Monthly Archives: April 2018

In our last installment of Technically Speaking, we discussed the current bullish trend and our price target of 3000 by year end. To wit:

“Regardless of the reasons, the breakout Friday, with the follow through on Monday, is indeed bullish. As we stated repeatedly going back to April, each time the market broke through levels of overhead resistance we increased equity exposure in our portfolios. The breakout above the January highs now puts 3000 squarely into focus for traders.” 

Early last week, we used that pullback to support to add equity exposure to portfolios. Again, we are moving cautiously. With the trend of the market positive, we realize short-term performance is just as important as long-term. It is always a challenge to marry both. As I noted on Saturday:

“While we are long-biased in our portfolios currently, such doesn’t remain there is no risk to portfolios currently. With ongoing ‘trade war’ rhetoric, political intrigue at the White House, and interest rates pushing back up to 3%, there is much which could spook the markets over the next 45-days.”

Well, yesterday, the markets got spooked as the President once again ramped up the rhetoric on China instituting another $200 billion in tariffs and threatening $200 billion more if “China retaliates.” 

With a double top in place, there is now a building level of overhead resistance traders will have to deal with to move the markets higher. It will be important for the market to consolidate the recent advance above current support. A break of support will likely lead to a test of critical support around 2800.

While a sell-off was not unexpected, we continue to undertake prudent steps in our overall portfolio management process:

  • Stop-loss levels have been moved up to recent lows.
  • A couple of defensive positions were added to equity portfolios.
  • With yields back to 3% on the 10-year Treasury, we will also look to add additional exposure to our bond holdings. The biggest gains over the next 5-years will come from Treasury bonds versus stocks.

Breadth has been weak as of late. Leadership in the FANG’s has fallen off with even the mighty AMZN falling sharply yesterday and breaking its recent uptrend joining the rest of the crowd. Small-cap outperformance has weakened as well.

While the trend of the domestic markets remain bullish, which is why we are domestic-focused in portfolios right now, the rest of the world isn’t.

The Warning From The World

One of the biggest concerns I have addressed previously is the divergence of global markets from the U.S. This suggests two things:

  1. Economic strength in the U.S. has been a function of short-term stimulus (ie. Natural disasters, tax cuts, and massive increases in Federal spending) rather than more sustainable long-term factors.
  2. Rising interest rates and “trade wars” are having an impact that will cycle back to the U.S.

Around the globe, sell signals abound.

In the United Kingdom, the 50-day moving average has crossed below the 200-day moving average which is viewed as an important warning. Furthermore, despite the S&P 500 being up almost 9% year-to-date, the U.K. is down -5%.

Likewise, Japan has also registered a similar warning despite the Government regularly buying equities directly in the market through their “QE” program.

Not surprisingly, with Trump’s “trade war” being levied directly at them, China has slumped markedly year-to-date pushing a near 10% decline since June.

South Korea, where exports are a strong leading economic indicator for the U.S., has also slumped -6% since June as trade woes continue.

Germany, a leading exporter of luxury automobiles, also suggests something has turned for the worse since the beginning of the year.

But it is not just these selected countries which have all signaled a change in their current trend, but as we noted previously, it is in the combined emerging market and industrialized international countries globally.

Since the turn of the century these global signals have been important warnings for the domestic markets. In fact, going back to 1998, when momentum and moving average crossovers have combined with more extreme overbought conditions (relative strength index above 70), the domestic markets have been negatively impacted.

The same analysis holds true for industrialized international markets as well. Again, we see that when these quarterly signals are combined with overbought conditions, the domestic markets have eventually been negatively impacted.

While the U.S. can certainly remain detached from the world in the short-term due to fiscal stimulus, the “demand pull” from stimulus fades rather quickly and leaves a consumption “void” in the future.

The point here is simple.

While bullish sentiment very much controls the short-term trend and direction of the market, in which we must participate, the longer-term dynamics are getting more cloudy. As noted just recently:

“These financial indicators don’t yet signal an impending recession. Does that mean the message of the flattening yield curve should be ignored? At your peril.

