Monthly Archives: November 2017


  • Clinging To Support
  • Tops Are Processes – A Review
  • Actions To Take Next Week
  • Sector & Market Analysis
  • 401k Plan Manager

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Clinging To Support

Over the last couple of weeks, as interest rates surged above 3%, we explored the question of whether something had “just broken” in the market.

This is an important question given the current stance by the Fed appears to be considerably hawkish as noted by the recent minutes:

 A Number of Officials Saw Need to Hike Above Long-Run Level

A few participants expected that policy would need to become modestly restrictive for a time and a number judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level.”

The Fed is worried about asset bubbles…

“Some participants commented about the continued growth in leveraged loans, the loosening of terms and standards on these loans, or the growth of this activity in the nonbank sector as reasons to remain mindful of vulnerabilities and possible risks to financial stability.”

In other words, the Fed is “gonna hike until something breaks” and it will likely break in a credit related area like junk bonds, covenant-light, and leveraged loans.

Important note: It won’t be one, or another, but all of them at once when “something breaks.” 

As noted by Bloomberg:

“The total of outstanding U.S. dollar leveraged loans has hit $1.27 trillion, according to data compiled by Bloomberg, overtaking high-yield bonds in the past week to cement their status as the go-to financing source for speculative-grade companies. October is on course for the highest issuance since June, while junk bond sales are the slowest since 2009.”

“For regulators at the BIS — sometimes called the central bank for central banks — a boom in leveraged loans often presages a bust in the wider economy. The market is ‘particularly procyclical,’ according to the report, and it rose faster than high-yield bonds in the run-up to the global financial crisis.”

With substantially weaker loan documentation, accelerating demand for CLO’s (collateralized loan obligations), and a proliferation of covenant-lite loans, the risk to the next “financial crisis” has risen markedly given the massive surge in debt due to an extended period of ultra-low interest rates.

Of course, with the Fed hiking interest rates, which is pushing debt servicing costs higher, it is only a function of time until the rate of change in interest rates causes a financial decoupling in heavily levered companies with marginal balance sheets and debt servicing capacity.

Pay attention to the warnings the credit market is sending.

Clinging To Support

The market may already be sniffing out an impending problem. I noted last week that if interest “rates remain above 3%, stocks are going to continue to struggle.” 

This past week has been a decidedly tough struggle for stocks to pick themselves up after last week’s drubbing. While we saw a sharp reflexive bounce earlier this week, that bounce quickly faded as stocks returned to retest support at critically important levels.

The chart below is the updated “pathway” chart from last week. I have only updated the price on the chart again this week but did NOT change any of the previously detailed paths set out last week.

Chart updated through Friday – pathways remain unchanged

As I wrote, no matter how many different paths I trace out, the possibilities of the market rallying back to new all-time highs this year have been greatly reduced. Therefore, all four possibilities continue to suggest a broader topping pattern in place through the end of this year.

The good news, if you want to call it that, is the market DID hold the 200-dma for the week. With the market deeply oversold currently, we still expect a bounce going into next week. This bounce could well be supported by the end of the “blackout” period for companies to buy back their own shares.

Also, note that back in early February we saw a similar short-term bottoming process where the initial bounce failed then bounced in mid-March before failing again to retest the February lows.

My suspicion is that we will likely see much of the same action over the next month or so. Currently, pathway #2a and #2b are still the most likely outcomes currently and should be used to “sell into” to raise capital, deploy portfolio hedges, raise stop levels, and reduce risk.

Pathway #2a: The market rallies from current levels to the January high. Again, this would likely be fueled by a stronger than expected earnings season and a pickup in economic activity. However, the run to the January highs is capped by that resistance but the market finds support at the 62% Fibonacci retracement level just below. (30%) 

Pathway #2b: The most feasible rally from current oversold levels is back to the 50% Fibonacci retracement of the recent decline. The market gets back to very overbought conditions and the market begins to trade between the 200-dma and/or the 32% Fibonacci retracement level. (30%)

However, the risk of Pathway #3 becoming a reality has also risen markedly during this past week. But given the deep short-term oversold condition, we are due for a fairly strong bounce first.

With the understanding the economic and fundamental background may not be supportive for higher asset prices heading into 2019, it is important to note the market is sending a very different technical signal this time. As discussed last week, this is the FIRST time the market has broken the bullish trend line that began in 2016.

Importantly, the market surge last week tested, and failed, at the previous rising bullish trend line. While the market is still holding important support this past week, the deterioration in momentum is warning of a potentially larger correction process in the making.

With an early “sell signal” intact, the warnings to reduce portfolio risk could not be more prevalent.

Importantly, we should not react emotionally to these issues but be opportunistic about making changes. With the “blackout” period ending, earnings season in full swing, and a deeply oversold market – the likelihood of a substantial rally is a very real possibility. However, just because the market rallies, does NOT mean the problems are solved and the “bull market” is back in full swing. Only new “all time” highs would signal the return of the “bull market” and given the current technical, fundamental, and economic backdrop such is only a faint possibility. 

Actions To Take Next Week

With the market still 3-standard deviations below the 50-dma and very oversold technically, we still suspect a fairly strong bounce to sell into next week. Portfolio management processes should be switched from “buying dips” to “selling rallies” until the technical backdrop changes.

The actions remain the same as this past week and the actions we will specifically be taking on a rally.

  1. Re-evaluating overall portfolio exposures. It is highly likely that equity allocations have gotten out of tolerance from the original allocation models. We will also look to reduce overall allocation models from 60/40 to 50/50 or less.
  2. Look to add bond exposure to mitigate volatility risk. (Read:  The Upcoming Bond Bull Market)
  3. Use rallies to raise cash as needed. (Cash is a risk-free portfolio hedge)
  4. Review all positions (Sell losers/trim winners)
  5. Look for opportunities in other markets (Gold may finally shine)
  6. Add hedges to portfolios (If the market begins to show a negative trend we will add short positions)
  7. Trade opportunistically (There are always rotations that can be taken advantage of)
  8. Drastically tighten up stop losses. (We  had previously given stop losses a bit of leeway as long as the bull market trend was intact. Such is no longer the case.)

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)

If I am wrong, and the bull market resumes, we simply remove hedges, and reallocate equity exposure.

As investors, we have to prepare for the storm BEFORE it hits, and there are definitely storm clouds on the horizon. This was a point J.C. Parets noted last week:

“In my opinion, we are in a stock market environment where a crash is entirely possible. Now, just because it is possible doesn’t mean it will come. I think of it like the city of Miami, where I grew up, during hurricane season. Just because it’s the season doesn’t guarantee that a storm will come, but it is absolutely the time to be aware that one can show up and destroy your home or even kill you if you’re not prepared.

Hurricanes don’t hit Miami in February and stock market crashes aren’t sparked from all-time highs. It’s more of a process. The thing is, the ingredients for a market crash are absolutely starting to appear”

Tops are a process and my friend Doug Kass had an excellent piece on this issue last week.


Tops Are Processes – A Review

by Doug Kass

“Tops are a process, bottoms are an event.” –Wall Street adage

Tops are a process and bottoms are an event, at least most of the time in the stock market. If you looked at an ice cream cone’s profile, the top is generally rounded and the bottom V-shaped. That is how tops and bottoms often look in the stock market, and I believe that the market is forming such a top now.

The catalysts for a market top are multiple, some of which I detailed in last Monday’s two-part series, “Investors Are No Longer Being Compensated for Taking Risk.” Consider the following:

* Downside Risk Dwarfs Upside Reward. I base my expected market view on the probabilities associated with five separate (from pessimistic to optimistic) projected outcomes that seize on a forecast of economic and corporate profit growth, inflation, interest rates and valuation.

* Global Growth Is Less Synchronized . The trajectory of worldwide growth is becoming more ambiguous. I have chronicled extensively the erosion in soft and hard high-frequency data in the U.S., Europe, China and elsewhere, so I won’t clutter this missive with too many charts. But needless to say (and as shown by these charts here and here), with economic surprises moderating from a year ago and in the case of Europe falling to two-year lows, we are likely at “Peak Global Growth” now. (The data are even worse in South Korea, Taiwan, Indonesia and Thailand.)

* FAANG’s Dominance Represents an Ever-Present Risk. Last Monday I warned that earnings disappointments in the FANG stocks represents an immediate risk to this league-leading sector, and to the markets FANG has become GA!

* Market Structure Is One-Sided and Worrisome. Machines and algos rule the day; they, too, are momentum-based on the same side of the boat. The reality that “buyers live higher and sellers live lower” represents the potentially dangerous condition that investors face in a market dominated by passive investors.

* Higher Interest Rates Not Only Produce a More Attractive Risk-Free Rate of Return, They Also Make It Hard for the Private and Public Sectors to Service Debt

* Trade Tensions With China Are Intensifying and Mr. Market Is Improperly Looking Past Marginal Risks. From Goldman Sachs’ David Kostin (h/t Zero Hedge). Remember, as discussed within this column, the dispute has buoyed second-quarter U.S. GDP. The “benefit” soon will be over and a second-quarter economic cliff is possible.

* Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window by Both Political Parties. This has very adverse ramifications (which shortly may be discounted in lower stock prices), especially as it relates to the servicing of debt — a subject I have written about often. Not only are our legislators acting irresponsibly and recklessly, but the Republican Party is now considering more permanent tax cuts. Should economic growth moderate, tax receipts diminish and undisciplined spending continue, stock valuations will likely continue to contract.

* Peak Buybacks. Buybacks continue apace, but look who’s selling. As Grandma Koufax used to say, “Dougie, that’s quite a racket!” If I am correct about the peaking in corporate profits, higher interest rates and slowing economic growth, we shortly will have another rate of change — negative in buybacks.

* China, Europe and the Emerging Market Economic Data All Signal a Slowdown. It’s in the early innings of such a slowdown based on any real-time analysis of the economic data. The rate-of-change slowdown on a trending basis is as clear as day. A rising U.S. dollar and weakening emerging-market economic growth sow the seeds of a possible U.S. dollar funding crisis.

* We Are Moving Closer to the November Elections, With Their Uncertainty of Outcome and the Potential For a “Blue Wave.” The current 40% approval rating for the president is historically a losing proposition for the incumbents. We also may be moving toward some conclusion of the Mueller investigation — is the Summer of 2018 the Summer of 1974?

Bottom Line

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

The search for value and comparing it to risk taken is, at its core, the marriage of a contrarian streak and a calculator.

While it is important to gauge the possibility that the market may be making an important top, it is even more important to distill, based on reasonable fundamental input, what the market’s reward vs. risk is. This calculus trumps everything else that I do in determining market value.

On that front, I continue to believe that downside risk dwarfs upside reward.

Moreover, there is a growing fundamental and technical list of signposts that may suggest that the market is starting to look like it is in the process of making a possible (and important) top.

As Joel Greenblatt wrote:

“There’s a virtuous cycle when people have to defend challenges to their ideas. Any gaps in thinking or analysis become clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.”

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:

Sector-by-Sector

Discretionary, Industrials, Materials, Staples, Energy, and Financials have all violated their 200-dma and failed to recover. Financials are particularly troubling given the decent fundamental backdrop for banks currently. These sectors are now in “sell rallies” mode until there is a resumption of a more bullish trend. Basic Materials violated its April lows and all previous stop levels. This sector should be sold on any rally in the coming days. Industrials also failed a rally to its 200-dma confirming a sell for the sector. Energy is now a sell after failing at a double-top and then breaking the 200-dma.

Real Estate, Healthcare, and Technology have held their 200-dma support during the recent rout. Technology is hanging on to that support along with the overall market. Real Estate rallied last week back above the 200-dma and off of previous support, however, the downtrend is still negative at the moment. Healthcare, after recommending to take some profits, broke below its 50-dma on big volume. Continue to rebalance risk in portfolios.

