Stop-loss is at $260

In this 4-part RIA series, I urge investors to develop their “Gut Box,” and not remain blindfolded to the stories that are churned out by Wall Street and regurgitated by the front lines of big-box financial retailers. Their objective is to keep money invested in stocks regardless of how long it takes to recover from losses. Losses don’t matter to them. They matter to you.

Which brings me to the scion of Wall Street’s stories. The big daddy. The fable so entrenched it’s a religion.

It’s not if you heard this one – it’s how many times you’ve heard it.

“Stocks are for the long run.”

Heck, there are books about the topic everywhere. It’s a darn religion. To sell stocks or surgically exit markets is like striking a stake into the heart of your broker (or his wallet).

Speaking of stakes: Have you ever wondered how vampires have managed to become so wealthy and live in such lush mansions on big hills? Easy. They began investing in the stock market back in 1871 and never sold. They averaged that ethereal promise of 10% annual compounded returns for stocks!

Alas, as humans we do not possess such an opportunity. Not consistently, anyway. You see – institutions are infinite. As flesh & blood, we are finite. To markets, 10 years is a half beat from an eternal heart. To individual investors, a decade can be a heart attack.

I guarantee (in financial services, guarantee is a four-letter word), that stocks will be higher in a century. I also guarantee that you won’t care either.

So, let’s adjust your gut box, shall we? Pay attention to the following tenets. Your wealth will thank you in the end (the human end).

Stocks are not safer in the long run.

Remember – it’s not stocks for the long term, it’s stocks for YOUR TERM.

Don’t be blinded by the panacea of stocks. Markets are irrational. Markets are driven by emotion. Even the father of Modern Portfolio Theory, Harry Markowitz wrote his seminal thesis originally for institutions, NOT people. The financial industry highjacked his work to sell product. Plain and simple.

Unlike the cancerous dogma communicated by money managers like Ken Fisher who boldly states that in the long-run, stocks are safer than cash, stocks are not less risky the longer you hold them. Unfortunately, academic research that contradicts the Wall Street machine rarely filters down to retail investors. One such analysis is entitled “On The Risk Of Stocks In The Long Run,” by prolific author Zvi Bodie, the Norman and Adele Barron Professor of Management at Boston University.

In the study, he busts the conventional wisdom that riskiness of stocks diminishes with the length of one’s time horizon. The basis of Wall Street’s counter-argument is the observation that the longer the time horizon, the smaller the probability of a shortfall. Therefore, stocks are less risky the longer they’re held. In Ken Fisher’s opinion, stocks are less risky than the risk-free rate of interest (or cash) in the long run. Well, then it should be plausible for the cost of insuring against earning less than the risk-free rate of interest to decline as the length of the investment horizon increases.

Dr. Bodie contends the probability of a shortfall is a flawed measure of risk because it completely ignores how large the potential shortfall might be. Sound familiar? It should. We write of this dilemma frequently here on the blog. Using the probability of a shortfall as the measure of risk, no distinction is made between a loss of 20% or a loss of 99%.

If it were true that stocks are less risky in the long run, it should portend to a lower cost to insure against that risk the longer the holding period. The opposite is true. Dr. Bodie uses modern option pricing methodology i.e., put options to validate the truth.

Using a simplified form of the Black-Scholes formula, he outlines how the cost of insurance rises with time. For a one-year horizon, the cost is 8% of the investment. For a 10-year horizon it is 25%, for a 50-year time frame, the cost is 52%.

As the length of horizon increases without limit, the cost of insuring against loss approaches 100% of the investment. The longer you hold stocks the greater a chance of encountering tail risk. That’s the bottom line (or your bottom is eventually on the line).

There exists a formidable body of work that validates reducing equity exposure as markets break down. It’s not a ‘all in, all out’ story. It’s a surgical reduction saga. Sell until you can handle the motion. If you must sell all stocks in your portfolio to feel better, then frankly, you shouldn’t own stocks regardless of the conditions. It’s a harsh truth but best to face it.

Andrew Lo, professor of finance at the MIT School of Management, creator of the Adaptive Market Theory and co-author of A Non-Random Walk Down Wall Street outlines that stock price movements are all not random.

Today more than ever, stock prices balk at random walks. With the proliferation of algorithms with big mathematical hooks that grab on to the latest trend (up or down), stocks herd on steroids.

It’s crucial that an advisor maintains a sell or risk reduction strategy based on rules. No system is perfect. The key is to ask the question, understand the rules and then determine whether you agree with the sell philosophy. A surgical sell discipline isn’t active trading. It’s risk management. Time may or may not minimize your risk depending on how many months and years you’re willing to trade to get ahead or most likely, just breakeven which gets me to…

Investing to breakeven is NOT a strategy.

It occurs too often I meet with an investor who has wasted most of an investing life breaking even; where most of the portfolio “returns” are derived from human capital commitment or the ability to invest on a consistent basis. I cannot solely blame the stock market for such unfortunate outcomes. It’s a behavioral soup with a foundation in financial industry stretches of the truth that lethally mix with high fees, bad advice and a complacent attitude toward the lasting damage of bear markets (markets laugh at bears but bears damage humans).

Time grows increasingly precious. There’s a point where you painfully internalize its speed, comprehend its worth. Unlike markets that can disrespect time, laugh defiantly in its face – time as it moves ahead at hyper-speed, batters the human condition like storms against aging barriers.  Investors recognize the luxury of waiting for recovery of wealth runs short. Scars remain where money once existed.

Realistically, you as a human probably experiences 20 uninterrupted years of saving before life gets in the way of a long-term plan – An illness, layoff, underemployment, caregiving for a loved one, college loans for children and grandchildren. The tribulations of life are not part of a broker’s story. Too depressing. So, how many years of breakeven are you willing to accept? Can your entire investing life be sadly dictated by breakeven? Yea, it can.

Harvesting stocks or selling, does not classify you as a trader (traitor).

Valid reasons exist (no, really), for the harvest of stock investments.

  1. Your portfolio allocation hasn’t been rebalanced in what feels like an eternity. Brokers are great at selling, not so great at ongoing portfolio maintenance or risk management which includes bringing stock allocations back into alignment with your emotionally-neutral allocation or willingness to take on risk. For example, if an agreed-upon allocation target is 30% stocks, 70% fixed income and stands at 45%, it’s acceptable to act to reduce stocks to 30% and increase cash or bond exposure. With Fed Chair Powell seeking to relent to stock markets perhaps due to slowing economic growth, the “Powell Put” has provided a brief tailwind to stocks which is an opportunity to sell.
  2. The risk reward for stocks vs. cash isn’t as appealing during a market cycle. In the brokerage biz, cash is trash. The mandate from upper management (or lose your job) is cash must be monetized, cemented into managed product for fee revenue.

Below is a chart we feature at our Retirement “Right-Lane” Class. One of my favorites.

Here, RIA’s Chief Investment Strategist Lance Roberts outlines the inflation-adjusted return of $100 invested in the S&P 500 (capital appreciation only using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller’s CAPE ratio. Lance caps the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets. He then conducts a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves back to cash at a ratio of 23x.

During the great inflation of the 1970s in the United States, the value of cash experienced downward pressure. In other words, although the CAPE ratio in 1970 was roughly 23x, the switch to cash didn’t work so well.

Today, with the Shiller PE at roughly 29x, the 2-year Treasury yield at 2.467% and cash in money markets earning close to 2%, a tactical overweight to cash and short-duration bonds is not a bad idea. Per the Federal Reserve Bank of Dallas’ Trimmed Mean PCE Inflation Rate which stands at an annualized rate of 1.9%, inflation doesn’t appear to be out of control. In other words, the maintenance of cash shouldn’t place your long-term personal rate of return targets in jeopardy.