The Economic Cycle Research Institute’s array of indicators point to a ‘stealth cyclical slowdown,’ according to Lakshman Achuthan, its co-founder. The growth rate of the ECRI Weekly Leading Index is unambiguously downward, reaching zero in its latest reading.

And in contrast to the latest robust GDP readings, ECRI’s broader U.S. Coincident Index is below last October’s peak. ‘That’s pretty remarkable because we’ve had massive fiscal stimulus on top of an energy production boom,’ he writes in an email.

Bottom line, ECRI’s Weekly Leading Indicator is ‘telling us in no uncertain terms that economic growth will ease in coming months,’ but not fall into a recession, Achuthan concludes. That’s consistent with the message of the yield curve, which may explain why I’m obsessed with it.”

I agree. The international slowdown is becoming increasingly obvious. The most popular U.S. measures seem to present more of a mixed bag. And, as we pointed out late last year, something the bond market has already been sniffing out.

There is a growing risk of a negative shock caused by rising rates. We have seen some early warnings from international bond market episodes, currency crashes, and declining asset prices. However, these issues will ultimately extend contaminate the entire globe. This is a risk that is vastly under-appreciated by domestic investors currently which have become extremely complacent and overly allocated to equities.

Goldman Sachs laid out three reasons in this regard (courtesy of Zerohedge):

  • First, the real rate of return available on “safe” US assets is rising, both in absolute terms and relative to non-US markets. As the rate of return on “cash” rises, the appeal of risky assets falls. The low level of real rates over most of the post-crisis period set a very low bar for risky assets. That bar is now rising, and as long as the US economy continues firing on all cylinders, the bar will continue to rise.
  • Second, the equity risk premium (ERP), credit risk premium (CRP), and bond risk premium (BRP) – have been compressing over the course of this expansion. While the compression of risk premia shown in this exhibit is typical over the course of most business cycle expansions, “but in this cycle, our measures of ERP and BRP, in particular, appear to have fallen to unusually low levels.”

  • Third, risk itself is rising as the risk of macro imbalances (most visibly in labor markets) creeps steadily higher. Thus, the low-risk premia available on most risky assets is steadily becoming even less appealing as the cycle ages.

The era of growth fueled by macroeconomic stimulus, with no apparent adverse side effects such as high inflation, appears to be drawing to an end. In the absence of deep-rooted reforms to improve productivity, the growth spurts in both emerging and major international economies is coming to an end.

With surging deficits in the U.S., mounting public debt, and unfavorable demographics, not to mention rising external debt levels of some emerging market economies, these risk factors reduce policy space for responding to exogenous macroeconomic shocks.

There are a multitude of risks on the horizon, from geopolitical, to fiscal, to economic which could easily derail growth if policymakers continue to count on the current momentum continuing indefinitely. The dependency on liquidity, interventions, and debt has displaced fiscal policy that could support longer-term economic resilience.

This doesn’t mean the markets will “mean revert” tomorrow, but it does suggest that there is a rising risk of disappointment for economic growth, and ultimately earnings, in the future.

This past week marked the 10th-Anniversary of the collapse of Lehman Brothers. Of course, there were many articles recounting the collapse and laying blame for the “great financial crisis” at their feet. But, as is always the case, an “event” is always the blame for major reversions rather than the actions which created the environment necessary for the crash to occur. In the case of the “financial crisis,” Lehman was the “event” which accelerated a market correction that was already well underway.

I have noted the topping process and the point where we exited the markets. Importantly, while the market was giving ample signals that something was going wrong, the mainstream analysis continued to promote the narrative of a “Goldilocks Economy.” It wasn’t until December of 2008, when the economic data was negatively revised, the recession was revealed.

Of course, the focus was the “Lehman Moment,” and the excuse was simply: “no one could have seen it coming.”