Staples & Utilities – the rotation to safety trade, despite higher rates, is evident in both of these sectors. Staples, after a successful test of the 200-dma surged back above the 50-dma last week. The sector is about to test a triple-top but a break above that level will put it on a momentum buy signal for portfolios. Utilities broke out to all-time highs last week also putting the sector on a momentum buy.

Small-Cap and Mid Cap – the breakdown in small and mid-cap stocks suggest a broader change to the overall market complexion. Last week, both markets violated their 200-dma and their bullish trend lines from February of this year. Last week, both indices failed a test of the 200-dma and are threatening to break recent lows. Sell any rally and put a stop at recent lows.

Emerging and International Markets this past week, both markets retested their lows. There still remains, since we recommended selling in January of this year, no reason to be long these sectors just yet. If we start to see real improvement, versus a bounce in a downtrend, we will reconsider our weightings.

Dividends, Market, and Equal Weight – The overall market dynamic appears to have changed last week. With the markets deeply oversold short-term look for a rally to reduce risk, rebalance weightings in portfolios, and raise some cash.

Gold – as I noted last week:

“After repeated failures at the 50-dma, the metal finally found some life in the midst of the recent market meltdown. With Gold now extremely overbought short-term, use this rally to sell holdings if you are deeply underwater. From a trading perspective, IF, and this is a big if, Gold can hold the 50-dma on a pullback and turn higher, a rally to the 200-dma is feasible. Such would coincide with a much bigger sell-off in stocks.” 

Bonds – broke their near-term support at $114 triggering the stop loss on trading positions. However, we are now aggressively buying individual bonds at depressed prices and increasing yield in portfolios. All trading positions are currently closed.

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:

The rally we were wanting to use to reduce risk into last week – last one day. This is not a good sign, and is something that has raised our “caution” levels markedly.

However, despite the volatility of last week’s action, the market DID NOT violate the 200-dma and, therefore, remains a correction within a bull market for now.

The market remains deeply oversold on a short-term basis and we continue to expect a rally this week in which we can reduce equity risk accordingly.

Please review the “Checklist Summary Of Actions To Take” in the main missive above. We will be applying this rules to our portfolios as well.

  • New clients: We are holding OFF on-boarding into our portfolio models until a better risk/reward opportunity emerges. 
  • Equity Model: All positions are being reviewed and positions that have violated stop levels will be sold to reduce portfolio risk.
  • Equity/ETF blended – Same as with the equity model. 
  • ETF Model: We will reduce small and mid-cap holdings on any rally back toward the 50-dma.
  • Option-Wrapped Equity Model – If the market rallies back to previous resistance levels, we will add a long-dated S&P 5oo put option to portfolios to hedge risk. 

As we have repeatedly stated, we are well aware of the present risk. However, these violent declines are symptomatic of the liquidity issues posed by the massive surge in passive indexing.

As we have stated previously: 

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.”

This past week, it did.


THE REAL 401k PLAN MANAGER

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

Market Fails To Rally

As discussed at length in the main body of this missive, the market remains deeply oversold short-term. We continue to expect a rally this coming week to take some action to reduce overall portfolio risk.

Currently, we have our FIRST of FOUR sell-signals in place.  The first signal is simply a “WARNING” to pay attention to what is currently happening in the markets. Think of it as a “yellow flashing light” at an intersection – slow down and be aware of your surroundings.

As noted, there are indeed some early indications that things have changed. However, with the markets VERY oversold, the best course of action going into next week is use ANY rally next week to make sure your 401k plans are balanced. Use the following guidelines for now.

  • If you are overweight equities – reduce international and emerging market exposure and add to domestic exposure if needed to bring portfolios in line to target weights.
  • If you are underweight equities – Hold for the moment and let’s see if the market can stabilize.
  • If you are at target equity allocations use rallies to rebalance risk in portfolios.

Unfortunately, 401k plans don’t offer a lot of flexibility and have trading restrictions in many cases. Therefore, we have to minimize our movement and try and make sure we are catching major turning points. Over the next couple of weeks, we will know for certain as to whether more changes need to be done to allocations as we head into the end of the year.

If we get a confirming SELL signal, we will begin discussing reducing the target allocation model.

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

Trying to find value in an over-valued market is difficult to say the least. This becomes even more problematic when we discuss the issue within the reality of a late-stage economic cycle and the potential for an economic recession.

So, in looking for opportunity at a time where there is a rising unfavorable economic and earnings backdrop, we turned to our database to screen for stocks with a very strict set of fundamental guidelines.

In order for a company to become a watch list candidate it must have:

  • Five-year average returns on equity (ROE) greater than 15%;
  • Five-year average returns on invested capital (ROIC) greater than 15%;
  • Debt-to-equity (D/E) less than or equal to 80% of the industry average;
  • Five-year average pretax profit margin (PM) 20% higher than the industry average;
  • Current price-to-book value multiples(P/B) below historical and industry multiples;
  • Current price-to-cash flow (P/CF) ratios below the industry average

Out of the universe of more than 6,500 issues, only 10 passed the test.

This should immediately ring some alarm bells on the market as a whole with respect to valuations and the risk being undertaken by investors in general.

However, here are the 10 top stocks we are adding to our watch list currently.

*Disclosure: We currently own BA in both our Equity and Equity/ETF portfolio models.
**While REMI made the screening list, it is excluded from consideration due to being under $5/share.

Below I am providing a brief snapshot of each for your own review.

CL

SNBR

DENN

PZZA

  • Warning:  The company is facing numerous class action lawsuits which could have an adverse effect on the company.

ANIK

CBPO

TARO

REMI

  • Warning: This is a sub-$5 stock and is extremely high risk. It is not suitable for investors or our portfolios.

LII

BA

Importantly, just because these companies cleared a screen, such is only the first step in determining if it should be added to an investment portfolio. Each company must be evaluated not only on it fundamental merits but its price trends as well. They should also be evaluated relative to other holdings in your portfolio, your own personal risk tolerance, and your investment objectives.

Disclaimer: As always, you must do your homework BEFORE making any investment. The information contained herein should not be construed as investment advice or a solicitation to buy or sell any security. Past performance is no guarantee of future results. Use of this information is at your own risk and peril. 

IBD recently penned an article touting the success of the recent tax cuts from the Trump administration.

“The Treasury Department reported this week that individual income tax collections for FY 2018 totaled $1.7 trillion. That’s up $14 billion from fiscal 2017, and an all-time high. And that’s despite the fact that individual income tax rates got a significant cut this year as part of President Donald Trump’s tax reform plan.”

Hold on a second.

A $14 billion increase on $1.68 Trillion in receipts is a very paltry 0.8% increase. This is the 8th LOWEST rate of increase in the history of data and is more representative of population growth rather than the success of tax cuts bringing in more revenue.

In fact, when looking at Federal Receipts on an annualized basis, growth in receipts as of the end of Q2 has fallen by more than 4% annually. Importantly, throughout history, negative growth rates in Federal receipts have been associated with recessionary periods in the economy rather than expansions.

But IBD in their effort to support the Trump tax cuts continues:

“Critics of the Trump tax cuts said they would blow a hole in the deficit. Yet individual income taxes climbed 6% in the just-ended fiscal year 2018, as the economy grew faster and created more jobs than expected.”

Well first, as we have shown previously, the tax cuts DID INDEED blow a hole in the deficit. Currently, the deficit is rapidly approaching $1 Trillion and will exceed that level in 2019.

To IBD’s point, the economy has grown faster than expected and jobs have increased (but not more than expected.)

“Yes, the economy was booming in fiscal 2018. But it probably wouldn’t have been booming without the tax cuts.

Actually, no.

It wasn’t Trump’s tax cuts that led to this growth but, as we discussed recently with Danielle Dimartino-Booth, it came from a “sugar-high” created by 3-massive Hurricanes in 2017 which have required billions in monetary stimulus, created jobs in manufacturing and construction, and led to an economic lift. We saw the same following the Hurricanes in 2012 as well.

However, these “sugar highs” are temporary in nature. Fortunately, for the economic bulls, a bit of reprieve has come from Hurricanes Florence and Michael which will provide some continued boost to economic growth into Q2 of 2019.

The problem is the massive surge in unbridled deficit spending which provides a temporary illusion of economic growth but leads to long-term economic suppression.

Eventually, the debt will come due.

So, while IBD is taking a victory lap touting the success of the Trump agenda, the reality is that the pro-growth policies were launched to late within an economic cycle. This will ultimately ensure the next recessionary drag will likely be larger and last longer than most expect as both fiscal and monetary policy tools were spent during the boom, rather than saved for an eventual “rainy day.”

Just something to think about as you catch up on your weekend reading list.


Economy & Fed


Markets


Most Read On RIA


Research / Interesting Reads


Every once in a while, the market does something so stupid it takes your breath away.” – Jim Cramer

Questions, comments, suggestions – please email me.

The FIRE (Financial Independence Retire Early) Movement is literally on “fire” after Suze Orman recently suggested that one would need $5 million if they wanted to retire early.

“You need at least $5 million, or $6 million. … Really, you might need $10 million,” she said — short of that, it’s just not going to be enough for most people.

“You can do it if you want to. I personally think it is the biggest mistake, financially speaking, you will ever, ever make in your lifetime. I think it’s just ridiculous. You will get burned if you play with FIRE.”

FIRE supporters immediately leapt to the movement’s defense and criticized Orman’s view.

Here is the interesting part – both are right and wrong.

The amount of money you need in retirement is based on what you think your income needs will be when you get there and how long you have to reach that goal. In other words, how much money will you need in the future, on an annualized basis, to live the same lifestyle you live today?

In other words, you have to adjust for inflation.

Suze Orman suggests that number will be a lot larger due to “life,” increased healthcare costs as we get older, etc.  She’s right, but $5 million is a number completely out of touch for most Americans and larger than most would actually need.

FIRE supporters are right in that you will need 25x your income to fund living costs, but they are also wrong in basing it on current income rather than future inflation-adjusted income.

Let me explain.

The basic FIRE premise is that you need to save 50% of income until you have saved 25x your annual income. Then you live on a 4% withdrawal rate. Here is an example:

Current annual income is $50,000 x 25 = $1,250,000 at 4% = $50,000 

It’s simple math.

As I said, it’s wrong because it is based on TODAY’S income level and not that of future income requirements.

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

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

Here is the same chart lined out.

The chart above exposes two problems with the entire FIRE premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of 25x of current income and what is actually required at 4% to generate the income level needed.

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

Suze was right.  If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years. For the FIRE followers, not adjusted for inflation is going to leave you short.

The FIRE Movement Fizzles For Most

A new study notes the U.S. retirement savings shortfall is worse than even we previously discussed. The study by the National Institute on Retirement Security, using data from the U.S. Federal Reserve, shows that retirement savings “are dangerously low” and that the U.S. retirement savings deficit is between $6.8 and $14 trillion.

Worse, the median retirement account balance is $3,000 for all working-age households and $12,000 for near-retirement households, the study reports.

This was also something I discussed recently in“80% of Americans Face A Retirement Crisis.”

“Those fears are substantiated even further by a new report from the non-profit National Institute on Retirement Security which found that nearly 60% of all working-age Americans do not own assets in a retirement account.”

Here are some additional findings from the report:

  • Account ownership rates are closely correlated with income and wealth. More than 100 million working-age individuals (57 percent) do not own any retirement account assets, whether in an employer-sponsored 401(k)-type plan or an IRA nor are they covered by defined benefit (DB) pensions.
  • The typical working-age American has no retirement savings. When all working individuals are included—not just individuals with retirement accounts—the median retirement account balance is $0 among all working individuals. Even among workers who have accumulated savings in retirement accounts, the typical worker had a modest account balance of $40,000.
  • Three-fourths (77 percent) of Americans fall short of conservative retirement savings targets for their age and income based on working until age 67 even after counting an individual’s entire net worth—a generous measure of retirement savings.