Brokers lament – “Cash isn’t working for you! Cash will lose to inflation!” Well, there are times when cash will do just that. However, it’s the responsibility of your money manager to make portfolio adjustments. The ebb and flow of portfolios to adjust for risk is a responsibility most brokers will not undertake therefore they must trash cash regardless of valuations and the overall health of the market.

REMEMBER – It’s not cash forever; it’s cash for now.

As Lance so eloquently states –

“While no individual could effectively manage money this way, the importance of “cash” as an asset class is revealed. While cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at lower valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover.

While we can debate over methodologies, allocations, etc., the point here is that “time frames” are crucial in the discussion of cash as an asset class. If an individual is “literally” burying cash in their backyard, then the discussion of the loss of purchasing power is appropriate.

However, if cash is a “tactical” holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future.”

Much of the mainstream media will quickly disagree with the concept of holding cash and tout long-term returns as the reason to just remain invested in both good times and bad. The problem is it is YOUR money at risk. Furthermore, most individuals lack the “time” necessary to truly capture 30 to 60-year return averages.

Stocks are one alternative to growing and preserving wealth. They’re not the only investment in town. There is no time period (unless you’re Dracula), where stocks should be considered ‘safe.’ There are cycles where risk vs. reward are in an investor’s favor. There are occasions when taking on more risk does not generate a commensurate or greater degree of return. Sometimes, it’s merely taking on more risk.

It’s the responsibility of an advisor to establish and communicate realistic expectations for future returns for risk assets and assess whether stocks are a head or tailwind to achieving financial objectives.

In this past weekend’s missive, we discussed the market stalling at the 200-dma. To wit:

“We said then the most likely target for the rally was the 200-dma. It was essentially the level at which the ‘irresistible force would meet the immovable object.'”

“What will be critically important now is for the markets to retest and hold support at the Oct-Nov lows which will coincide with the 50-dma. A failure of that level will likely see a retest of the 2018 lows.” 

“A retest of those lows, by the way, is not an “outside chance.” It is actually a fairly high possibility.  A look back at the 2015-2016 correction makes the case for that fairly clearly.”

“But even if a retest of lows doesn’t happen, you should be aware that sharp market rallies are not uncommon, but almost always have a subsequent retracement.”

Importantly, as I expanded to our RIA PRO subscribers:

We are likely going to have another couple of attempts next week as the bulls aren’t ready to give up the chase just yet. We are continuing to watch the risk carefully and have been working on repositioning portfolios over the last couple of weeks. 

As noted, we lifted profits at the 200-dma and added hedges to the Equity and Equity Long/Short portfolios.”

On Monday, the markets rallied a bit out of the gate over continuing hopes of a “trade deal” between the U.S. and China but fell back to even by the end of the day. With earnings season now largely behind us, the “bulls” are going to need improving economic data and relief from Washington to provide continued support for the rally.

This morning, futures are once again pointing higher on news that a proposal is ready to be sent to the President providing just $1.4 billion for border “security,” no wall, to avert another Government shut down. It is highly likely the bill will be rejected by the President and he will start talking about the use of a “national security” issue to fund the building of the wall. This will divide Congress even more than it is already almost ensuring NO legislation passes before the end of the President’s first term.

Also, talks are once again starting with China over trade. This is also buoying markets in the short-term in hopes of a resolution to reduce the impact of tariffs on businesses. Hopes for a noteworthy “deal” remain extremely slim at this point.

But those two issues are actually relatively minor as other issues, as noted on Saturday, will actually bear much more weight on the market going forward.

  • Earnings estimates for 2019 have sharply collapsed as I previously stated they would and still have more to go. In fact, as of now, the consensus estimates are suggesting the first year-over-year decline since 2016.
  • Stock market targets for 2019 are way too high as well.
  • Despite the Federal Reserve turning more dovish verbally, they DID NOT say they actually WOULD pause their rate hikes or stop reducing their balance sheet.
  • Larry Kudlow said the U.S. and China are still VERY far apart on trade.
  • Trump has postponed his meeting with President Xi which puts the market at risk of higher tariffs. 
  • There is a decent probability the U.S. Government winds up getting shut down again after next week over “border wall” funding. 
  • The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  • Economic growth is slowing as previously stated.
  • Chinese economic has weakened further since our previous note.
  • European growth, already weak, will likely struggle as well. 
  • Valuations remain expensive

Of course, despite those more macro-concerns, the market has had a phenomenal run from the “Christmas Eve” lows and has moved above both the Oct-Nov lows and the 50-dma. This is clearly bullish in the short-term for investors. With those levels of previous resistance now turned support, there is a little cushion for the bulls to hold on to.

The biggest hurdle for a bullish advance from current levels is the cluster of resistance sitting just overhead. Sven Heinrich noted the market remains stuck below the collision of the 200-day, the 50-week, and the 15-month moving averages.

As shown, this set up previously existed back in late 2015 and early 2016. The initial challenge saw the market actually break back above the cluster of resistance, which “sucked the bulls” back into the market before setting new lows.

The correction, that was then in process, was cut short by massive infusions of global liquidity as I discussed yesterday:

“Global Central banks had stepped in to flood the system with liquidity. As you can see in the chart below, while the Fed had stopped expanding their balance sheet, everyone else went into over-drive.”

Another concern for a further rally is that investor allocations never got extremely bearish. The chart below compares the S&P 500 to various measures of Rydex ratios (bear market to bull market funds)

Note that during the recent sell-off, the move to bearish funds never achieved the levels seen during the 2015-2016 correction. More importantly, the snap-back to “complacency” has been quite astonishing. The next chart puts it into a longer-term perspective for comparison.

Despite the depth of the decline, and the belief that the “bear market” of 2018 is now complete, it is worth noting the reversion in investor positioning has not even begun to approach levels seen during an actual “bear market.”

But stepping back to the long-term trends, when managing money the most important part of the battle is getting the overall “trend” right. “Buy and hold” strategies work fine in rising price trends, and “not so much” during declines.

The reason why most “buy and hold” supporters suggest there is no alternative is because of two primary problems:

  1. Trend changes happen slowly and can be deceptive at times, and;
  2. Bear markets happen fast.

Since the primary messaging from the media is that “you can’t miss out” on a “bull market,” investors tend to dismiss the basic warning signs that markets issue. However, because “bear markets” happen fast, by the time one is realized, it is often too late to do anything about it.

So, you just have to ride it out. You don’t have any other option. Right?

The chart below is one of my favorites. It is a monthly chart of several combined indicators which are excellent at denoting changes to overall market trends. The indicators started ringing alarm bells in early 2018 which is when I begin talking about the end of the “bull market” advance.

Currently, every single monthly indicator, as of the end of January, is currently suggesting downward pressure on the market. The only signal which has yet to confirm is the cross of the 15-month and 21-month moving averages. The 21-month moving average has pretty much been both support and/or resistance, to the overall trend of the market for the past 25-years. At present, the market is “trapped in the middle” between those two monthly averages.

If the bull market is going to resume, the market needs to break above the 15-month moving average and rally enough to reverse the torrent of sell-signals running across the complex of price indications. With earnings and economic growth weakening, this could be a tough order to fill in the near term.

So, for now, with our portfolios underweight equity, over weight cash and fixed income, we remain “stuck in the middle with you.”