But many did. In December of 2007 we wrote:

“We are likely in, or about to be in, the worst recession since the ‘Great Depression.'”

A year later, we knew the truth.

Throughout history, there have been numerous “financial events” which have devastated investors. The major ones are marked indelibly in our financial history: “The Crash Of 1929,” “The Crash Of 1974,” “Black Monday (1987),” “The Dot.Com Crash,” and the “The Financial Crisis.” 

Each of these previous events was believed to be the last. Each time the “culprit” was addressed and the markets were assured the problem would not occur again. For example, following the crash in 1929, the Securities and Exchange Commission, and the 1940 Securities Act, were established to prevent the next crash by separating banks and brokerage firms and protecting against another Charles Ponzi. (In 1999, legislation was passed to allow banks and brokerages to reunite. 8-years later we had a financial crisis and Bernie Madoff. Coincidence?)

In hindsight, the government has always acted to prevent what was believed to the “cause” of the previous crash. Most recently, Sarbanes-Oxley and Dodd-Frank legislations were passed following the market crashes of 2000 and 2008.

But legislation isn’t the cure for what causes markets to crash. Legislation only addresses the visible byproduct of the underlying ingredients. For example, Sarbanes-Oxley addressed the faulty accounting and reporting by companies like Enron, WorldCom, and Global Crossing. Dodd-Frank legislation primarily addressed the “bad behavior” by banks (which has now been mostly repealed).

While faulty accounting and “bad behavior” certainly contributed to the end result, those issues were not the cause of the crash.

Recently, John Mauldin addressed this issue:

“In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

While the idea is correct, this assumes that at some point the markets collapse under their own weight when something gives.

I think it is actually a little different. In my view, ingredients like nitrogen, glycerol, sand, and shell are mostly innocuous things and pose little real danger by themselves. However, when they are combined together, and a process is applied to bind them, you make dynamite. But even dynamite, while dangerous, does not immediately explode as long as it is handled properly. It is only when dynamite comes into contact with the appropriate catalyst that it becomes a problem. 

“Mean reverting events,” bear markets, and financial crisis, are all the result of a combined set of ingredients to which a catalyst was applied. Looking back through history we find similar ingredients each and every time.

The Ingredients

Leverage

Throughout the entire monetary ecosystem, there is a consensus that “debt doesn’t matter” as long as interest rates remain low. Of course, the ultra-low interest rate policy administered by the Federal Reserve is responsible for the “yield chase” and has fostered a massive surge in debt in the U.S. since the “financial crisis.”  

Importantly, debt and leverage, by itself is not a danger. Actually, leverage is supportive of higher asset prices as long as rates remain low and the demand for, rates of return on, other assets remains high.

Valuations

Likewise, high valuations are also “inert” as long as everything asset prices are rising. In fact, rising valuations supports the “bullish” thesis as higher valuations represent a rising optimism about future growth. In other words, investors are willing to “pay up” today for expected further growth.

While valuations are a horrible “timing indicator” for managing a portfolio in the short-term, valuations are the “great predictor” of future investment returns over the long-term.

Psychology

Of course, one of the critical drivers of the financial markets in the “short-term” is investor psychology. As asset prices rise, investors become increasingly confident and are willing to commit increasing levels of capital to risk assets. The chart below shows the level of assets dedicated to cash, bear market funds, and bull market funds. Currently, the level of “bullish optimism” as represented by investor allocations is at the highest level on record.

Again, as long as nothing adversely changes, “bullish sentiment begets bullish sentiment” which is supportive of higher asset prices.

Ownership

Of course, the key ingredient is ownership. High valuations, bullish sentiment, and leverage are completely meaningless if there is no ownership of the underlying equities. The two charts below show both household and corporate levels of equity ownership relative to previous points in history.

Once again, we find rising levels of ownership are a good thing as long as prices are rising. As prices rise, individuals continue to increase ownership in appreciating assets which, in turn, increases the price of the assets being purchased.