So, FIRE should solve that problem right.

Just save 50% of your income and you are good to go.

Maybe not.

“Why do so many Americans face a retirement crisis today after a decade of surging stock market returns? A survey from Bankrate.com touched on the issue.

’13 percent of Americans are saving less for retirement than they were last year and offers insight into why much of the population is lagging behind. The most popular response survey participants gave for why they didn’t put more away in the past year was a drop, or no change, in income.’

In other words, the “inability” to save is a huge issue for the FIRE movement.

Buy And Hold Won’t Get You There

The other problem for the FIRE movement is current valuations. With the markets currently at the second highest level of valuations in history, returns going forward are likely not going to work out as planned.

However, let’s give FIRE the benefit of the doubt and assume that someone started the program in 1988 at the beginning of one of the greatest bull market booms in history. They also got one to end with one as well. Since our young saver has to have a job from which to earn income to save and invest, we assume he begins his journey at the age of 25.

The chart below starts with an initial investment of 50% of the various income levels shown above with 50% annual savings into the S&P 500 index. The entire portfolio is on a total return basis and adjusted for inflation. 

As shown, the FIRE program certainly works.

You just didn’t actually retire all that early.

Despite the idea that by saving 50% of one’s income and dollar-cost averaging into index funds, it still took until April of 2017 to reach the retirement goal. Yes, our your saver did retire early at the age of 54, and it only took 29-years of saving and investing 50% of their salary to get there.

But given the realities of simply maintaining a rising standard of living, the ability for many to save 50% of their income is simply unrealistic. Instead, the next chart shows the same data but starting with 10% of our young saver’s income and adding 10% annually.

There are two important things to note in the chart above.  The first is that saving 10% annually leaves individuals far short of their retirement needs. The second is that despite two massive bull market advances, it was the lost 20-year period from 1997 to 2009 which left individuals far short of their retirement goals. 

It should be relatively obvious the last decade of a massive, liquidity driven advance will eventually suffer much the same fate as every other massive bull market advance in history. This isn’t a message of “doom,” but rather the simple reality that every bull market advance must be followed by a reversion to remove the excesses built up during the previous cycle.

The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.

With valuations currently on par with those on the eve of the Great Depression and only bettered by the late 1990’s tech boom, it should not be surprising that many are ringing alarm bells about potentially low rates of return in the future. It is not just CAPE, but a host of other measures including price/sales, Tobin’s Q, and Equity-Q are sending the same message.

The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a “mean reverting” event, occurs. It is these long periods where valuation indicators “appear” to be wrong where investors dismiss them and chase market returns instead.

Such has always had an unhappy ending.

There are many ways to approach managing portfolio risk and avoiding more major “mean reverting” events. While we don’t recommend or suggest that you try to “time the market” by being “all in” or “all out,”  it is critical to avoid major market losses during the accumulation phase. The example below uses a simple 12-month moving average to explain the importance of avoiding major drawdowns. It is the same 10% savings rate as above, dollar cost averaging into an S&P 500 index on a monthly basis, and moving to cash when the 12-month moving average is breached.

By avoiding the drawdowns, our young saver not only succeeded in reaching their goals but did so 31-months sooner than our example of saving 50% annually.

Don’t misunderstand me….I love the FIRE program.

I love ANY program that encourages individuals to get out of debt, save money, and invest. 

Period. No caveats.

In 1980, a million dollars would fund a healthy retirement.

That isn’t the case any longer as rising inflation eats away at the purchasing power of individuals.

It’s true when they say: “A million dollars sure ain’t what it used to be.”

President Donald Trump has been making a big stink about the Federal Reserve’s rate hikes lately. Last week, after the Dow plunged nearly 2,000 points, he blamed the Fed for it, saying “I think the Fed is making a mistake. They’re so tight. I think the Fed has gone crazy…” On Tuesday, Trump said that the Federal Reserve is “my biggest threat.” Since he became president, Trump has been praising the soaring stock market (something I said was very dangerous to do), viewing it as evidence of the success of his administration’s policies. Trump is worried that rising interest rates will put an end to the stock market boom, which will make him look bad.

Unfortunately, the president is extremely misguided about how interest rates work and the role they play in creating booms in the stock market and economy. As I’ve explained in great detail, the U.S. stock market has been booming because the Fed held interest rates at record low levels for a record length of time after the Great Recession. This Fed-driven stock market boom is an unsustainable bubble instead of a genuine, organic boom.

Fed Funds Rate

The fact that the Fed held rates at record low levels and inflated a credit and asset bubble meant that a crisis was already “baked into the cake” whether the Fed raised interest rates or not. Once a credit expansion or bubble is already in motion, the actions of the central bank from that point on can only determine what type of crisis occurs when the credit expansion ends – not whether a crisis will occur or not.

The Austrian School economist Ludwig von Mises said it best in his book Human Action:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

If the Fed or other central bank voluntarily abandons further credit expansion (most commonly by raising interest rates), the credit and asset bubble will experience a deflationary bust. Deflationary episodes entail credit busts, falling consumer prices, bear markets in stocks and housing prices, and falling wages. If the central bank decides to never put an end to the credit expansion (for example, if the Fed never raised rates), however, the result would be a runaway credit and asset bubble that leads to a severe decrease in the value of the currency and high rates of inflation. The latter scenario is what would occur if President Trump got his way – hardly a desirable outcome for the economy.

To summarize, the Fed is crazy – they’re crazy for creating such a large bubble in the first place via loose monetary policy, but not for raising interest rates and normalizing their monetary policy.

We at Clarity Financial LLC, a registered investment advisory firm, specialize in preserving and growing investor wealth in times like these. If you are concerned about your financial future, click here to ask me a question and find out more.

Since 2009, the U.S. has been experiencing a household wealth boom due to soaring stock, housing, and bond prices. Unfortunately, this wealth boom is driven by cheap credit and asset bubbles just like the late-1990s and mid-2000s wealth booms before it (both of which ended in a crash).

Jesse Colombo (the creator of this presentation) and Clarity Financial have been very wary of following the overcrowded “buy and hold” strategy when the stock market and household wealth is so inflated (because reversion to the mean is inevitable), which is why we have always employed a very disciplined strategy which follows the trend of the market while it is rising, but protects capital from eventual and inevitable downturns.

After having successfully navigated out of the markets in 2008 and identifying the “buying” opportunity in 2009, we continue to understand the importance of proper asset allocation, sector rotation, value and momentum based investing, and a strong, rule based, “buy/sell” investment discipline.

We at Clarity Financial LLC, a registered investment advisory firm, specialize in preserving and growing investor wealth in times like these. If you are concerned about your financial future, click here to ask me a question and find out more.

I’m a low interest rate person – Donald Trump 2016

On Donald Trump’s hit TV show, The Apprentice, contestants competed to be Trump’s chief apprentice. Predictably, each show ended when the field of contestants was narrowed down by the firing of a would-be apprentice. While the show was pure entertainment, we suspect Trump’s management style was on full display. Trump has run private organizations his entire career. Within these organizations, he had a tremendous amount of unilateral control. Unlike what is required in the role of President or that of a corporate executive for a public company, Trump largely did what he wanted to do.

On numerous occasions, Trump has claimed the stock market is his “mark-to-market.” In other words, the market is the barometer of his job performance. We think this is a ludicrous comment and one that the President will likely regret. He has made this comment on repeated occasions, leading us to conclude that, whether he believes it or not, he has tethered himself to the market as a gauge of performance in the mind of the public. We have little doubt that the President will do everything in his power to ensure the market does not make him look bad.

Warning Shots Across the Bow

On June 29, 2018, Trump’s Economic Advisor Lawrence Kudlow delivered a warning to Chairman Powell saying he hoped that the Federal Reserve (Fed) would raise interest rates “very slowly.”

Almost a month later we learned that Kudlow was not just speaking for himself but likely on behalf of his boss, Donald Trump. During an interview with CNBC, on July 20, 2018, the President expanded on Kudlow’s comments voicing concern with the Fed hiking interest rates. Trump told CNBC’s Joe Kernen that he does not approve [of rate hikes], even though he put a “very good man in” at the Fed referring to Chairman Jerome Powell.

“I’m not thrilled,” Trump added. “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time I’m letting them do what they feel is best.”

“As of this moment, I would not see that this would be a big deal yet but on the other hand it is a danger sign,” he said.

Two months later in August of 2018, Bloomberg ran the following article:

Trump Said to Complain Powell Hasn’t Been Cheap-Money Fed Chair

“President Donald Trump said he expected Jerome Powell to be a cheap-money Fed chairman and lamented to wealthy Republican donors at a Hamptons fundraiser on Friday that his nominee instead raised interest rates, according to three people present.”

On October 10, 2018, following a 3% sell-off in the equity markets, CNBC reported on Donald Trump’s most harsh criticism of the Fed to date.  Trump said, “I think the Fed is making a mistake. They’re so tight. I think the Fed has gone crazy.”

Again-“I think the Fed has gone crazy

These comments and others come as the Fed is publicly stating their preference for multiple rate hikes and further balance sheet reduction in the coming 12-24 months. The markets, as discussed in our article Everyone Hears the Fed but Few are Listening, are not priced for the same expectations. This is becoming evident with the pickup in volatility in the stock and bond markets.  There is little doubt that a hawkish tone from Chairman Powell and other governors will increasingly wear on an equity market that is desperately dependent on ultra-low interest rates.

Who can stop the Fed?

We think there is an obstacle that might stand in the Fed’s way of further rate hikes and balance sheet reductions.

Consider a scenario where the stock market drops 20-25% or more, and the Fed continues raising rates and maintaining a hawkish tenor.

We believe this scenario is well within the realm of possibilities. Powell does not appear to be like Yellen, Bernanke or Greenspan with a finger on the trigger ready to support the markets at early signs of disruption. In his most recent press conference on September 26, 2018, Powell mentioned that the Fed would react to the stock market but only if the correction was both “significant” and “lasting.”

The word “significant” suggests he would need to see evidence of such a move causing financial instability. “Lasting” implies Powell’s reaction time to such instability will be much slower than his predecessors. Taken along with his 2013 comments that low rates and large-scale asset purchases (QE) “might drive excessive risk-taking or cause bubbles in financial assets and housing” further seems to support the notion that he would be slow to react.

Implications

President Trump’s ire over Fed policy will likely boil over if the Fed sits on their hands while the President’s popularity “mark-to-market” is deteriorating.

This leads us to a question of utmost importance. Can the President of the United States fire the Chairman of the Fed? If so, what might be the implications?

The answer to the first question is yes. Pedro da Costa of Business Insider wrote on this topic. In his article (link) he shared the following from the Federal Reserve Act (link):

Given that the President can fire the Fed Chairman for “cause” raises the question of implications were such an event to occur.  The Fed was organized as a politically independent entity. Congress designed it this way so that monetary policy would be based on what is best for the economy in the long run and not predicated on the short-term desires of the ruling political party and/or President.

Although a President has never fired a Fed Chairman since its inception in 1913, the Fed’s independence has been called into question numerous times. In the 1960’s, Lyndon Johnson is known to have physically pushed Fed Chairman William McChesney Martin around the Oval Office demanding that he ease policy. Martin acquiesced. In the months leading up to the 1972 election, Richard Nixon used a variety of methods including verbal threats and false leaks to the press to influence Arthur Burns toward a more dovish policy stance.