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

  • Long-term trend line is currently broken
  • Previous support from February lows has been broken and is now resistance.
  • Sell-signal is reversing (bottom panel)
  • XLB back to extreme overbought conditions (top panel)
  • Running into downtrend resistance in channel.
  • Short-Term Positioning: Neutral
    • Last Week: Recommend to hold 1/2 position.
    • This Week: Hold
    • Stop-loss moved up to $62
  • Long-Term Positioning: Bearish

Communications

  • Long-term trend line is currently broken
  • XLC finally broke above resistance due to rally in NFLX
  • Sell-signal (bottom panel) is reversing.
  • Sector back to extreme overbought.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended to “hold” 1/2 position
    • This Week: Hold 1/2 position
    • Stop-loss moved up to $45
  • Long-Term Positioning: Bearish

Energy

  • Long-term trend line is currently broken
  • Previous support from February lows and has rallied back to resistance.
  • 200-Day Moving average is sloping downward providing additional price pressure.
  • Sell-signal (bottom panel) is reversing
  • Back to extreme overbought condition. Failed at resistance.
  • Short-Term Positioning: Neutral
    • Last week: Recommend “hold” 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss moved up to $63
  • Long-Term Positioning: Bearish

Financials

  • Long-term trend line is currently broken
  • Previous support from 2017 consolidation is currently holding.
  • Sell-signal (bottom panel) is reversing
  • XLF back to extreme overbought condition short-term. Failed at downtrend resistance.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss moved up to $25.50
  • Long-Term Positioning: Bearish

Industrials

  • Long-term trend line is currently broken
  • Finally broke above resistance from February lows.
  • Sell-signal (bottom panel) is reversing.
  • Back to extreme overbought conditions short-term.
  • Sector pushed up above downtrend resistance.
  • Short-Term Positioning: Bullish
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position, add on pullback to $71
    • Stop-loss moved up to $70
  • Long-Term Positioning: Neutral

Technology

  • Long-term trend line is currently broken
  • Broke above February low resistance level.
  • Sell-signal (bottom panel) is reversing.
  • Back to extreme overbought conditions short-term.
  • Pushed above downtrend resistance
  • Short-Term Positioning: Bullish
    • Last week: Recommended sell “hold” 1/2 position
    • This week: Hold 1/2 position, Add on pullback to $65-66
    • Stop-loss moved up to $64.00
  • Long-Term Positioning: Neutral

Staples

  • Long-term trend line is currently broken
  • Previous support from 2016 and 2017 is holding and pushed above the 400-dma.
  • Early sell-signal (bottom panel) is reversing back to “buy”
  • Currently back to extreme overbought conditions but pushed above important resistance.
  • Short-Term Positioning: Bullish
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position, look to add 1/2 position on pullback.
    • Stop-loss remains at $52.50
  • Long-Term Positioning: Bullish

Real Estate

  • Long-term trend line is currently holding.
  • Just broke out to all-time highs.
  • Early sell-signal has reversed back to buy. (bottom panel)
  • Back to extreme overbought condition short-term. (top panel)
  • Short-Term Positioning: Bullish
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position
    • Add on any weakness that works off over-bought condition or holds support at $33
    • Stop-loss adjusted to $32.50
  • Long-Term Positioning: Bullish

Utilities

  • Long-term trend line remains intact.
  • Previous support continues to hold.
  • Sell signal close to reversing. (bottom panel)
  • Heading back to overbought, upside remains. Broke above resistance which puts all-time highs into focus.
  • Short-Term Positioning: Bullish
    • Last week: Recommended “buy” 3-weeks ago
    • This week: Hold
    • Stop-loss moved up to $54 with a target of $56
  • Long-Term Positioning: Bullish

Health Care

  • Sector broke the longer term trend but recovered on rally.
  • Sell-signal (bottom panel) is being reversed.
  • Back to extreme overbought conditions (top panel) and failed at target resistance.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss moved up to $88
  • Long-Term Positioning: Neutral

Discretionary

  • Long-term trend line has been broken.
  • Previous support was violated but was reclaimed.
  • Downtrend resistance has been broken but overhead resistance remains short-term. Rally failed at resistance.
  • Sell signal close to being reversed. (bottom panel)
  • Back to extreme overbought conditions short-term.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss moved up to $106.00
  • Long-Term Positioning: Neutral

Transportation

  • Long-term trend line has been violated.
  • Previous support is holding for now.
  • Sell signal. (bottom panel) is being reversed.
  • Extreme overbought on a short-term basis. But XTN broke above downtrend resistance. 
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 of position
    • Stop-loss moved up to $58
  • Long-Term Positioning: Bearish
Bill Dudley, who is now a senior research scholar at Princeton University’s Center for Economic Policy Studies and previously served as president of the New York Fed and was vice-chairman of the Federal Open Market Committee, recently penned an interesting piece from Bloomberg stating:

“Financial types have long had a preoccupation: What will the Federal Reserve do with all the fixed income securities it purchased to help the U.S. economy recover from the last recession? The Fed’s efforts to shrink its holdings have been blamed for various ills, including December’s stock-market swoon. And any new nuance of policy — such as last week’s statement on “balance sheet normalization” — is seen as a really big deal.

I’m amazed and baffled by this. It gets much more attention than it deserves.”

I find this interesting.

A quick look a the chart below will explain why “financial types” have a preoccupation with the balance sheet.

The preoccupation came to light in 2010 when Ben Bernanke added the “third mandate” to the Fed – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

In his opening paragraph, Bill attempts to dismiss the linkage between the balance sheet and the financial markets.

“Yes, it’s true that stock prices declined at a time when the Fed was allowing its holdings of Treasury and mortgage-backed securities to run off at a rate of up to $50 billion a month. But the balance sheet contraction had been underway for more than a year, without any modifications or mid-course corrections. Thus, this should have been fully discounted.”

While this is a true statement, what Bill forgot to mention was that Global Central banks had stepped in to flood the system with liquidity. As you can see in the chart below, while the Fed had stopped expanding their balance sheet, everyone else went into over-drive.

The chart below shows the ECB’s balance sheet and trajectory.  Yes, they are slowing “QE” but it is still growing currently.

It’s All About Yield

But Bill then moves to the impacts on yields:

“Moreover, if anything, the run-off of the Fed’s balance sheet had a smaller-than-expected impact on the yields of those securities. Longer-term Treasury yields remained low, and the spread between them and the yields on agency mortgage-backed securities didn’t change much. It’s hard to see how the normalization of the Fed’s balance sheet tightened financial conditions in a way that would have weighed significantly on stock prices.”

Yes, it is true that nominal yields may not have changed much in total, but what Bill missed was the impact of the “rate of change” on the economy. As I noted back in October:

“On Thursday and Friday, stocks crumbled as the reality that higher rates and tighter financial conditions will begin to negatively impact growth data. With housing and auto sales already a casualty of higher rates, it won’t be long before it filters through the rest of the economy.

The chart below shows nominal GDP versus the 24-month rate of change (ROC) of the 10-year Treasury yield. Not surprisingly, since 1959, every single spike in rates killed the economic growth narrative.”

As we have written about many times previously, the linkage between interest rates, the economy, and the markets is extremely tight. As the Fed began reducing their balance sheet the roll-off caused rates to jump to more than 3%.

In turn, higher rates which directly impacted consumers, led to an almost immediate downturn in economic activity. Specifically, in September of last year, we wrote:

“Rising interest rates, like tariffs, are a ‘tax’ on corporations and consumers as borrowing costs rise. When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events.”

Of course, it was the following month the market begin to peel apart.

As Bill noted, part of the reason for the correction in the market was indeed the realization of what we had been warning about since the beginning of the year – weaker growth.