Momentum

Another key ingredient to rising asset prices is momentum. As prices rice, demand for rising assets also rises which creates a further demand on a limited supply of assets increasing prices of those assets at a faster pace. Rising momentum is supportive of higher asset prices in the short-term.

The chart below shows the real price of the S&P 500 index versus its long-term bollinger-bands, valuations, relative-strength, and its deviation above the 3-year moving average. The red vertical lines show where the peaks in these measures were historically located.

The Formulation

Like dynamite, the individual ingredients are relatively harmless. However, when the ingredients are combined they become potentially dangerous.

Leverage + Valuations + Psychology + Ownership + Momentum = “Mean Reverting Event”

Importantly, in the short-term, this particular formula does indeed remain supportive for higher asset prices. Of course, the more prices rise, the more optimistic the investing becomes as it becomes common to believe “this time is different.”

While the combination of ingredients is indeed dangerous, they remain “inert” until exposed to the right catalyst.

These same ingredients were present during every crash throughout history.

All they needed was the right catalyst.

The catalyst, or rather the “match that lit the fuse,” was the same each time.

The Catalyst

In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became “active,” monetarily policy-wise. As shown in the chart below, when the Fed has embarked upon a rate hiking campaign, bad “stuff” has historically followed.

With the Fed expected to hike rates 2-more times in 2018, and even further in 2019, it is likely the Fed has already “lit the fuse” on the next financially-related event.

Yes, the correction will begin as it has in the past, slowly, quietly, and many investors will presume it is simply another “buy the dip” opportunity.

Then suddenly, without reason, the increase in interest rates will trigger a credit-related event. The sell-off will gain traction, sentiment will reverse, and as prices decline the selling will accelerate.

Then a secondary explosion occurs as margin-calls are triggered. Once this occurs, a forced liquidation cycle begins. As assets are sold, prices decline as buyers simply disappear. As prices drop further, more margin calls are triggered requiring further liquidation. The liquidation cycle continues until margin is exhausted.

But the risk to investors is NOT just a market decline of 40-50%.

While such a decline, in and of itself, would devastate the already underfunded 80% of the population that is currently woefully under-prepared for retirement, it would also unleash a host of related collapses throughout the economy as a rush to liquidate holdings accelerates.

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

As debts and deficits swell in coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

All the ingredients for the next market crash are currently present. All that is current missing is the “catalyst” which ignites it all.

There are many who currently believe “bear markets” and “crashes” are a relic of the past. Central banks globally now have the financial markets under their control and they will never allow another crash to occur. Maybe that is indeed the case. However, it is worth remembering that such beliefs were always present when, to quote Irving Fisher, “stocks are at a permanently high plateau.” 


  • Bulls Keep It Together
  • Which Year Is It?
  • Sector & Market Analysis
  • 401k Plan Manager

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Bulls Keep It Together

Picking up where we left off last week, we discussed the sell-off after the initial breakout to all-time highs and the continuation of the bull market rally. To wit:

“Currently, it is pathway #2a which continues to play out fairly close to the prediction from two weeks ago. But it is make, or break, next week as to whether pathway #2b comes into play. 

As I have repeatedly noted, we remain primarily allocated in our portfolios. However, we were looking for a pullback to support which holds before increasing our existing holdings further.”

Here is the updated chart through Friday. The market has followed the pathways precisely over the last several weeks.

The pullback to the previous breakout support level did allow us to add further exposure to our portfolios as we said we would do last week. 

Next week, the market will likely try and test recent highs as bullish momentum and optimism remain high. Also, with many hedge funds lagging in performance this year, there is likely going to be a scramble to create some returns by year end. This should give some support to the rally over the next couple of months. However, as shown above, the short-term oversold condition which fueled last week’s rally has been exhausted, so it could be a bumpy ride higher.

As I wrote on Tuesday, our current projected short-term target remains 3000 on the S&P 500:

“Regardless of the reasons, the breakout Friday, with the follow through on Monday, is indeed bullish. As we stated repeatedly going back to April, each time the market broke through levels of overhead resistance we increased equity exposure in our portfolios. The breakout above the January highs now puts 3000 squarely into focus for traders. 