If hawkish Fed policy actions, as proposed above, result in a large market correction and Trump were to fire Fed Chairman Jerome Powell, it is plausible that the all-important veil of Fed independence would be pierced. Although pure conjecture, it does not seem unreasonable to consider what Trump might do in the event of a large and persistent market drawdown. Were he to replace the Fed chair with a more loyal “team player” willing to introduce even more drastic monetary actions than seen over the last ten years, it would certainly add complexity and risk to the economic outlook. The precedent for this was established when President Trump recently nominated former Richmond Fed advisor and economics professor Marvin Goodfriend to fill an open position on the Fed’s Board of Governors. Although Goodfriend has been critical of bond buying programs, “he (Goodfriend) has a radical willingness to embrace deeply negative rates.” –The Financial Times

Such a turn of events might initially be very favorable for equity markets, but would likely raise doubts about market values for many investors and raise serious questions about the integrity of the U.S. dollar. Lowering rates even further leaves the U.S. debt problem unchecked and potentially unleashes inflation, a highly toxic combination. A continuation of overly dovish policy would likely bolster further expansion of debt well beyond the nation’s ability to service it. Additionally, if inflation did move higher in response, bond markets would no doubt eventually respond by driving interest rates higher. The can may be kicked further but the consequences, both current and future, will become ever harsher.

It’s debatable whether the recent stock market slide created some bargains, but there’s another corner of financial markets where inefficiencies prevail more regularly – the closed-end fund universe.

What’s a Closed-End Fund?

Unlike mutual funds, which continually issue and redeem shares according to investor demand, closed-end funds take in money and issue a finite number of shares once, in an initial public offering. After the IPO, the fund closes to new money; there are no outflows and no inflows, making the arrangement convenient for holding illiquid assets. Investors must then trade shares on an open exchange like stocks to each other rather than purchasing and redeeming with the fund itself.

For that reason, the share price of a closed-end fund can rise above or fall below the net asset value of the fund’s holdings. When a fund’s share price drops below, or trades at a discount to, its net asset value (NAV), it can be a bargain as long as investors understand there’s no guarantee that the price will match its NAV soon or ever. Sometimes activist investors accumulate closed-end fund shares to pressure fund management to liquidate the assets and use the proceeds to buy back shares in order to close the gap between price and NAV. But there’s no guarantee an activist will accumulate shares of any fund or apply pressure successfully after accumulation.

The other important feature of closed-end funds is that they often borrow money against their investments. Regulations demand that a fund have $3 in assets for every $1 of debt issued and $2 of assets for every $1 of preferred stock issued. But those rules still allow for a significant amount of borrowed money that can boost returns when the assets in the funds are doing well and interest rates remain stable or hurt returns when underlying assets are slumping and interest rates are increasing. As of the end of 2017, around 64% of closed-end funds used leverage or borrowed money, according to the Investment Company Institute.

Currently, 250 out of 638 funds in Morningstar’s database are trading at discounts to NAV of 10% or more. Municipal bond funds have significant representation among the funds trading at the largest discounts, though other classes of funds, including energy and MLP funds are among the most heavily discounted.

Any Bargains?

I compiled a list of funds trading at the biggest discounts and with a z-score of -2.5 or lower. A z-score is the difference between the fund’s current and average discounts relative to its standard deviation. Many analysts consider a z-score of -2.5 or less as an indication of cheapness.

Four of the top-10 on our list of biggest current discounts and Z-Scores of -2 or lower are muni bond funds. All of them have leverage ratios above 35%. That means if interest rates continue to move higher, bond funds using borrowed money could suffer. But if rates stabilize or decline, that could be a boon for these funds.

Also, a word of caution about the Boulder fund – I’ve seen it among funds with the cheapest discounts for many years. The discount could narrow from here, but I wouldn’t count on it to close.

Overall, investors have a variety of funds in different asset classes from which to choose. But investors should think of this type of investment as a stock investment even if the fund holds bonds. That’s because using borrowed money magnifies the overall investment risk.

“We gathered on porches; the moon rose; we were poor.

And time went by, drawn by slow horses.

Somewhere beyond our windows shone the world.

The Great Depression had entered our souls like fog.” – Pantoum of the Great Depression – Donald Justice.

Wall Street insiders relish market troughs.

They bask sanguine in their confidence of history. Tenured pros are comforted in the belief that monetary and fiscal stimulus triggers are cocked and at the ready, reinforced in the knowledge that taxpayers without choice in the matter, will again, be the bail-out solution.

In a last irony to turn the blade in the back slowly, this group confidently takes credit for saving a system they helped to bust in the first place.

They are the strong hands who patiently await to scoop up shares when markets falter. As the smart money, these players unload inflated shares to the ‘dumb’ money or retail investors at “FOMO” or fear-of-missing-out emotional peaks.

The masses are advised to blind buy and hold. Retail investors are cajoled as “brave” if they “ride it out.” And whatever “it” is can be counted in years, even decades. Time is precious to us mere mortals. Our lives are finite; Wall Street lives on forever. The precious time it takes to break-even is ignored. Not relevant.

One of my favorite Nashville-based songwriters Drew Holcomb begins a song with a seminal line:

“Time steals every paradise I’ve been looking for.”

When Wall Street prospers, Main Street doesn’t necessarily follow a similar, prosperous path.

For example, Pew Research Center outlines that overall, American Household wealth has not fully recovered from the Great Recession. As early as 2016, median wealth of all U.S. households was $97,300; well below median wealth of $139,700 before the recession began in 2007.

Haven’t most Americans benefited from the triple-digit returns of the stock market since March 2009?

Not really.

According to the Federal Reserve’s Changes in U.S. Family Finances survey published in September 2017, median values of retirement accounts were little changed, remaining at about $60,000 in 2016. For the top income group, the rate of stock ownership, directly or indirectly, increased, continuing the trend from the 2010 survey. Stock ownership for this group was 93.6 percent in 2016.

Main Street or the middle-class’ primary motivation is wages and wage growth. Appreciation of primary residences is a strong second. Finally, signs of life exist with inflation-adjusted wages (red line), exceeding 1999 levels. Notice the average (blue line), skewed by higher wage earners.

The stock market is finally paying heed to the bond market; rising rates are having a material impact on housing as 30-year mortgage rates reach an eight-year high. Increased corporate leverage is threatening to put profit margins at risk.

A spike in ten-year Treasury rates from 3.05-3.25% (3.15% at the time of this writing), was enough to get the stock market’s attention especially at a time where there was dearth of earnings news to distract it.

Also, an observation – the uncustomary silence and respectively, bearish tones from a Fed Chair and the scattered Governor minions during the recent stock market routing didn’t help. We’re not used to silent treatment from the Fed when stocks pull back or volatility picks up. Investors have gotten accustomed to the Fed jawboning the markets quiet or higher.

Fed head-honcho Powell believes the economy is running hot and he’s just the fireman to tame the flames.

Believe him.

I write this because interest rates matter; accommodative monetary, and or fiscal, policies that increase liquidity can be significant stock market catalysts, even while a majority of Main Street’s populace suffers.

As a leading indicator, markets are characterized by a counterintuitive nature that leaves investors – novice or experienced along with the general population, dumbfounded.

I thought the Great Depression, a tragic slice of American history could prove my point.

Six weeks into his new administration, FDR wasn’t fooling around. He came out of the gate as a strong, determined hand at the nation’s helm. He held strong convictions that weren’t going to be deterred. Lack of ethics in business, the excesses of the 1920s were his targets, and he had the courage to expose and correct them.

The Roosevelt Program wasn’t popular. Businesses from meat packers to investment bankers believed the Roosevelt Program spelled hardship for their businesses. It was difficult (even more so today), to separate special individual or trade business interests from their interests as citizens or units in the overall poor state of the nation.

A big disagreement at the time was what to do with current wages. A majority of business leaders were advocates for a reduction in wages as prices for goods were quickly deflating. The consumer price index fell by close to 27% from 1929 to 1933. Less wages would translate to more bodies employed. Employees would be putting in less hours in a day however, the strategy would allow additional workers to be hired. Although a good idea, the resistance was too strong.

One of the most aggressive FDR initiatives was to aggressively deflate debt for those who held farm and home mortgages. In 1933, the economic life of your everyday Americans simply couldn’t pay mortgage interest at 1929 levels. The plan was to lower interest rates dramatically from 1929 to 1933 levels. At the time, the action was deemed ‘heroic,’ by advocates.

Uncle Sam was to gather mortgages that concern the mortgagee and crush the mortgagor. The lenders to receive Federal Land Bank bonds at 4.5% as against 7-10% on present mortgages with the Federal government to guarantee the interest. Business could not revive within an environment choked by debt. The overall deflation of debt was inevitable.

Interest rates as represented by call loan and discount, began their ascension in 1928 to cool off speculation in securities markets. By 1930, the discount rate fell from 6% to 2.5% as the Fed realized they may have overdone it to tighten the money supply.

One theory is that the Fed kept rates too low in the 1920s which was a catalyst for errant lending that lead to the great bust. Another is the money supply was too tight during the early 30s as the monetary base suffered a great decline. Deflation was a culprit, not inflation.

Consequently, the discount rate should have been close to 1% or less! In other words, The Federal Reserve’s monetary policy and interest rates were catalysts to boom and bust in the economy and markets.

Stocks had a dazzling run from 1933-1936 due to accommodative monetary and fiscal policies. The Roosevelt Program along with the money supply – M2 (M2 is cash and deposits (M1) + time deposits), bottoming and beginning to improve, sparked a hunger by Wall Street players for speculative assets like stocks. Main Street was disinterested. Unemployment was a shade lower than a tragic 25% in 1933. It fell to 16.9% in 1936.

“Hoovervilles” or tent cities remained prominent. Before 1935, there were very few relief systems in place outside of local churches and whatever services cities could provide.

But that stock market whew, what a run!

We ponder the question

“How can the stock market do so well when the economy appears broken?”

A picture does more to showcase the reality of the time than any words I share:

Here is Florence Owens Thompson. She was an iconic image of the Great Depression.

She’s 32 years old in this photo (what age does she look to you?)

Florence was a migrant worker in California in 1936. Here she is with her two children. She had seven. From 1931-1936, the stock market as represented by the Dow Jones was up 136 percent.

Now matter how you cut it, things were just fine on Wall Street.

Not so for Florence and many others at the intersection of Main Street and the Great Depression.

One lesson to never forget: Markets can and do indeed prosper during tough economic cycles due to fiscal and monetary stimulus. Markets falter when rates increase.

As the Fed continues to drain liquidity from the system, target a neutral rate, normalize (whatever that is), all of us as investors may finally understand how painful it can be for stocks, again.

For the last few months, we have repeatedly warned about the mounting risks which were being ignored by an increasingly overly complacent, overly exuberant market. Doug Kass had a good compilation of those concerns on Friday:

  • The Fed Chairman seemed more hawkish in tone recently
  • Rising interest rates provide an alternative to stocks and reduce the value of long-dated assets.
  • Higher inflation (input costs) will pressure corporate margins and profitability.
  • A pivot in global monetary policy towards constraint from easing.
  • Policy risks.
  • Midterm election uncertainties.
  • Fiscal policy that has trickled up (not trickling down).
  • Our Administration’s trade policy and (as expressed in my missives this week) reversing the post-WWII liberal order holds multiple social and economic risks.
  • Increasingly leveraged public and private sectors.
  • A leveraged and dangerously weak European banking system who’s left-hand side of the balance sheet is loaded with overvalued assets (like sovereign debt).
  • Submerging emerging markets vulnerable to large U.S. dollar-denominated debt that will be difficult to pay off.
  • China’s economy is faltering – and its financial system is too leveraged.
  • Investor complacency – not a soul in the business media (save the Perma Bears) has warned of a large market markdown since the January highs.

Of course, the sell-off last week was simply more evidence of the influence of “algos gone wild” when technical levels are broken and the robots all hit the “sell” button at the same time. It was also further acknowledgment of the lack of liquidity due to the surge in ETF issuance which has now created a massive amount of overlap risk in the markets.