“But the cracks are already starting to appear as underlying economic data is beginning to show weakness. While the economy ground higher over the last few quarters, it was more of the residual effects from the series of natural disasters in 2017 than ‘Trumponomics’ at work. The “pull forward” of demand is already beginning to fade as the frenzy of activity culminated in Q2 of 2018.

To see this more clearly we can look at our own RIA Economic Output Composite Index (EOCI). (The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.”

Not surprisingly, and to Bill’s point, the market turned lower as a host of pressures still remain.

  • Earnings estimates for 2019 have sharply collapsed as I previously stated they would and still have more to go.
  • Stock market targets for 2019 are way too high as well.
  • Trade wars are set to continue as talks with China will likely be fruitless.
  • The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  • Economic growth is slowing as previously stated.
  • Chinese economic has weakened further since our previous note.
  • European growth, already weak, will likely struggle as well. 
  • Valuations remain expensive

Reserve Some For Me

Bill Dudley made a very interesting statement in relation to “excess reserves.” 

“The new news here is simply that Fed sees greater demand for reserves than it expected a year ago.” 

Why? What changed? Why do banks require more reserves, now?

The chart above shows excess reserves relative to the S&P 500. When bank reserves have previously declined, it was in the midst of market turmoil. It was then either the Federal Reserve, or global Central Banks, injected liquidity into the system.

The reason the banks need reserves, particularly during a market decline, is to ensure there is enough liquidity to meet demands for capital. This is also suggestive of why Steve Mnuchin, the Secretary of the Treasury, decided, just prior to Christmas as the market plunged, to call all the major banks to “assure them that liquidity was readily available.” 

Given that it is highly unusual for the Treasury Secretary to call the heads of banks AND the “President’s Working Group On Financial Markets,” aka the “plunge protection team,” to try assuage market fears, it raises the question of what does the Treasury know that we don’t?

The One Thing

However, the one statement, which is arguably the most important for investors, is what Bill concluded about the size of the balance sheet and it’s use a a tool to stem the next decline.

“The balance sheet tool becomes relevant only if the economy falters badly and the Fed needs more ammunition.”

In other words, it will likely require a substantially larger correction than what we have just seen to bring “QE” back into the game. Unfortunately, as I laid out in “Why Another 50% Correction Is Possible,” the ingredients for a “mean-reverting” event are all in place.

“What causes the next correction is always unknown until after the fact. However, there are ample warnings that suggest the current cycle may be closer to its inevitable conclusion than many currently believe. There are many factors that can, and will, contribute to the eventual correction which will ‘feed’ on the unwinding of excessive exuberance, valuations, leverage, and deviations from long-term averages.

The biggest risk to investors currently is the magnitude of the next retracement. As shown below the range of potential reversions runs from 36% to more than 54%.”

“It’s happened twice before in the last 20 years and with less debt, less leverage, and better funded pension plans.

More importantly, notice all three previous corrections, including the 2015-2016 correction which was stopped short by Central Banks, all started from deviations above the long-term exponential trend line. The current deviation above that long-term trend is the largest in history which suggests that a mean reversion will be large as well.

It is unlikely that a 50-61.8% correction would happen outside of the onset of a recession. But considering we are already pushing the longest economic growth cycle in modern American history, such a risk which should not be ignored.”

While Bill makes the point that “QE” is available as a tool, it won’t likely be used until AFTER the Fed lowers interest rates back to the zero-bound. Which means that by the “QE” comes to the fore, the damage to investors will likely be much more severe than currently contemplated.

There is one important truth that is indisputable, irrefutable, and absolutely undeniable: “mean reversions” are the only constant in the financial markets over time. The problem is that the next “mean reverting” event will remove most, if not all, of the gains investors have made over the last five years.

This is why us “Financial Types” pay such close attention to the size of the Fed’s balance sheet.

MarketWatch published a piece today called “It’s been almost 100 years since America’s 1% had this much wealth“:

It’s not fashionable to wear flapper dresses and do the Charleston, but 1920s-style wealth inequality is definitely back in style.

New research says America’s ultra-rich haven’t held as much of the country’s wealth since the Jazz Age, those freewheeling times before the country’s finances shattered.

“U.S. wealth concentration seems to have returned to levels last seen during the Roaring Twenties,” wrote Gabriel Zucman, an economics professor at the University of California, Berkeley.

Zucman said all the research on the issue also points to large wealth concentrations in China and Russia in recent decades. The same thing is happening in France and the U.K., but at a “more moderate rise,” the paper said.

In 1929 — before Wall Street’s crash unleashed the Great Depression — the top 0.1% richest adults’ share of total household wealth was close to 25%, according to Zucman’s paper, which was distributed by the National Bureau of Economic Research.

As I’ve explained countless times (but nobody seems to listen), growing U.S. wealth inequality is the byproduct of an unsustainable bubble in asset prices such as stocks and bonds:

What is lost on left-wing wealth inequality alarmists like Gabriel Zucman is the fact that America’s wealth inequality is not a permanent situation, but a temporary one because the asset bubbles behind the wealth bubble are going to burst and cause a severe economic crisis. My argument is that our society should be worrying more about these asset bubbles than the temporary inequality.

What is the common denominator between U.S. wealth inequality during the Roaring Twenties and now? A massive stock market bubble, which I have written about extensively:

Why isn’t Gabriel Zucman discussing the role of the Fed-driven U.S. stock market bubble in driving wealth inequality? It’s very simple: he is disingenuous and not interested in genuine solutions. His goal is to help make the United States a socialist country – end of story. I will be writing much more extensively on this topic in the near future – stay tuned.

Please follow me on LinkedIn and Twitter to keep up with my updates.

Please click here to sign up for our free weekly newsletter to learn how to navigate the investment world in these risky times.

Ever since the market plunge and sharp reversal late last year, the financial markets have been trading in a truly bizarre, confusing manner. A Bloomberg piece describes this dynamic well – “Weird Market Moves Mean No One Knows If It’s Goldilocks Or Bust“:

Investors are riding helter-skelter markets — causing headaches as they try to figure out whether Goldilocks is back or recession is nigh.

From stocks, currencies to commodities, a slew of assets are moving in seemingly erratic ways.

Take the U.S. dollar — it’s on a rip higher ever since the Federal Reserve took a dovish pivot. Small-cap stocks are among the best-performing equities out there, even though the only thing everyone seems to agree on is that we’re late in the cycle. And industrial metals and miners are surging as the world’s biggest consumer slows down.

It all helps to explain the lack of consensus that’s been on display across markets this year.

“It’s very erratic and a clear direction is missing,” reckons Georgette Boele, a currency and commodity strategist at ABN Amro Bank NV. “There’s a lot of uncertainty with Brexit, trade negotiations, China’s economy, the weaker euro zone data and unclear picture about U.S. data — this all makes it a very hard market to trade.”

While bulls in credit and emerging markets are on the rampage, government bonds are getting a mammoth bid and outflows are hitting rallying stocks.

A New York Times piece describes the Fed’s 180 degree move a “flip-flop” (I called it a #FedFake) – “Flip-Flop by Fed Scrambles Outlook for World Markets“:

Once again, the Federal Reserve has upended markets.

Investors had been bracing for the Fed to keep raising interest rates and shrinking its vast portfolio of assets, the equivalent of tapping on the brakes of the United States economy.

But this year, the central bank has signaled that it was backing off.

Much has been written about the stock market’s joyful reaction to the Fed’s altered approach. But the impact was much broader than that. The central bank’s shift cascaded through markets around the world in ways large and small.

Essentially, the bizarre trading in U.S. stocks is the result of a tug-of-war that is occurring: the market wants to fall and needs to fall, but it is being propped up by the Fed and other central banks. The market “wants” to fall due to the downward pressure created by the Fed’s balance sheet unwind, high valuations, falling earnings estimates, uncertainty caused by the trade war with China, Brexit, etc., but is being propped up by the Plunge Protection Team, the Fed’s dovish turn, and foreign central bank balance sheet expansions.