This idea of a push to 3000 is also confirmed by the recent ‘buy signal’ triggered in June where we begin increasing equity exposure and removing all hedges from portfolios. The yellow shaded area is from the beginning of the daily ‘buy signal’ to the next ‘sell signal.’”

While we are long-biased in our portfolios currently, such doesn’t remain there is no risk to portfolios currently. With ongoing “trade war” rhetoric, political intrigue at the White House, and interest rates pushing back up to 3%, there is much which could spook the markets over the next 45-days.

Moving into next week, we are currently running portfolios primarily unhedged at the moment. We have taken prudent steps in our overall portfolio management process:

  • Stop-loss levels have been moved up to recent lows.
  • A couple of more defensive positions were added to our equity portfolios.
  • With yields back to 3% on the 10-year Treasury, we will also look to add additional exposure to our bond holdings.

We continue to use dips in bond prices to be buyers. This is because the biggest gains over the next 5-years will come from Treasury bonds versus stocks.

This has to do with valuations, and what I want to discuss next.


Which Year Is It?

As noted above, there is little argument the market is bullish. The trend is positive, we just came off of a correction process which has now broken out to new highs. In fact, the 2015-2016 correction, while deeper than the correction earlier this year, had many of the same characteristics. Of course, the Fed was quick to intervene at the bottom of the market in 2016 as concerns of “Brexit” weighed on the market. This year, it was “tariffs” and a stimulus carry through from the slate of natural disasters last year, combined with tax cuts, and a massive increase in Federal spending which provided the necessary liquidity support to drive prices higher.

Looking back further, 2011 also looked much the same. As market turmoil increased following the end of QE-1, the Fed intervened with QE-2 as the Fed fretted over a market decline that would potentially quench the early flames of an economic recovery. That advance ended in 2012 as QE-2 came to its conclusion.

The commonality between 2011, 2015, and 2018 is the extremely loose monetary conditions which have remained a constant throughout. As Jesse Colombo recently noted in his Forbes column:

It is very helpful to adjust the Fed Funds Rate for inflation (known as the “real Fed Funds Rate”) because that is a more accurate way of determining how loose, or tight, monetary policy really is. If inflation is higher than the Fed Funds Rate, that means that the real Fed Funds Rate is actually negative. To put it simply, negative real interest rates mean that interest rates do not compensate for inflation well enough, so capital tends to flow from savings or other conservative investments into rapidly-rising speculative assets.

Negative real interest rate environments are the most conducive to the formation of dangerous economic bubbles. The only time in recent decades that the U.S. has experienced negative real interest rates for a significant amount of time was during the mid-2000s housing bubble and during the current bubble period that started after 2009.”

However, that is changing. As Michael Hartnett at BofA notes:

“Indeed, so far the tailwind from global QE is still here, and has resulted in record global EPS, 4% US GDP, $1.5tn US tax cuts, $1tn stock buybacks… yet poor 2018 returns.”

Yes, the market is up almost 10% for the year, but should be up much more given the current liquidity backdrop.

However, the “end of excess liquidity” is in the works:

End of excess returns: CB’s bought $1.6tn assets in 2016, $2.3tn 2017, $0.3tn 2018, will sell $0.2tn in 2019; liquidity growth turns negative in Jan’19 for 1st time since GFC.”

As the Fed continues to hike rates and reduce their balance sheet (QT), monetary policy is being tightened as liquidity is being drained from the system. While investor confidence remains high, which is essential to providing the operating room necessary for the Fed to hike rates, the similarities between today and 1998 may be a much better comparison.

During that period, there was an early correction during the Fed’s rate hiking campaign as a result of Long-Term Capital Management, a massive hedge fund, imploding. It was an early warning sign that went unheeded by the Fed and the markets that higher rates were beginning to take their toll.