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.” – James Rickards

The same was noted by portfolio manager Frank Holmes as well:

“Nevertheless, the seismic shift into indexing has come with some unexpected consequences, including price distortion. This isn’t just the second largest bubble of the past four decades. E-commerce is also vastly overrepresented in equity indices, meaning extraordinary amounts of money are flowing into a very small number of stocks relative to the broader market. Apple alone is featured in almost 210 indices, according to Vincent Deluard, macro-strategist at INTL FCStone.

If there’s a rush to the exit, in other words, the selloff would cut through a significant swath of index investors unawares. – Frank Holmes

Due to massive amounts of Central Bank interventions, combined with low interest rates, investors have been trained to “buy the dips” and disregard everything else. As Frank noted, that bullish mantra has now led to the “second largest bubble in four decades.” 

(If you consider the amount of debt and leverage that has been piled on – I would argue this is likely the largest bubble ever as it encompasses so many different asset classes at the same time.)

So, is this time different? Should we just “buy the dip” and keep ignoring everything else? 

I am not so sure.

As I noted this past weekend, the technical backdrop to the market has changed for the worse. To wit:

“With the understanding the economic and fundamental background may not be supportive for higher asset prices heading into 2019, the market is also sending a very different technical signal as well. As I showed on Thursdaythis is the FIRST time the market has broken the bullish trend line that began in 2016.

As shown below, that break of the bullish trend pulls in a new dynamic of potential market action over the next several months which is more akin to a market topping process than the continuation of the previous bullish trend.”

Given the short-term OVERSOLD condition of the market, we want to use rallies to rebalance risks in portfolios.

#1 – A rally back to the bullish trend line will be used to reduce risk (ie. raise cash) in portfolios by selling lagging positions and rebalancing risk in winning positions. Rule: sell losers and let winners run. 

We fully expect an initial rally to fail as investors caught in the sell-off will be looking for an opportunity to sell. However, if that sell-off fails to hold support at the recent lows it will suggest a bigger corrective action is in process. We will be looking to reduce equity risk further, raise cash, evaluate portfolio allocation models. 

#2– If the sell-off following a failed rally holds support at the recent lows, and turns up, such will suggest a rally back to either the January highs or all-time highs. NOTE: A rally back to all-time highs following a corrective pullback will again retest the underside of the bullish trend line from the 2016 lows. Such remains a ‘bearish’ backdrop from equity risk going into 2019 where economic and earnings data is expected to slow further. We will use any rally back to those levels to reduce risk as noted in #1.

#3– If the rally from the recent lows fails at the January highs we will again use that opportunity to reduce equity risk and rebalance portfolio allocations.”

The chart below pulls that analysis back to the 2015-2016 correction where you can see the trend more clearly.

The nominal “new highs” in 2015 were not confirmed by a strengthening cumulative advance-decline line which suggested a correction was likely. The same non-confirmation was also evident with the most recent nominal new highs in September. As noted above, the break below the bullish trend line, combined with the downside break of the consolidation from the January highs, changes the entire tenor of the market heading into the end of the year.

When we switch from weekly to daily analysis, we can update our ongoing “pathway analysis” which we have been producing each week since January. The following chart is updated through Monday’s close.

No matter how many different paths I trace out, the possibilities of the market rallying back to new all-time highs this year have been greatly reduced. As noted, all four possibilities continue to suggest a broader topping pattern in place through the end of this year.

Pathway #1: The most bullish outcome would be from a strong earnings season, combined with a pickup in economic activity from the two most recent Hurricanes, which pushes markets back to resistance near all-time highs. While this is certainly entirely possible, there is a tremendous amount of technical damage to overcome between current levels and that high point. (10%)

Pathway #2a: The market rallies from current levels to the January high. Again, this would likely be fueled by a stronger than expected earnings season and a pickup in economic activity. However, the run to the January highs is capped by that resistance but the market finds support at the 62% Fibonacci retracement level just below. (30%) 

Pathway #2b: The most feasible rally from current oversold levels is back to the 50% Fibonacci retracement of the recent decline. The market gets back to very overbought conditions and the market begins to trade between the 200-dma and/or the 32% Fibonacci retracement level. (30%)

Pathway #3: The biggest concern, given the technical deterioration, the threat of weaker economic and earnings growth, and the possibility of a Mid-term election upset, is a rally back to the 32% Fibonacci retracement level which coincides with the previous resistance at the May highs. A failure at the point would likely lead to a sell-off that pushes the markets back to retest last week’s intra-day lows.  Lower lows become a real threat. (30%)

Here is the bottom line:

While a year-end rally is certainly feasible, the probability of the markets setting new highs has been markedly reduced. 

As I have repeatedly discussed over the last several weeks, prudent portfolio management practices reduce inherent portfolio risk thereby increasing the odds of long-term success. Any rally that occurs over the next few days from the current levels SHOULD be used as a “sellable rally” to rebalance portfolios and related risk. These practices align with our most basic investment rules/philosophies as noted above.

  • Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
  • Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
  • Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

Remember, we can ALWAYS add money back into the markets once the evidence of the continuation of a bull market is available.

Until then, we are going to err on the side of caution.

There has been a lot of angst lately over the rise in interest rates and the question of whether the government will be able to continue to fund itself given the massive surge in the fiscal deficit since the beginning of the year.

While “spending like drunken sailors” is not a long-term solution to creating economic stability, unbridled fiscal stimulus does support growth in the short-term. Spending on natural disaster recovery last year (3-major hurricanes and two wildfires) led to a pop in Q2 and Q3 economic growth rates. The two recent hurricanes that slammed into South Carolina and Florida were big enough to sustain a bump in activity into early 2019. However, all that activity is simply “pulling forward” future growth.

But the most recent cause of concern behind the rise in interest rates is that there will be a “funding shortage” of U.S. debt at a time where governmental obligations are surging higher. I agree with Kevin Muir on this point who recently noted:

“Well, let me you in on a little secret. The US will have NO trouble funding itself. That’s not what’s going on.

If the bond market was truly worried about US government’s deficits, they would be monkey-hammering the long-end of the bond market. Yet the US 2-year note yields 2.88% while the 30-year bond is only 55 basis points higher at 3.43%. That’s not a yield curve worried about US fiscal situation.

And let’s face it, if Japan can maintain control of their bond market with their bat-shit-crazy debt-to-GDP level of 236%, the US will be just fine for quite some time.”

That’s not a good thing by the way.

Let’s Be Like Japan

“Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the ‘painkilling’ effect wears off, U.S. and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.” – Keiichiro Kobayashi, 2010

While Kobayashi will ultimately be right, what he never envisioned was the extent to which Central Banks globally would be willing to go. As my partner Michael Lebowitz pointed out previously:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

The belief was that by driving asset prices higher, economic growth would follow. Unfortunately, this has yet to be the case as debt both globally and specifically in the U.S. has exploded.

“QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.”

Not surprisingly, the massive surge in debt has led to an explosion in the financial markets as cheap debt and leverage fueled a speculative frenzy in virtually every asset class.

The continuing mounting of debt from both the public and private sector, combined with rising health care costs, particularly for aging “baby boomers,” are among the factors behind soaring US debt. While “tax reform,” in a “vacuum”  should boost rates of consumption and, ultimately, economic growth, the economic drag of poor demographics and soaring costs, will offset many of the benefits.

The complexity of the current environment implies years of sub-par economic growth ahead as noted by the Fed last week as their long-term projections, along with the CBO, remain mired at 2%.

The US is not the only country facing such a gloomy outlook for public finances, but the current economic overlay displays compelling similarities with Japan in the 1990s.

Also, while it is believed that “tax reform” will fix the problem of lackluster wage growth, create more jobs, and boost economic prosperity, one should at least question the logic given that more expansive spending, as represented in the chart above by the surge in debt, is having no substantial lasting impact on economic growth. As I have written previously, debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service.

One only needs to look at Japan for an understanding that QE, low-interest rate policies, and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus the growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

But yet, the current Administration believes our outcome will be different.

With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 25 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

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

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

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

Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.

More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case for two reasons.

  1. As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of global economies are pushing low to negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.
  2. Increases in rates also kill economic growth which drags rates lower. Like Japan, every time rates begin to rise, the economy rolls into a recession. The U.S. will face the same challenges. 

Unfortunately, for the current Administration, the reality is that cutting taxes, tariffs, and sharp increases in debt, is unlikely to change the outcome in the U.S. The reason is simply that monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

But hey, let’s just keep doing the same thing over and over again, which hasn’t worked for anyone as of yet, but we can always hope for a different result. 

What’s the worst that could happen?  

The stocks of retail REITs have struggled lately. Malls and shopping centers are under pressure from Amazon and online shopping. But not all retailers are under extreme pressure. Home Depot, TJX Companies, Kroger, WalMart, Whole Foods (now an Amazon subsidiary), Best Buy, CVS, and Walgreen’s are financially healthy big tenants of many shopping center REITs. And that means the landlords that rent to stores that can withstand pressure from Amazon are worth a look.

We’ve listed the 7 largest shopping center REITs by market capitalization, showing their dividend yields and Price/FFO.

As a reminder FFO (funds from operations) is net income adjusted for property sales and depreciation. It’s not a perfect measure of cash flow since stripping out all depreciation can’t be accurate. Some long term capital expenditures are required to maintain property. But adjustments to FFO aren’t uniform, while FFO is. So it allows for the comparison of companies. It’s also useful in judging the safety of dividends.

The top-7 shopping mall REITs are averaging a Price/FFO ratio of 14.43 and a dividend yield of 5.3%. That’s a reasonable P/FFO ratio for healthy businesses and a decent yield since the 10-year US Treasury is 2 percentage points behind. The companies with higher valuations and lower dividend yields tend to have better property. Regency, for example, has more property than the others in California. KIMCO and Brixmor, by contrast, have a higher percentage of Midwest property, where the economy struggles, and Southeast property vulnerable to hurricanes.

All of the companies appear financially healthy, and aren’t struggling to pay interest on mortgages or dividends. Most of them are also growing net operating income (NOI). That means, though vulnerable to further encroachments from Amazon, this would be a reasonable basket of stocks to own as a small part of a dividend portfolio.

Brixmor and KIMCO, especially, could be attractive holdings at their current prices, despite being heavy in Midwest and Southeast property.  In addition to attractive dividend yields covered by cash flow and healthy balance sheets for both companies, a recent Morningstar report indicates that KIMCO has revamped its portfolio since 2010, shedding over 400 assets for $6 billion over that time.

Additionally, Weingarten Realty, though with a lower dividend yield than Brixmor and KIMCO, has 56 of its 190 properties in fast-growing Texas. More than half the landlord’s property is in Texas, Florida, California, and Arizona. Gunning for the biggest dividend yield is usually a recipe for disaster, but, currently among beaten up shopping mall REITs, it may be a reasonable course.

Get The Rest Of The Story On Our Top 3-Picks By Subscribing To RIA PRO Today!

It’s no secret that malls are under pressure from e-commerce and Amazon. Even strip malls anchored by supermarkets and stores like Target and WalMart are struggling as shoppers buy more necessities and staples online. But some shopping center REITs’ stocks have declined so much that they’re worth a look from investors. Three of the largest – Brixmor, KIMCO, and Weingarten are yielding 5.70% or more.

Covering Dividends & Interest Payments

First, all three companies can cover their dividends with funds from operations (FFO). FFO is an important REIT cash flow metric that’s useful for understanding dividend coverage. It adjusts net income for property sales and depreciation, the latter of which can be an unrealistic charge in real estate. It’s not perfect because some capital is required to maintain property every year, but it’s a decent start to see if companies can maintain their current dividends. Our three  companies are producing FFO that’s at least 38% higher than their current dividend payouts.

Second, none of our companies is carrying a dangerous amount of debt. Their fixed charge (bonds and preferreds) coverage ratios are all over 3x. The typical cash flow metric used to calculate coverage is EBITDA or earnings before interest, taxes, depreciation and amortization. Again, that’s imperfect because it doesn’t include maintenance capital expenditures, but at 3x or more it’s fair to say our companies don’t have unreasonable amounts of debt.