The chart of the cyclically-adjusted P/E ratio below shows that the U.S. stock market is still quite overvalued, which explains the natural tendency for the market to fall unless it is actively being propped up:

How will this situation resolve itself? Unfortunately, I can only see it ending in chaos. Central banks are becoming increasingly desperate to keep the bubble markets inflated, which means that risk is being transferred to unbacked fiat (or “paper”) currencies. While this approach may assuage the fears of market participants for a while longer, it’s just a matter of time before the currencies themselves bear the brunt of the debasement.

Please follow me on LinkedIn and Twitter to keep up with my updates.

Please click here to sign up for our free weekly newsletter to learn how to navigate the investment world in these risky times.

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

  • Long-term trend line is currently broken.
  • Recent rally pushed above initial resistance and the downtrend line from the 2018 highs.
  • Initial test of 200-dma failied. Will likely be another challenge. 
  • If challenge fails, and breaks last week’s low, look for test of Oct-Nov lows and 50-dma.
  • Long-term “sell signal” still reversing but still intact.
  • Short-term market is extremely overbought.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 position
    • This Week: Hold 1/2 of position
    • Stop-loss moved up to $265
  • Long-Term Positioning: Neutral

Dow Jones Industrial Average

  • Long-term trend line is currently broken
  • Recent rally pushed above initial resistance and was the first index to move back above it’s 200-dma.
  • Deep sell-signal (bottom panel) being reversed
  • Market is back to extreme overbought, look for retracement to support before additional advancement.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss moved up to $245
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • Long-term trend line is currently broken
  • Recent rally pushed above initial resistance.
  • The 200-dma (green dashed line) proved to be resistance.
  • Look for another attempt to breach the 200-dma next week, a failure will likely retest support.
  • Sell-signal (bottom panel) is being reversed.
  • Market back to extreme overbought. Need a pullback to support before an additional advance.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss moved up to $165
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • Long-term trend line is currently broken
  • Recent rally pushed above downtrend line from all-time highs
  • 200-dma (green dashed line) providing additional overhead resistance to rally.
  • Currently on very deep sell-signal (bottom panel)
  • Market back to extreme overbought. Look for a pullback to support before an additional advance.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss moved up to $64
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • Long-term trend line is currently broken
  • Recent rally pushed above downtrend from all-time highs and the 200-dma (green dashed line) are providing additional downward resistance.
  • Extremely deep sell-signal (bottom panel) is improving
  • Market back to extreme overbought. Look for a pullback to support before an additional advance.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss moved up to $325
  • Long-Term Positioning: Neutral

Emerging Markets

  • Long-term trend line is currently broken
  • Recent rally pushed above initial resistance and the 200-dma.
  • Market has broken above the downtrend line from last-years highs
  • While a “buy signal” was triggered last week (bottom panel) on a short-term basis EEM is extremely overbought. (red box)
  • EEM pulled back to initial support last week. Look to add back 1/3rd position if support holds.
  • Short-Term Positioning: Bullish
    • Last Week: Hold 2/3rd position
    • This Week: Hold 2/3rd position 
    • Stop-loss moved up to $42
  • Long-Term Positioning: Bearish

International Markets

  • Long-term trend line is currently broken
  • Recent rally pushing into cluster of resistance from 2018.
  • Downtrend from all-time highs is converging with 200-dma (green dashed line) providing additional downward resistance.
  • Deep sell-signal (bottom panel) is being reversed
  • EFA is back to extremely overbought in the short-term.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss moved up to $61.50
  • Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

  • Long-term trend line is currently broken
  • Recent rally pushing into resistance at top of 3-year channel.
  • Oil failed at resistance. Look for further pullback in the days ahead.
  • Deep sell-signal (bottom panel) being reversed.
  • Oil is back to extremely overbought on a short-term basis.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended “sell” of 1/4 position @ $63
    • This Week: Hold remaining 1/2 position
    • Stop-loss moved up to $62.5
  • Long-Term Positioning: Bearish

Gold

  • Long-term trend line has been recovered.
  • Recent rally is pushing into resistance at 3-year highs.
  • Currently on “buy” signal (bottom panel)
  • Overbought on short-term basis. Needs pullback to allow for better entry point.
  • Short-Term Positioning: Bullish
    • Market pulled back to initial support at $123 last week.
    • Add 1/2 position on any retest of support at $123
    • Add 1/2 position on pullback to $122
    • Stop-loss is currently $120
  • Long-Term Positioning: Improving From Bearish To Bullish

Bonds (Inverse Of Interest Rates)

  • Long-term support continues to hold at $111.
  • Currently on a buy-signal (bottom panel)
  • Entry point was triggered at $120
  • Resistance currently overhead at $124.50
  • Strong support at the 720-dma (2-years) (green dashed line)
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions.
    • This Week: Hold positions – add on breakout above $124.
    • Stop-loss moved up to $120
  • Long-Term Positioning: Bullish

Many investment advisors and money managers have a little secret. They will proudly tell you that they rely heavily on fundamental analysis, carefully weighing earnings, market share, competitive environment and demographic trends to select the best stocks for their clients. What they do not tell you is that they check their stock charts before they make any moves.

Why? Because technical analysis of the market – using charts – still is the best way to know whether their other analyses are validated in the real world.

Let’s say a company creates a new product that they project will sell millions of units at a handsome margin. They even get favorable reviews by critics at their industry trade show. Investors armed with this intelligence buy up all the shares they can – then watch them drop sharply in value.

How can that be?

What those investors did not know was that the stock was already up 50% on the year, and that sellers were starting to trade with more urgency. So even though the company is sound and will make a lot of money, the stock’s value already reflected that knowledge.

That information is in the charts.

Technical analysis gets a bad rap in the investment world. Don’t blame the analysis. Blame the practitioners. Even I, as a 30-year veteran in the discipline, cringe when I hear a TV interview with a technician forecasting the market because two lines on a chart crossed each other.

The stock does not move because the lines crossed. The lines crossed because the stock is telling us something. And it is telling us whether the odds for buying or for selling are better.

That’s it. It does not tell us exactly what will happen, but it does give us a good idea of what we should do.

There’s plenty of jargon and high-level math for the experts to ponder, but I’d like to take you through a few simple aspects of technical analysis that any investor can use. Once you’re armed with this, you’ll be well on your way toward assembling a winning portfolio.

What Is Technical Analysis?

There are several popular definitions, but I boil it down to this: Technical analysis is just the study of data generated from the market and from the actions of people in the market.

Such data include price levels that served as turning points in the past, the number of shares of stock bought and sold each day (volume), and how fast price movements occur (momentum) over a given period of time.

Let’s say that a stock price of $50 brought out the sellers on one or two occasions in the past. This price level is now called “resistance” (more on this later) because it tends to resist price advances over time. Why? Likely because that level is considered expensive, and therefore when the stock gets near that price, investors step up their selling activities, increasing the supply of stock relative to the demand. Economics 101 suggests the stock will stop going up and may actually start to decline.

Technical analysis, or charting, also attempts to measure how investors feel about the market at any given time. This is important because when everyone thinks the same way, the market tends to do the opposite.

It’s the fear-and-greed pendulum. When everyone is convinced the market is going to keep moving higher, as it did at the peak of the housing bubble or the peak of the bitcoin bubble, then theoretically everyone has already bought. There is nobody left to buy, so any negative news, either actual or perceived, will cause a stampede to the exits.