We saw the same with Bear Stearns in 2008. Again, economic data seemed strong at the time, markets hiccuped and quickly escalated back to new highs, investors assumed the upward trend would continue. Of course, we would find out several months later, when the economic data was negatively revised, Bear Stearns was also a warning sign the economy was already deep into a recession.

Today, the similarities to 1998 and 2008 are much more aligned:

  • The Fed is tightening
  • The U.S. is decoupling from the rest of the world
  • The yield curve is flattening
  • Emerging markets are declining
  • Hedge funds and quant-strategies are under-performing.
  • Debt and leverage, the two areas most affected by higher rates, are at record levels.

And, once again, the Fed is on a mission to hike rates under the assumption they will know when to stop.  Unfortunately, they are batting ZERO in that endeavor as every time previously something “broke” first.

Doug Kass also noted on Friday:

Reactionary technicians find the markets to be titillating (scoffing at the anticipation of untoward fundamentals) and unconcerned about reward v. risk or, arguably rising economic ambiguities (low interest rates and a narrowing yield curve), the unprecedented lack of cooperation between world powers (in a flat and interconnected world), large public and private debt loads, the unstable political setting, the failure of fiscal policy to trickle down, the divergence between the S&P Index and other world (emerging) markets, orange and black swans and the global pivot of monetary policy.

In particular, the fact that the rising wave of debt and central bankers’ liquidity injections have failed to produce steady wage growth and productive investments in the real economy go unnoticed by those that worship at the altar of stock price momentum.

And I will remind everyone, what caused the ten percent correction in late January/early February was the rise in interest rates. Well, today, we are right back a fresh ten year high in the yield on the two year note and the ten-year Treasury yield is back to 2.99%.

Both the bull market and the economic recovery are long in the tooth and face the challenges of a pivot in global monetary policy, competition from ever-higher risk-free rates of return (the one-month Treasury bill yields more than 2.00% compared to the S&P 500 dividend yield of about 1.80%) and a number of other possible adverse outcomes in the economic, political and policy spheres.”

Importantly, as we noted last week, it is Emerging Markets which may well be the “canary in the coal mine.” 

(In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)

This feels a whole lot more like 1998 than 2011 or 2016.

Don’t mistake what I am saying.

Just because it “feels like” 1998, doesn’t mean we are going to sit in cash and wait for the inevitable crash. The best run of the markets are always the last leg of the advance to the peak. As Dr. Robert Shiller noted on Friday:

The stock market could get a lot higher before it comes down. It’s highly priced, but it could get much more highly priced. It’s a risky market now,”

The point is to be AWARE of the risk, have a strategy, and most importantly have the discipline to act when the evidence suggests the markets have ended their bullish trend.

It will happen.

Just not today. So, for now we remain fully allocated to the markets.

We will let you know when that changes.

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:

As I noted last week:

“Despite the markets breaking out to all-time highs last week, there is definitely signs of rotation from previously leading sectors of the market to the laggards. This is shown below in the 10-week relative-rotation graph which compares performance relative to the S&P 500 index.”

Despite the rally in the market, there was continued deterioration among the leadership sectors. Money did rotate a bit into some of the beaten down international markets, along with Finance, Industrials and Healthcare (defensive.) Weakening and lagging sectors continue to expand which does give us short-term caution on the market.

Sector-by-Sector

Industrials were the clear winner last week as the 50-dma crossed above the 200-dma. Despite the threat of trade wars and tariffs, investors chased industrial stocks looking for a place to flee too from declining energy and technology shares.

Discretionary, Technology, and Staples – all performed better this week as well. After taking profits there is little to do now except wait for an opportunistic entry point to add further exposure.

Healthcare and Utilities – as noted above, maintained their strength. The momentum chase is alive and well and despite higher rates, investors are back “chasing yield” in sector that is particularly interest rate sensitive. Continue to use pullbacks to support, and oversold conditions, to add exposure accordingly.