Same Property NOI Growth & Property Quality

Another important metric in real estate is if companies are experiencing same-property rent and net operating income (NOI) growth. Our companies are. Brixmor, however generated the lowest same property NOI growth for the second quarter of 2018 (the most recent available), and that may be why its stock is trading at the lowest FFO multiple and delivering the highest current yield.

One possible reason for Brixmor lagging in this category is that its sprawling property portfolio includes malls in less upscale areas. When looking at the amount of annualized base rent (ABR) each firm had from each city or metropolitan area, and Brixmor had only 24% of its rent come from Los Angeles, Houston, metropolitan New York City, Chicago, Miami, Washington, D.C., and San Francisco. By contrast, Weingarten had 34% of its rent come from those locations and KIMCO had nearly 39% of its rent come from those locations.

Additionally, Brixmor may have the least desirable top tenants. Weingarten and KIMCO count Home Depot and WholeFoods as top-10 tenants, but Brixmor doesn’t. Brixmor has more discount stores in its top-10, including Burlington and Dollar Tree.

Overall, all three companies are healthy, but KIMCO and Weingarten have a more attractive tenant lineup that make paying up for them worth it. Incidentally, this exercise also shows why investors need to be wary of advisors who say to them “I can get  you x% yield.” Higher yield usually comes with higher risks or, in this case, inferior real estate and tenants. You can have any yield you want, but you have to be cognizant of the risk associated with each yield.


  • Yes, Something Broke
  • More Than Just Rates
  • This Time IS Different
  • What To Expect Next Week
  • Checklist Summary Of Actions To Take
  • Sector & Market Analysis
  • 401k Plan Manager

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Yes, Something Broke

In this missive, we are just going to focus on the “WTF!” moment of this past week. In order to do this properly, I need to start with last week’s missive where we asked the question “Did Something Just Break?” In that article we addressed very specific concerns about interest rates and the problem they were going to cause.

Speaking of rates, each time rates have climbed towards 3%, the market has stumbled.”

Chart updated through Friday.

“If you note in the chart above, a short-term ‘warning signal’ has been triggered which suggests that if rates remain above 3%, stocks are going to continue to struggle. The last time this occurred was in May when rates popped above 3%, stocks struggled and bonds outperformed.”

We also updated the pathway analysis for the highest probability outcomes over the next couple of months.

Chart updated through Friday – pathways remain unchanged

While the majority of the pathway’s accounted for a continued corrective, consolidation, process through the end of the year. It was Pathway #3 which came to fruition.

“Pathway #3: The issue of rising interest combines with a break in the economic data, or another credit-related event, and sends the market heading back to test supports at 2800 and 2750. This would likely coincide with a more severe contraction in the economic data which is not an immediate threat. Nonetheless, we should always consider the risk of an unexpected, exogenous, event. (10%)”

The recent sell-off coincides with the rising concerns of higher rates coupled with deterioration in economic growth heading into 2019. To wit:

“As such, our best initial take is that yesterday’s repricing of US growth was an overdue gut-check following last week’s monetary and oil supply shocks.”

In other words, as we have been repeatedly stating, the underlying economic growth story, outside of one-time events and natural disasters isn’t nearly as strong as reported. My friend, Danielle DiMartino-Booth, concurs with my assessment:

” Against that backdrop, it’s becoming clear that many companies are rushing to secure products and materials before prices rise regardless of current demand. You could say they are in panic-buying mode. The upside is that this behavior bolsters economic growth in the short term. The downside is that there is likely to be a nasty hangover. The noise in the economic data will be amplified by the rebuilding from Hurricane Florence. The estimates of the storm’s damage span from $20 billion to $50 billion.”

Of course, you can now add Hurricane Michael to the list. But don’t forget the current spat of economic growth this year was from the 3-massive Hurricanes in 2017.

But here is her conclusion:

“In the event you’re hoping the virtuosity of panic buying can become a permanent prop to the economy, you might want to rethink your thesis. 

Rather, artificial, tariff-driven panic buying pumps up GDP growth in the short term but ensures it will disappoint in the future. Look for fourth quarter estimates to be revised upwards and then look out below into the first of the year. And no, the first-quarter disappointment will not be the seasonal anomaly many economists typically ascribe to economic growth in the first three months of the year. In other words, it could be that much worse.”

More Than Just Rates

But it isn’t just the rise in interest rates, and the threat of slowing economic growth, that is most concerning for the outlook of investors going forward. Both of those issues also translate into weaker earnings growth as well.

“As stated, the risk to current estimates remains higher rates, tighter monetary accommodation, and trade wars. More importantly, year over year comparisons is going to become markedly more troublesome even as expectations for the S&P 500 index continues to rise.”

“With the number of S&P 500 companies issuing negative EPS guidance is now the highest since 2016, it is only a function of time until we see forward estimates into 2019 begin to revised substantially lower.”

The issue of earnings, combined with higher rates, tariffs, and valuations, will likely continue to way on asset prices as we move into 2019.

The one bright spot going into the end of this year is that corporations have been in a “blackout” period for buying back their own shares heading into Q3-earnings reporting period. 

“Given a large bulk of the surge in earnings was due to the “one-time” repatriation of overseas profits of $300 billion which flowed directly into share buybacks.” 

By the beginning of November, that restriction will be lifted and the markets will likely get some support from an acceleration of buybacks headed into year end. However, as stated, that growth will become much more muted.

This Time IS Different

With the understanding the economic and fundamental background may not be supportive for higher asset prices heading into 2019, the market is also sending a very different technical signal as well. As I showed on Thursday, this is the FIRST time the market has broken the bullish trend line that began in 2016.

As shown below, that break of the bullish trend pulls in a new dynamic of potential market action over the next several months which is more akin to a market topping process than the continuation of the previous bullish trend. 

Given the short-term OVERSOLD condition of the market, we want to use rallies to rebalance risks in portfolios.

#1 – A rally back to the bullish trend line will be used to reduce risk (ie. raise cash) in portfolios by selling lagging positions and rebalancing risk in winning positions. Rule: sell losers and let winners run. 

We fully expect an initial rally to fail as investors caught in the sell-off will be looking for an opportunity to sell. However, if that sell-off fails to hold support at the recent lows it will suggest a bigger corrective action is in process. We will be looking to reduce equity risk further, raise cash, evaluate portfolio allocation models. 

#2– If the sell-off following a failed rally holds support at the recent lows, and turns up, such will suggest a rally back to either the January highs or all-time highs. NOTE: A rally back to all-time highs following a corrective pullback will again retest the underside of the bullish trend line from the 2016 lows. Such remains a ‘bearish’ backdrop from equity risk going into 2019 where economic and earnings data is expected to slow further. We will use any rally back to those levels to reduce risk as noted in #1.

#3– If the rally from the recent lows fails at the January highs we will again use that opportunity to reduce equity risk and rebalance portfolio allocations.”

Back in April of this year, I wrote 10-Reasons The Bull Market Ended In 2018. Primarily, that analysis was built around fundamental issues that would potentially plague markets going forward. With the failure of the markets this past week, along with the break of the bull trend, the bull market still has not yet resumed. More importantly, the current actions are consistent with both previous major market peaks as shown below. (Nominal new highs, declining momentum, and weekly MACD sell signal)

What To Expect Next Week

As shown in the chart below, the market was more than 4-standard deviations below its 50-dma on Friday. This is a very rare event and is an extreme oversold condition. However, along with the evidence above, also suggests the recent bull market trend is finished for the time being. Portfolio management processes should be switched from “buying dips” to “selling rallies” until the technical backdrop changes.

Next week, I would expect to see a rally from the short-term oversold conditions. The good news is that the market WAS ABLE TO CLOSE ABOVE THE 200-DMA on Friday which will keep buyers (algos) in play into next week. However, it will be the breadth and strength of that rally that will be important to watch.

If it is a weak, narrow bounce with little conviction, use the rally to lift positions, trim losers, raise cash and potentially look at initiating some hedges.

As I wrote last week:

“Our bigger concern remains interest rates simply for one reason – you can NOT have higher stock prices AND higher interest rates. Period. One or the other will have to give.”

We now know that was indeed the case.

Checklist Summary Of Actions To Take

As stated, it is highly unlikely the bull market will quickly resume without a further shakeout first. This doesn’t mean we can’t have some hellacious rallies in the meantime. However, the entire supportive structure of the market has now changed which suggests a very different set of actions need to be taken on rallies over the next several months.

Here is what we will specifically be doing on subsequent rallies.

  1. Re-evaluating overall portfolio exposures. It is highly likely that equity allocations have gotten out of tolerance from the original allocation models. We will also look to reduce overall allocation models from 60/40 to 50/50 or less.
  2. Look to add bond exposure to mitigate volatility risk. (Read:  The Upcoming Bond Bull Market)
  3. Use rallies to raise cash as needed. (Cash is a risk-free portfolio hedge)
  4. Review all positions (Sell losers/trim winners)
  5. Look for opportunities in other markets (Gold may finally shine)
  6. Add hedges to portfolios (If the market begins to show a negative trend we will add short positions)
  7. Trade opportunistically (There are always rotations that can be taken advantage of)
  8. Drastically tighten up stop losses. (We  had previously given stop losses a bit of leeway as long as the bull market trend was intact. Such is no longer the case.)

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)

If I am wrong, and the bull market resumes, we simply remove hedges, and reallocate equity exposure.

“There is little risk, in managing risk.” 

The end of bull markets can only be verified well after the fact, but therein lies the biggest problem. Waiting for verification requires a greater destruction of capital than we are willing to endure.

“It’s probably wiser to assume [that God] exists because infinite damnation is much worse than a finite cost.” – Blaise Pascal

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:

Everything changed last week as the “bull market” stumbled.

Sector-by-Sector

Industrials, Materials, Staples, Real Estate, and Financials all violated their 200-dma last week and failed to recover. Financials are particularly troubling given the decent fundamental backdrop for banks currently. Also, Real Estate finally woke up to the risk of rising rates. These sectors are now in “sell rallies” mode until there is a resumption of a more bullish trend. Basic Materials violated its April lows and all previous stop levels. This sector should be sold on any rally in the coming days.

Discretionary, Healthcare, Energy and Technology violated their 50-dma last week but held their 200-dma support during the recent rout. Energy’s double top suggest a reduction in energy weightings on any rally that fails at the 50-dma in the next few days.  Rebalance risk in Healthcare (after a huge run-up), Technology, and Discretionary sectors by rebalancing back to original portfolio weightings.

Utilities – despite breaking the 50-dma last week, the overall trend for Utilities remains very bullish. Look for continued rotation into this sector if market volatility continues.

Telecommunications – with the new reshuffle in this sector could well see a pick up in volatility. There is no reason to add this sector to holdings right now as there simply isn’t enough data yet to determine much of anything from a trading perspective. We will watch this over the next couple of months to see how things develop.

Small-Cap and Mid Cap – the breakdown in small and mid-cap stocks suggest a broader change to the overall market complexion. Last week, both markets violated their 200-dma and their bullish trend lines from February of this year. Sell rallies back to the 200-dma and put stops at the recent lows.

Emerging and International Markets as I noted two weeks ago.

“Both sectors rallied a bit last week, providing an opportunity to reduce exposure for the time being and reallocate that capital to better performing areas. WHEN international and emerging markets begin to perform more positively we will add positions back to portfolios. There is just no reason to do so now.”

This past week, both markets collapsed to new lows. There still remains, since we recommended selling in January of this year, no reason to be long these sectors just yet. If we start to see real improvement, versus a bounce in a downtrend, we will reconsider our weightings.

Dividends, Market, and Equal Weight – The overall market dynamic appears to have changed last week. With the markets deeply oversold short-term look for a rally to reduce risk, rebalance weightings in portfolios, and raise some cash.