Remember back in March 2009 at the end of the bear market? Investor sentiment was as negative as it ever was … and in hindsight, it was one of the best buying opportunities in history.

Technical analysis presents the opinion of the market itself through the unchangeable facts of stock price and volume movements.

How It Works

The basic idea is that the collective actions of all market players leave clues in the charts for us to find. Let’s say that after a nice run-up, both bulls and bears become a bit more uncertain. Bulls tend to take their profits a bit earlier, and bears don’t press their short positions (bets against stocks) – essentially the same thing in reverse.

On the charts, we see lower price highs and higher price lows. They form a shrinking trading range that looks like a triangle. In fact, that’s what this pattern is called.

Whenever such a pattern forms in a stock, we know that stock is resting before making a move. Whether that move is to march higher or head lower is yet to be determined. However, most of the time, when price action breaks out of the shrinking trading range, it tends to continue in that direction for a while.

The triangle pattern does not forecast what will happen. However, when the market breaks out from the pattern, we get a good idea what we should do about it.

But even when a stock breaks out from a pattern, chartists do not know for sure that the stock will go up, and they do not know how long it might take. They simply know that the probability of making money by owning the stock is good.

If they are wrong? A failed breakout is possible, but the beauty of the pattern is that it tells us when we are wrong sooner, rather than later, to minimize losses.

There is an old joke where a fundamental analyst and a technical analyst are eating dinner together and someone knocks a knife off the table. It lands firmly in the fundamental analyst’s shoe.

The technician asks, “Why didn’t you move your foot?”

The fundamentalist replies, “I thought it would go back up.”

The knife falling is the same as a downside breakout from a triangle. When that happens, it is best to get out of the way.

How to Use It

You can get as complex as you want, but most investors can benefit from knowing just a few things about the market or the stock they want to buy.

  1. Is the trend rising or falling?
  2. What support and resistance levels are nearby?
  3. For a stock, how does it look compared to its sector and to the market as a whole?

A trend is simply a directional move over time. If prices on the chart seem to move from the lower left corner to the upper right corner, then the trend is rising. (And if it moves from the upper left to the lower right, the trend is falling.)

We can measure how powerful the trend is with momentum and many other indicators. But the bottom line is that a stock or a market making higher highs and higher lows over time is in a rising trend.

As in physics, a body in motion tends to stay in motion unless acted upon by an outside force. Some of these forces come from within the market, such as waning performance or lack of interest (shown by falling volume). There also are price levels.

Support is a price level at which a stock or market tends to stop falling. Resistance is a price level at which it tends to stop rising. Support often represents a cheap price, while resistance often represents an expensive price.

If a stock you want to buy is approaching a price at which sellers got active in the past (resistance), you might want to reconsider that purchase. But if your stock just pushed through that resistance level, you know the market’s psyche may have changed and what was once considered to be expensive may now be considered cheap.

There’s also “relative strength analysis,” which is a comparison to peers, sectors and the broader market. Even during a bull market, some stocks perform better than others. So you may, for instance, not want to load up on lagging areas of the market no matter what the fundamentals might say.

Fundamentals and Technicals Are Partners

While they seem to be at odds, fundamental analysis and technical analysis can complement each other, even if they have different conclusions about the same stock. For example, a stock may be overvalued based on the fundamentals, but if it has a strong chart, it may have more room to run before value players really start to sell. Conversely, a stock may seem fundamentally cheap, but chartists are selling it because it is in a strong declining trend.

That’s not a problem with either method. It’s just that sometimes, the charts see things that don’t yet show up in the fundamentals.

And sometimes non-company-specific news overshadows the fundamentals. For example, a company might issue strong earnings guidance, but that same day, a peer might also release bad news that sends the entire sector lower.

When the fundamentals and technicals agree, investors can buy or sell with confidence. But even when they do not agree, simply being aware of risks from the other side will allow investors to make better decisions.

 


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Since the day after Christmas, the markets have been in a surge very similar to what we saw in January of 2018.

Here is January 2018

And 2019

Of course, in February 2018, the rally ended.

While I am not suggesting that the markets are about to suffer a 10% correction, I am suggesting, as I wrote this past week, is that the markets have been Too Fast & Too Furious.” 

“Short-term technical indicators also show the violent reversion from extreme oversold conditions back to extreme overbought.”

As we have discussed previously, price movements are very much confined by the “physics” of technicals. A couple of weeks ago, we drew out what we expected to be the movement over the market over the next couple of weeks. 

Don’t forget to grab a cup of coffee and start your trading/investing day with me as I kick off my new radio show. 
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We said then the most likely target for the rally was the 200-dma. It was essentially the level at which the “irresistible force would meet the immovable object.”

The chart below is updated through Friday afternoon:

As noted, we lifted profits at the 200-dma and added hedges to the Equity and Equity Long/Short portfolios. (If you are reading this as a non-RIA PRO subscriber you can see our 3-live portfolios at the site use code PRO30 for a 30-day free trial.)

What will be critically important now is for the markets to retest and hold support at the Oct-Nov lows which will coincide with the 50-dma. A failure of that level will likely see a retest of the 2018 lows. 

A retest of those lows, by the way, is not an “outside chance.” It is actually a fairly high possibility.  A look back at the 2015-2016 correction makes the case for that fairly clearly. 

But even if a retest of lows doesn’t happen, you should be aware that sharp market rallies are not uncommon, but almost always have a subsequent retracement. 

The point here is that the move off of the December lows is likely now complete, for now.

Thomas Thornton from Hedge Fund Telemetry had a great note out this past week on this point.

“The strong move off the lows in December is complete.  As you have seen I’ve moved from a very high exposure level of 90% net long from mid December to now net short.  Various internals are overbought, sentiment is back in the elevated zone, and price targets have been achieved.  There have been 45 new DeMark sell signals and only 2 buy signals so far in February. Recall in December there were 225 buy signals and 25 sell signals which had an average gain together of 11.5% since.  In January there were 72 total signals with the majority 53 sells/19 buys with only a gain of 0.5% since. It’s telling me a shift is coming and that’s lower.  How low?  As of now, I’m not saying new lows but higher lows but that could change if some Trend Factor levels break and we see downside Countdowns start.”  

Sentimentrader also recently noted market performance when the VIX hits a 3 month low with the S&P under the 200 day. Performance is very negative going forward.  

Signs Of Caution

As we noted last Tuesday, there are a litany of things that are worth paying attention to. To wit:

“It is too early to suggest the “bear market of 2018” is officially over.

But, the rally has simply been “Too Fast, Too Furious,” completely discounting the deteriorating fundamental underpinnings:”

  • Earnings estimates for 2019 have sharply collapsed as I previously stated they would and still have more to go. In fact, as of now, the consensus estimates are suggesting the first year-over-year decline since 2016.

  • Stock market targets for 2019 are way too high as well.
  • Despite the Federal Reserve turning more dovish verbally, they DID NOT say they actually WOULD pause their rate hikes or stop reducing their balance sheet.
  • Larry Kudlow said the U.S. and China are still VERY far apart on trade.
  • Trump has postponed his meeting with President Xi which puts the market at risk of higher tariffs. 
  • There is a decent probability the U.S. Government winds up getting shut down again after next week over “border wall” funding. 
  • The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  • Economic growth is slowing as previously stated.
  • Chinese economic has weakened further since our previous note.
  • European growth, already weak, will likely struggle as well. 
  • Valuations remain expensive


Despite recent comments that “recession risk” is non-existent, there are various indications which suggest that risk is much higher than currently appreciated.  The New York Federal Reserve recession indicator is now at the highest level since 2008.