Gold – after repeated failures at the 50-dma, the metal finally found some life in the midst of the recent market meltdown. With Gold now extremely overbought short-term, use this rally to sell holdings if you are deeply underwater. From a trading perspective, IF, and this is a big if, Gold can hold the 50-dma on a pullback and turn higher, a rally to the 200-dma is feasible. Such would coincide with a much bigger sell-off in stocks. 

Bonds – broke their near-term support at $114 triggering the stop loss on trading positions. However, we are now aggressively buying individual bonds at depressed prices and increasing yield in portfolios. All trading positions are currently closed.

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:

This past week was another example of just how fast and brutal sell-offs in the market can be. Importantly, while these sell-offs are brutal we do not want to get emotionally swept up in the moment and “panic sell” a market low.

With the markets holding their 200-dma last week, and hitting 4-standard deviations below the 50-dma, a rare event, we want to give the markets an opportunity to trade back up to previous resistance next week.

Please review the “Checklist Summary Of Actions To Take” in the main missive above. We will be applying this rules to our portfolios as well.

  • New clients: We are holding OFF on-boarding into our portfolio models until a better risk/reward opportunity emerges. 
  • Equity Model: All positions are being reviewed and positions that have violated stop levels will be sold to reduce portolio risk.
  • Equity/ETF blended – Same as with the equity model. 
  • ETF Model: We will reduce small and mid-cap holdings on any rally back toward the 50-dma.
  • Option-Wrapped Equity Model – If the market rallies back to previous resistance levels, we will add a long-dated S&P 5oo put option to portfolios to hedge risk. 

As we have repeatedly stated, we are well aware of the present risk. However, these violent declines are symptomatic of the liquidity issues posed by the massive surge in passive indexing.

As we have stated previously: 

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.”

This past week, it did.


THE REAL 401k PLAN MANAGER

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

Market Breaks

As I noted three weeks ago:

“With the move in portfolios back to full target allocations, there is not much for us to do right now except to remain on the lookout for the risks which could rapidly take away our performance…but I do want to note that the market is extremely extended above its longer-term trend lines and moving averages. Historically, short-term corrective processes like we saw in February are NOT uncommon.”

Then last week I specifically noted:

“However, with rates above 3%, there could be more angst as we move into next week. Also, given the deterioration in the breadth of performance, risk has risen in the short-term.”

Well, we got “angst.”

Importantly, there are some early indications that, as discussed in the main body of this missive, that things may have changed. But it is still way too early to tell.

With the markets VERY oversold, the best course of action going into next week is to WAIT AND SEE what happens. 

However, as we have repeated over the last couple of weeks, use ANY rally next week to make sure your 401k plans are balanced. Use the following guidelines for now.

  • If you are overweight equities – reduce international and emerging market exposure and add to domestic exposure if needed to bring portfolios in line to target weights.
  • If you are underweight equities – Hold for the moment and let’s see if the market can stabilize.
  • If you are at target equity allocations use rallies to rebalance risk in portfolios.

Unfortunately, 401k plans don’t offer a lot of flexibility and have trading restrictions in many cases. Therefore, we have to minimize our movement and try and make sure we are catching major turning points. Over the next couple of weeks, we will know for certain as to whether more changes need to be done to allocations as we head into the end of the year.

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

In this presentation, Clarity Financial’s economic analyst Jesse Colombo explains why the U.S. stock market is experiencing a dangerous bubble that is going to burst violently and cause serious damage to the underlying economy.

Jesse and Clarity Financial have been very wary of following the overcrowded “buy and hold” strategy when the market is so overvalued (because reversion to the mean is inevitable), which is why we have always employed a very disciplined strategy which follows the trend of the market while it is rising, but protects capital from eventual and inevitable downturns. After having successfully navigated out of the markets in 2008 and identifying the “buying” opportunity in 2009, we continue to understand the importance of proper asset allocation, sector rotation, value and momentum based investing, and a strong, rule based, “buy/sell” investment discipline.

Despite the recent angst in the market over increasing interest rates, there has been little evidence of concern by investors overall. A recent report showed that investors have the LEAST amount of cash in their investment accounts…EVER.

“Individual investors drew down cash balances at brokerage accounts to record lows as the S&P 500 surged 7.2 percent in the three months ended Friday.

Cash as a percentage of assets among Charles Schwab Corp. clients in August fell to 10.4 percent, matching the level in January that marked the lowest since at least 2004.”

Of course, eight months ago the markets suffered a 10.4% decline just as investors scrambled to “get in.”

The monthly survey from the American Association of Individual Investors shows the same. Individuals are carrying some of the highest levels in history of equities, are reducing their exposure to bonds, and carrying very low levels of cash.

As Dana Lyons recently noted:

” From the Federal Reserve’s Z.1 release, we find that U.S. Households had a reported 34.3% of their financial assets invested in the equity market as of the 2nd quarter. Outside of a slightly higher reading in the 4th quarter of 2017, that is the highest level of stock investment in the 70-plus year history of the series, other than the 1999-2000 bubble top.”

Investors are once again….“all in.”

And the market once again tumbled. 

The one thing we know for sure is that individual investors do exactly the opposite of what they should when it comes to investing – “buy high” and “sell low.” 

Households have repeatedly learned, and then subsequently forgotten, this lesson repeatedly over the entirety of the financial market history.

The challenge, of course, it understanding that the next major impact event, market reversion, will NOT HAVE the identical characteristics of the previous events. This is why comparing today’s market to that of 2000 or 2007 is pointless. Only the outcome will be the same.

The reality is that the majority of investors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high, risk is dismissed for chasing returns, and value is displaced by momentum.

The recent sell-off was NOT the impact event. That event is still coming, and the discussion of why “this time is not like the last time” remains largely irrelevant. Whatever gains that investors garner in the between now and that next event by chasing the “bullish thesis” will largely be wiped away in the swift and brutal downdraft. The routs in February and October are only early warnings of how swift and brutal the actual event will be.

Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy” but never “when to sell.”

You can do better.

Just something to think about as you catch up on your weekend reading list.


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“Investors always decide to do the same thing, at the same time, and it is usually the wrong thing.” – T.R. Roberts.

Questions, comments, suggestions – please email me.

As seen on Forbes by RealInvestmentAdvice.com’s Jesse Colombo: “Volatility Is Surging.”

After a calm spring and summer, volatility has come back with a vengeance in October. The CBOE Volatility Index or VIX has surged from the 13s at the start of the month to nearly 23 right now, which is the largest volatility spike since the stock market correction in February. As volatility spiked, the Dow fell nearly 2,000 points since the start of October as rising interest rates spooked investors out of the frothy stock market.

Here’s what the VIX looks like right now:

VIX

While many traders and market participants were caught off-guard by the volatility spike, I specifically warned about it on October 2nd in a Forbes piece called “Why Another Market Volatility Surge Is Likely Ahead.”

Read the full article on Forbes.

This is a short update to Tuesday’s Technically Speaking post. In that post, I stated:

“In this past weekend’s newsletter, I discussed the fact the markets had finally awoken to the reality that rates have once again broken above 3%.

‘Speaking of rates, each time rates have climbed towards 3%, the market has stumbled.'”

Well, on Wednesday, the markets did indeed stumble.

As I noted, the market was testing the January breakout highs and that this was a “make or break” point. I noted the two important things we were paying attention to:

  1. There is a defined trendline the market has held since the April lows. (Blacked dashed line) In July, the market broke that trendline but quickly recovered. A failure to get back above that trendline on this bounce, and a failure to attain new highs, will continue what appears to be an early topping pattern. 
  2. The momentum sell signal, which signaled a “risk off” market in early February, is very close to triggering. As shown this signal was very close to triggering in July but the market rallied strongly enough to keep that from occurring. Can it do the same this time?

I also stated:

“It will be imperative the market maintains support and musters a rally by the end of the week. Otherwise, there is a high probability the market will retest the bullish trend line from the 2016 lows. With the longer-term moving average currently running along that trend line, a break below that level changes the entire dynamic of the market to a ‘risk-off’ mode.”

I have updated the chart from Tuesday. Note the deeply oversold condition currently like we saw back in early February. These oversold conditions tend to generate a short-term rally that can be used to reduce risk into. 

The break of support at the January highs triggered the “algos” to start selling, and the liquidation across markets was fast and furious. The selloff also triggered a short-term “sell signal” which suggests the markets have now moved into a “risk off” mode.

As I have often stated, the initial crack in the market will often give you an opportunity to rebalance risks in a portfolio. So, it is often never wise to make emotional sell decisions. As shown in the first chart above, the recent sell-off has exhausted much of the short-term downside risk. However, it is where the market finishes the week which is most critical.

The chart below is a WEEKLY chart going back to the 2015-2016 lows.

Currently, the market IS HOLDING support at the longer-term moving average. However, the break below the accelerated bullish trend line from the 2016 lows is very disturbing and, as noted above, this break changes our stance from a near-term bullish to near-term bearish outlook.  

The next chart zooms in for a closer look at what we expect to happen and what actions we will be taking in portfolios over the days ahead.

The vertical red and green lines were very short-term buy/sell signals which show when price momentum is favorable for increasing or reducing equity-related risk. That signal is currently triggering a “sell” and suggests reducing risks in portfolios currently.

Given the short-term OVERSOLD condition of the market, we want to use rallies to rebalance risks in portfolios.

I have mapped out three possible outcomes between now and the end of the year in which we will take actions.

#1 – A rally back to the bullish trendline will be used to reduce risk (ie. raise cash) in portfolios by selling lagging positions and rebalancing risk in winning positions. Rule: sell losers and let winners run. 

We fully expect an initial rally to fail as investors caught in the selloff will be looking for an opportunity to sell. However, if that selloff fails to hold support at the recent lows it will suggest a bigger corrective action is in process. We will be looking to reduce equity risk further, raise cash, evaluate portfolio allocation models. 

#2– If the selloff following a failed rally holds support at the recent lows and turns up, such will suggest a rally back to either the January highs or all-time highs. NOTE: A rally back to all-time highs following a corrective pullback will again retest the underside of the bullish trend line from the 2016 lows. Such remains a “bearish” backdrop from equity risk going into 2019 where economic and earnings data is expected to slow further. We will use any rally back to those levels to reduce risk as noted in #1.

#3– If the rally from the recent lows fails at the January highs we will again use that opportunity to reduce equity risk and rebalance portfolio allocations. 

I must reiterate we are not suggesting blowing out of portfolios and moving to cash. What I am suggesting is that we are taking actions to:

  1. Manage our exposure levels,
  2. Maintaining trailing stop-loss levels; and
  3. Reducing risk and raising some cash until “the smoke clears.” 

The reason we are not becoming overly negative yet, is that the longer-term backdrop of the market does indeed remain bullish for now.

However, there is clear evidence that backdrop is becoming more bearish on both a macro-economic and earnings front. Therefore, by taking some actions now, reduces the risk of something going wrong and destroying a lot of capital very quickly.

As I have repeatedly discussed over the last several weeks, prudent portfolio management practices reduce inherent portfolio risk thereby increasing the odds of long-term success. Any rally that occurs over the next few days from the current levels will be used as a “sellable rally” to rebalance portfolios and related risk. These practices align with our most basic investment rules/philosophies as noted above.

  • Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
  • Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
  • Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

Remember, we can ALWAYS add money back into the markets once the evidence of the continuation of a bull market is available.

Until then, we are going to err on the side of caution.

This is a short update to Tuesday’s Technically Speaking post. In that post, I stated:

“In this past weekend’s newsletter, I discussed the fact the markets had finally awoken to the reality that rates have once again broken above 3%.

‘Speaking of rates, each time rates have climbed towards 3%, the market has stumbled.'”

Well, on Wednesday, the markets did indeed stumble.

As I noted, the market was testing the January breakout highs and that this was a “make or break” point. I noted the two important things we were paying attention to:

  1. There is a defined trendline the market has held since the April lows. (Blacked dashed line) In July, the market broke that trendline but quickly recovered. A failure to get back above that trendline on this bounce, and a failure to attain new highs, will continue what appears to be an early topping pattern. 
  2. The momentum sell signal, which signaled a “risk off” market in early February, is very close to triggering. As shown this signal was very close to triggering in July but the market rallied strongly enough to keep that from occurring. Can it do the same this time?

I also stated:

“It will be imperative the market maintains support and musters a rally by the end of the week. Otherwise, there is a high probability the market will retest the bullish trend line from the 2016 lows. With the longer-term moving average currently running along that trend line, a break below that level changes the entire dynamic of the market to a ‘risk-off’ mode.”

I have updated the chart from Tuesday. Note the deeply oversold condition currently like we saw back in early February. These oversold conditions tend to generate a short-term rally that can be used to reduce risk into. 

The break of support at the January highs triggered the “algos” to start selling, and the liquidation across markets was fast and furious. The selloff also triggered a short-term “sell signal” which suggests the markets have now moved into a “risk off” mode.

As I have often stated, the initial crack in the market will often give you an opportunity to rebalance risks in a portfolio. So, it is often never wise to make emotional sell decisions. As shown in the first chart above, the recent sell-off has exhausted much of the short-term downside risk. However, it is where the market finishes the week which is most critical.

The chart below is a WEEKLY chart going back to the 2015-2016 lows.

Currently, the market IS HOLDING support at the longer-term moving average. However, the break below the accelerated bullish trend line from the 2016 lows is very disturbing and, as noted above, this break changes our stance from a near-term bullish to near-term bearish outlook.  

The next chart zooms in for a closer look at what we expect to happen and what actions we will be taking in portfolios over the days ahead.

The vertical red and green lines were very short-term buy/sell signals which show when price momentum is favorable for increasing or reducing equity-related risk. That signal is currently triggering a “sell” and suggests reducing risks in portfolios currently.

Given the short-term OVERSOLD condition of the market, we want to use rallies to rebalance risks in portfolios.

I have mapped out three possible outcomes between now and the end of the year in which we will take actions.

#1 – A rally back to the bullish trendline will be used to reduce risk (ie. raise cash) in portfolios by selling lagging positions and rebalancing risk in winning positions. Rule: sell losers and let winners run. 

We fully expect an initial rally to fail as investors caught in the selloff will be looking for an opportunity to sell. However, if that selloff fails to hold support at the recent lows it will suggest a bigger corrective action is in process. We will be looking to reduce equity risk further, raise cash, evaluate portfolio allocation models. 

#2– If the selloff following a failed rally holds support at the recent lows and turns up, such will suggest a rally back to either the January highs or all-time highs. NOTE: A rally back to all-time highs following a corrective pullback will again retest the underside of the bullish trend line from the 2016 lows. Such remains a “bearish” backdrop from equity risk going into 2019 where economic and earnings data is expected to slow further. We will use any rally back to those levels to reduce risk as noted in #1.

#3– If the rally from the recent lows fails at the January highs we will again use that opportunity to reduce equity risk and rebalance portfolio allocations. 

I must reiterate we are not suggesting blowing out of portfolios and moving to cash. What I am suggesting is that we are taking actions to:

  1. Manage our exposure levels,
  2. Maintaining trailing stop-loss levels; and
  3. Reducing risk and raising some cash until “the smoke clears.” 

The reason we are not becoming overly negative yet, is that the longer-term backdrop of the market does indeed remain bullish for now.

However, there is clear evidence that backdrop is becoming more bearish on both a macro-economic and earnings front. Therefore, by taking some actions now, reduces the risk of something going wrong and destroying a lot of capital very quickly.

As I have repeatedly discussed over the last several weeks, prudent portfolio management practices reduce inherent portfolio risk thereby increasing the odds of long-term success. Any rally that occurs over the next few days from the current levels will be used as a “sellable rally” to rebalance portfolios and related risk. These practices align with our most basic investment rules/philosophies as noted above.

  • Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
  • Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
  • Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

Remember, we can ALWAYS add money back into the markets once the evidence of the continuation of a bull market is available.

Until then, we are going to err on the side of caution.

Tesla’s corporate debt is rated B2 and B- by Moody’s and Standard & Poors respectively. In market parlance, this means that Tesla debt is rated “junk”. This term is often a substitute way of saying “low-rated” or frequently the term “high-yield” is used interchangeably. Tesla’s bond maturing in October of 2021 pays a 4.00% coupon and has a current yield to maturity of 6.29% based on a market price of $93.625 per $100 of face value. Based on prices in the credit default swap markets, Tesla has a 41% percent chance of defaulting within the next five years.

  • The upside of owning this Tesla bond is 6.29% annually
  • The bond’s annual expected return, factoring in the odds of a default and a generous 50% default recovery rate, is 0.17%
  • Should Tesla default an investor could easily lose half of their initial investment.

Tesla is, in many ways, symbolic of the poor risk/return proposition being offered throughout the high-yield (HY) corporate bond market. Recent strength in the HY sector has resulted in historically low current yields to maturity and tight spreads versus other fixed income classes deemed less risky. Given the current state of yields and spreads and the overall risks in the sector, we must not assume that the outperformance of the HY sector versus other sectors can continue. Instead, we must ask why the HY sector has done so well to ascertain the expected future returns and inherent risks of an investment in this sector.

In this article we’ll examine:

  • What is driving HY to such returns?
  • How much lower can yields on HY debt go?
  • Is further spread tightening possible?
  • What does scenario analysis portend for the HY sector?

All data in this article is courtesy of Barclays.

HY Returns

The HY sector, again also known as “junk bonds”, is defined as corporate bonds with credit ratings below the investment grade (IG) rating of BBB- and Baa3 using Standard and Poors and Moody’s rating scales respectively.

The table below presents returns over various time frames and the current yields for six popular fixed income sectors as well as Barclay’s aggregate fixed income composite. As shown, the HY sector is clearly outperforming every other sector on a year-to-date basis and over the last 12 months.

We believe the outperformance is primarily due to four factors.

First, many investors tend to treat the HY sector as a hybrid between a fixed-income and an equity security. The combination of surging equity markets, low HY default rates and historically low yields offered by alternative fixed-income asset classes has led to a speculative rush of demand for HY from equity and fixed income investors.

The following graph compares the performance between the HY aggregate index and its subcomponents to the S&P 500 since 2015. Note that highly risky, CCC-rated bonds have offered the most similar returns to the stock market.

The next graph further highlights the correlation between stocks and HY. Implied equity volatility (VIX) tends to be negatively correlated with stocks. As such, the VIX tends to rise when stocks fall and vice versa. Similar, HY returns tend to decline as VIX rises and vice versa.

Second, the supply of high yield debt has been stable while the supply of higher rated investment grade (IG) bonds has been steadily rising. The following graph compares the amount of BBB rated securities to the amount of HY bonds outstanding. As shown, the ratio of the amount of BBB bonds, again the lowest rating that equates to “investment grade, to HY bonds has been cut in half over the last 10 years.  This is important to note as increased demand for HY has not been matched with increased supply thus resulting in higher prices and lower yields.

Third, ETF’s representing the HY sector have become very popular. The two largest, HYG and JNK, have grown four times faster than HY issuance since 2008. This has led many new investors to HY, some with little understanding of the intricacies and risk of the HY sector.

Fourth, the recent tax reform package boosted corporate earnings overall and provided corporate bond investors a greater amount of credit cushion. While the credit boost due to tax reform applies to most corporate issuers of debt, HY investors tend to be more appreciative as credit analysis plays a much bigger role in the pricing of HY debt. However, it is important to note that many HY corporations do not have positive earnings and therefore are currently not impacted by the reform.

In summation, decreased supply from issuers relative to investment grade supply and increased demand from ETF holders, coupled with better earnings and investors desperately seeking yield, have been the driving forces behind the recent outperformance of the HY sector.

HY Yields and Spreads

Analyzing the yield and spread levels of the high yield sector will help us understand if the positive factors mentioned above can continue to result in appreciable returns. This will help us quantify risk and reward for the HY sector.

As shown below, HY yields are not at the lows of the last five years, but they are at historically very low levels. The y-axis was truncated to better show the trend of the last 30 years.

Yields can decline slightly to reach the all-time lows seen in 2013 and 2016, which would provide HY investors marginal price gains. However, when we look at HY debt on a spread basis, or versus other fixed-income instruments, there appears to be little room for improvement. Spreads versus other fixed income products are at the tightest levels seen in over 20 years as shown below in the chart of HY to IG option adjusted spread (OAS) differential.

The table below shows spreads between HY, IG, Treasury (UST) securities and components of the high-yield sector versus each other by credit rating.

The following graph depicts option adjusted spreads (OAS) across the HY sector broken down by credit rating. Again, spreads versus U.S. Treasuries are tight versus historical levels and tight within the credit stack that comprises the HY sector.

Down in Credit

As mentioned, the HY sector has done well over the last three years. Extremely low levels of volatility over the period have provided further comfort to investors.

The strong demand for lower rated credits and lack of substantial volatility has led to an interesting dynamic. The Sharpe Ratio is a barometer of return per unit of risk typically measured by standard deviation. The higher the ratio the more return one is rewarded for the risk taken.

When long term Sharpe ratios and return performance of IG and HY are compared, we find that HY investors earned greater returns but withstood significantly greater volatility to do so.  Note the Sharpe Ratios for IG compared to HY and its subcomponents for the 2000-2014 period as shown below. Now, do the same visual analysis for the last three years. The differences can also be viewed in the “Difference” section of the table.

The bottom line is that HY investors were provided much better returns than IG investors but with significantly decreased volatility. Dare we declare this recent period an anomaly?

Scenario Analysis

Given the current state of yields and recent highs and lows in yield, we can build a scenario analysis model. To do this we created three conservative scenarios as follows:

  • HY yields fall to their minimum of the last three years
  • No change in yields
  • HY yields rise to the maximum of the last three years

Further, we introduce default rates. As shown below, the set of expected returns on the left is based on the relatively benign default experience of the last three years, while the data on the right is based on nearly 100 years of actual default experience.

Regardless of default assumptions and given the recent levels of volatility, the biggest takeaway from the table is that Sharpe Ratios are likely to revert back to more normal levels.

The volatility levels, potential yield changes and credit default rates used above are conservative as they do not accurately portray what could happen in a recession. Given that the current economic cycle is now over ten years old, consider the following default rates that occurred during the last three recessions as compared to historical mean.

Needless to say, a recession with a sharp increase in HY defaults accompanied with a surge in volatility would likely produce negative returns and gut wrenching changes in price. This scenario may seem like an outlier to those looking in the rear view mirror, but those investors looking ahead should consider the high likelihood of a recession in the coming year or two and what that might mean for HY investors.

Summary

An interest rate is the cost for borrowing money and the return for lending money. Most importantly for investors, interest rates or yields help ascertain the amount of risk investors believe is inherent in a security. When one’s risk expectation and those of the market are vastly different, an opportunity exists.

Given the limited ability for yields, spreads, volatility and default rates to decline further, we think the reward for holding HY over IG or other fixed income sectors is minimal. Not surprisingly, we believe the risk of a recession, higher yields, wider spreads, higher default rates and increased volatility carries a higher probability weighting. As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.

For those investors using ETF’s to replicate the performance of the HY sector, you should also be especially cautious. As a point of reference, Barclays HY ETF (JNK) fell 33% in the last few months of 2008. A repeat of that performance or even a fraction thereof would be a high price to pay for the desire to pick up an additional 2.03% in dividend yield over an IG ETF such as LQD.

The bottom line: Markets are not adequately paying you to take credit risk, move up in credit!

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