Also, as noted by George Vrba recently, the unemployment rate may also be warning of a recession as well. 

“For what is considered to be a lagging indicator of the economy, the unemployment rate provides surprisingly good signals for the beginning and end of recessions. This model, backtested to 1948, reliably provided recession signals.

The model, updated with the January 2019 rate of 4.0%, does not signal a recession. However, if the unemployment rate should rise to 4.1% in the coming months the model would then signal recession.”

The point here is that ignoring the “risks” leaves you “exposed.” If you think its going to rain, you carry an umbrella. 

This is why we recently raised cashed and added hedges to portfolios – just in case it rains. And, right now, it seems to be sprinkling a bit. As John Murphy via StockCharts.com noted on Friday:

It looks like the 200-day averages that we’ve all been watching have managed to contain the 2019 rally. Chart 1 shows the S&P 500 pulling back from that red overhead resistance line. That’s not too surprising considering the steepness of the recent rally which put stock indexes in a short-term overbought condition. The upper box in Chart 1 shows the more sensitive 9-day RSI line falling to the lowest level in a month after reaching overbought territory above 70. That also shows loss of upside momentum. The lower box shows daily MACD lines in danger of turning negative for the first time in a month. All of which suggests that the early 2019 stock rally has failed its first attempt to regain its 200-day moving average.”

However, one of the biggest “warning flags” we are watching currently, and why we have taken a more cautious stance in portfolios, is because “bonds ain’t buyin’ it.” 

As shown in the chart below, the market has not only broken out of its rising wedge, but yields have been dropping sharply as “risk on” is rotating to “risk off.” 

While the bulls clearly took charge of the market in late December, the question is whether or not they can maintain control. 

The weight of macro-evidence is going to weigh on the markets sooner than later which is why we are opting to hedge risk and hold on to higher levels of cash currently. 

The rally we discussed on December 25th, has hit all of our targets, and then some. 

Don’t be greedy.

See you next week. 


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


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

This past week:

Discretionary, Technology, Materials, Energy, Financials, and Communications – Two weeks ago, I noted that all of these sectors climbed above their respective 50-dma’s which are all negatively crossed below their 200-dma. While these sectors have had very respectable rallies, they are now all very overbought short-term. If you are long, take profits and rebalance portfolio risks accordingly. All positions should maintain a tight stop at the running 50-dma.

Current Positions: XLP, XLB, XLK, XLF – Stops moved up to 50-dmas.

Industrials and Staples – Industrials has rallied hard in recent weeks with earnings season and climbed above its 50 and 200-dma. Likewise, Staples also has regained its 50-dma which remains above its 200-dma. Both sectors are extremely overbought with this rally, therefore rebalance holdings accordingly. 

Current Positions: XLP, XLI – Stops moved up to 200-dmas.

Health Care and Real Estate are both above their respective 50- and 200-dma’s. Real estate exploded higher last week, which is interesting considering the “offensive” move in the markets, but so have bond prices. (Non-confirmation of bullish move in stocks). Health Care, has held its ground above the 50- and 200-dma as well. Both sectors are extremely overbought so stops should be raised to just below their respective 200-dma’s.

Utilities bounced off the 200-dma and has pushed above the 50-dma. Like Health Care, Real Estate and Staples, the defensive positioning suggest the rally in stocks may be short-lived. 

Current Positions: XLU  Stop is $54

Small-Cap and Mid Cap – both of these markets are currently on macro-sell signals but did rally above their respective 50-dma’s. Both markets are extremely overbought and are vulnerable to signs of rising economic weakness. The overall trend remains negative and, while on short-term “buy signals,” both markets are now back to extreme short-term overbought conditions. Look for a pullback to reduce some of the overbought condition before adding exposure with tight-stops at the 50-dma.

Current Position: None

Emerging, International & Total International Markets –

Note: We have added IXUS to our watch list which combines Emerging and International Markets. 

Last week, Emerging Markets puled back to its 200-dma after breaking above that resistance. With the 50-dma turning up we have been looking for an opportunity to add exposure. In the short-term emerging markets are extremely overbought so we will want to see the 200-dma hold before taking on exposure. 

Major International & Total International shares are extremely overbought but not performing nearly as well as Emerging Markets. Keep stops tight on existing positions, but no rush here to add new exposure. Emerging Markets are much more interesting.

Stops should remain tight at the running 50-dmas. 

Current Position: None, Looking to add 1/2 position in EEM

Dividends, Market, and Equal Weight – Not surprisingly, given the rotation to “defensive” positioning in the market, dividend-based S&P Index continues to outperform other weighting structures. The overall market dynamic remains negative and markets are pushing into very tough levels of overhead resistance. Early last week we took profits and reduced back to our target portfolio weightings. Stops are moved up to the running 50-dma’s. 

Current Position: RSP, VYM, IVV

Gold – We have been discussing a pullback in Gold to add exposure to portfolios. Gold remains very-overbought short-term, BUT given the short-term pullback and break above recent highs, the entry point for Gold has been pushed up to $122.50 with stops lowered to $120. 

Current Position: GDX (Gold Miners)

Next Position: GLD – Buy Target: $122.50, Sell-Stop: $120

Bonds 

Note: We have added HYG (High Yield) and BNDX (International Bonds) to our watch list.

Three weeks ago, we noted that the pullback in bonds to support occurred we added to our bond holdings. 

Current Positions: DBLTX, SHY, TFLO, GSY

With bond prices about to breakout of consolidation, it suggests a substantial move higher in price, or lower yields, is likely on the way. 

High Yield Bonds, representative of the “risk on” chase for the markets have surged back to all-time highs after the rout last year. International Bonds, also another area of very “high risk” have surged off to the moon as well. 

These two areas are the very definition of “risk appetite” by investors and given the extreme overbought conditions is suggestive the recent run in the markets may be closer to a corrective phase in February. 

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:

Two weeks ago, we noted the rally has pushed into the our maximum resistance zone. Also, as expected the markets did make it to the 200-dma but ran into tough resistance at the first attempt to move higher. 

We are likely going to have another couple of attempts next week as the bulls aren’t ready to give up the chase just yet.  We are continuing to watch the risk carefully and have been working on repositioning portfolios over the last couple of weeks. 

  • New clients: We are adding the core positions and our fixed income portfolios. Since our “core” positions are our long-term holds for inflation adjustments to income production we can add without too much concern. Tactical positions for growth will be added accordingly as needed.  
  • Equity Model: We added a short-hedge to our portfolios to hedge against market risk. With portfolios already defensively positioned, we are in good shape for any corrective process that may start.
  • ETF Model: We reduce our “core” holdings back to target model weight. 

There are some changes afoot, as noted above, which could indeed reverse the current bearish trend of the market. However, we are a long way from that happening and the downside risk currently dwarfs the upside reward. 

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

Looking For Support

Over the last several of weeks, we have watch a sharp rally in stocks as Washington, The Fed, and Global Central banks have put their best foot forward to provide a “put” underneath stock prices following the rout last year. 

That rally ran into our target resistance at the 200-dma last week and stocks are taking a breather. We continue to recommend taking some action in plans if you haven’t done so already. 

  • If you are overweight equities – reduce international, emerging market, mid, and small-capitalization funds on any rally next week. Reduce overall portfolio weights to 75% of your selected allocation target.
  • If you are underweight equities – reduce international, emerging market, mid, and small-capitalization funds on any rally next week but hold everything else for now.
  • If you are at target equity allocations hold for now.

Continue to use rallies to reduce risk towards a target level with which you are comfortable. Remember, this model is not ABSOLUTE – it is just a guide to follow. 

Unfortunately, since 401k plans don’t offer a lot of flexibility and have trading restrictions in many cases, we have to minimize our movement and try and make sure we are catching major turning points.

We want to make sure that we are indeed within a bigger correction cycle before reducing our risk exposure further. 

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

401k Choice Matching List

The list below shows sample 401k plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don’t see your exact fund listed, look for a fund that is similar in nature.

401k-Selection-List

At RIA Advisors, we do ongoing research on investments for managing client portfolios, of course. And we recently reassessed some popular bond funds. The results might be interesting for readers.

We looked at a group of bond funds that often make short lists for advisors – DoubleLine Total Return (DBLTX), DoubleLine Core Fixed Income (DBLFX), PIMCO Total Return (PTTRX), Baird Aggregate Bond (BAGIX), Dodge & Cox Income (DODIX), Western Asset Core Bond (WATFX), and Metropolitan West Total Return (MWTIX). We started with five year returns and Sharpe Ratios. That’s not a comprehensive analysis, but it’s where we began. Here’s what we found out.

DoubleLine Total Return’s 3.10% annualized return was the second best over the five years through January 2019, but that fund also had the best Sharpe Ratio of 1.16%. That means the fund delivered the best return per unit of volatility among this group of “usual suspects” on most advisors’ short lists. Lots of people think of the fund’s manager, Jeffrey Gundlach, as a gunslinger, who takes a lot of risks. That may be because of his outspoken and frank webcasts, which many investors, including the group here at RIA Advisors, find informative. But the truth is Gundlach runs risk-averse funds. When he’s done something unusual, such as his buying Alt-A mortgage-backed securities for the Total Return fund after the financial crisis, it’s been justified.

Those Alt-A’s probably delivered a ton of return in the first few years the fund owned them, so the fund’s gaudy post-crisis returns (more than 9% in each of the calendar years 2011 and 2012) might be a thing of the past. But that doesn’t mean the fund is any less attractive or that it can’t continue to beat most of its peers and the Bloomberg Barclays US Aggregate.

Western Asset has the best five-year annualized return at 3.44%. But its Sharpe Ratio of 0.92% shows that investors have to tolerate some volatility to achieve those returns. We also looked at how the funds – or the funds their current managers ran – did in 2008, and Western Asset had a difficult time in that stressful period. The firm went out on a limb at the wrong time.

PIMCO Total Return was the best performer in 2008, but those were the days when Bill Gross was at his peak. For the past five years, the fund looks more like the index in terms of its returns and volatility, but its new management team doesn’t own that entire record. Mark Kiesel, Scott Mather, and Mihir Worah have led the fund for a little more than 4 years, since September 26, 2014, and the fund’s 2.53% annualized return for the three years through January 2019 is better than those of most of its peers and than the index’s 1.95% annualized return.

Dodge and Cox Income was its usual solid self, with a 2.91% annualized return and a 0.90% Sharpe Ratio. During the crisis it lost 29 basis points, much better than the nearly 500 the average intermediate term bond fund lost, though behind the 5.24% return of the index.

Baird Aggregate has been solid as well. It has produced a 2.84% annualized return for the recent five-year period with a 0.76% Sharpe Ratio. In 2008, it dropped a little more than 2%, better than the category average, but worse than the index.

Finally, Metropolitan West has been lackluster. The fund has lagged the index with its 2.44% annualized return for the recent five-year period. However, it has surpassed the 2.25% return for the category average. The fund’s 0.67% Sharpe Ratio has surpassed those of both the index and the category average. So the fund has delivered better volatility adjusted returns than the index and category average. In fact, it’s Sharpe Ratio has also surpassed that of the PIMCO Total Return Fund.

Incidentally, it’s interesting to note how the Morningstar fund category average differed from the index in 2008 (-4.7% for the category average and 5.24% for the index) . That divergence results from the fact that the index is U.S. Treasury-heavy, and Treasuries did well in 2008. The average fund, however, often tries to beat the index by owning lots of corporate bonds or by taking other credit risk. And that was decidedly the wrong move in 2008, when the safest securities were the most loved.

There are other funds we could have included here such as PIMCO Income, Loomis Sayles Bond, Delaware Diversified Income, BlackRock Total Return, Guggenheim Total Return, JPMorgan Core plus Bond, and Lord Abbett Total Return but we had to make the cut somewhere for this article. We monitor those funds and others routinely, and so should other advisors who aren’t fully dedicated to passive funds.

The stock market, measured by the S&P 500 index, has risen by 17% since late December.   Despite the bullish sentiment, the options markets are pricing in a modest pull-back ahead of or into option expiration on Friday, February 15th.

We study over a dozen key options markets and publish a morning report on investor sentiment in these markets.  We use the word “sentiment,” differently than other investment services. We are not talking about quantifying levels of greed or fear, euphoria or despair and other investor “feelings.”  Instead, we calculate the ideal settlement value which enables the market makers and large traders to maximize their profits.

Here is a historical chart of the S&P 500 cash value (in green) graphed with options market delta (in red) and options market gamma (in blue).

Delta is a measure of the change of option prices to changes in the underlying index, and gamma is a measure of the sensitivity of delta. Since market makers and large traders often maintain delta-neutral portfolios, there is often a convergence between the value of the S&P index and the value of total delta neutral in the SPX options market.  Due to the regular convergence between price and delta-neutral, we call the point of delta- and gamma-neutral the “Price Magnets.”

It is our belief that the closer we are to option expiration, the more likely we should see convergence between price and the Price Magnets.  This is due to order flow in the markets as the large traders and market makers adjust and unwind their trading positions.  Because of the mechanics of CME and CBOE futures and options markets, all positions must eventually be unwound or cash-settled.

Historical Magnets

Let’s examine the four most recent option expirations to evaluate the effectiveness of the Price Magnet tool.  These option expiration dates are numbered above one through five (including the pending February expiration).

  1. In October, the S&P traded to a settlement low near 2725, with the Price Magnets near 2900. Over the next week, the S&P rallied and the Price Magnets declined, resulting in convergence right before the option expiration date.
  2. In November, the S&P fell to a closing low near 2640 with divergence from the Price Magnet. The market rallied thereafter to a settlement high near 2800, a few days prior to option expiration.
  3. December option expiration paints an interesting picture. After trading with significant volatility prior to and after the option expiration date, the S&P fell considerably as gamma spiked.  This shows the opposite polarity of the gamma Price Magnet.  If neutral gamma moves considerably out of range, it means that the aggregate option sellers – may have been forced to cover or liquidate their positions.  This spike in gamma can also be seen in the natural gas market as we discussed in a recent article.  It is typical for quarterly expiration dates to see higher volatility and unexpected price movement.  The quarterly expirations have more open interest and volume and are often referred to as “triple witching” events.  We do believe that the gamma spike and drop in S&P value are related.
  4. After the December sell-off, the stock market value slowly converged back to the delta- and gamma-neutral price magnets, settling right near the Price Magnets at the January expiration.

Current Situation

Currently, the stock market continues to push higher and surpassing key technical levels as February option expiration approaches next week.  While we could see a modest pull-back in stocks in February, it is important to keep in mind that the March expiration for SPX has about twice the open interest as February.  Again, the quarterly expirations are more influential, and large traders and market makers have likely hedged their February exposure with March positions.

The table below is an excerpt from our daily report showing intra-day values with a timestamp near 1:40pm on February 5th, 2019. Note the February magnet is about 80 points below the current level and the March magnet is nearly 100 below.

Final Notes

If you would like to learn more about Op-ex Price Magnets, please visit our website.  If you have any comments or questions, we would like to hear them!  Please e-mail any feedback to admin@viking-analytics.com.