Financial, Energy, and Materials – continue to lag the rest of the market. Despite a recent tick up in oil prices, Energy’s recent slump continues and again tested the 200-dma and is testing the overhead 50-dma a second time. The trend in the energy sector has turned negative but a break above the 50-dma next week could change that. A tradeable opportunity will present itself if that occurs. Stops should remain at the recent lows. Financials continue to languish along support but not showing much in the way of strength to support overweighting the sector currently.

Small-Cap and Mid Cap we noted three weeks ago that these markets were extremely overbought and extended, and a pullback to support was needed. Mid-cap has performed better but is short-term overbought. We continue to hold our target exposure and will look for opportunity as it comes.

Emerging and International Markets as I noted last week.

“The recent bounce again failed at the declining 50-dma. Positions should have been sold on that failed rally. Stops at the recent lows were triggered on Friday and suggest positions be closed out as lower levels are likely at this time.”

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.

Dividends, Market and Equal Weight – we added a pure S&P 500 index fund to our “core” holdings which will add some beta to the portfolio but acts as a placeholder for sectors and markets we have no allocation to (ie, international markets, gold, basic materials.) We continue to hold our allocations to these “core holdings”  and continue to build around these core with tactical positions that provided opportunistic advantages.

Gold – failed at the 50-dma this past week. This was your opportunity to sell your holdings for the time being. Stops remain firm at $111 again this week. 

Bonds – bonds sold off on Friday which was surprising since there were NO signs of inflation in the latest economic reports. However, bonds are once again very oversold on a short-term basis and sitting on support. We are adding bonds to portfolios at current levels and lower. Stops are set at $115. 

REIT’s got oversold last week as rates picked up a bit. With the sector back on the 50-dma a decent trade is available with a stop at $82.50 and continued upside on a break above $84.

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:

Over the last several weeks, I have discussed the increases to equity exposure in portfolios as the market’s momentum has continued to push higher. However, we have done this cautiously by using pullbacks to support, which then subsequently broke out above resistance, to do so.

Last week, the market was able to hold above the “breakout” levels once again, so last week we added exposure as have repeatedly discussed over the last several weeks. We took the following actions in Client accounts:

  • New clients: Add 50% of target equity allocations. 
  • Equity Model: Semiconductors (MU & KLAC) are on “Sell Alerts” – we will monitor closely and stop-loss levels have been tightened up. We added positions in JNJ, CVS, NKE, FDX, DUK, PEP, and WMT. We also brought existing positions up to full weight where needed.
  • Equity/ETF blended – Same as with the equity model. 
  • ETF Model: We overweighted our core “domestic” indices by adding a pure S&P 500 index ETF to offset lack of international exposure. We remain overweight outperforming sectors to offset underweights in under-performing sectors. 
  • Option-Wrapped Equity Model – We added PEP and JNJ to the portfolio and brought existing positions up to full-weights as needed.

Again, we are moving cautiously and we are well aware of the present risk. Stop loss levels have been moved up to recent lows and we continue to monitor developments on a daily basis. With the trend of the market positive, we want to continue to participate to book in performance now for a “rainy day” later.

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


THE REAL 401k PLAN MANAGER

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

Back To Full Weights

As I wrote last week:

“Over the last several weeks we have been discussing the issue of the breakout to new highs. We also noted that by the times these things happen the risk/reward set up is not optimal to increase equity exposure immediately. We have been suggesting waiting for a bit of “September” weakness to increase equity positions to full target weights. That weakness occurred last week, and any further weakness into early next week, which doesn’t violate support, will give us an opportunity to add exposure accordingly.”

Last week, we used the pullback to support to increase 401k allocations back to full-weights. The following guidelines can be used 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 – increase exposure towards domestic equity as you feel comfortable. There is no need to go “all in” at one time. Step in on any weak days. 
  • If you are at target equity allocations currently just rebalance weights to focus on domestic holdings.

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

One of the ongoing thesis behind a continuation of a bull market from current valuation levels is that there has been a permanent shift higher in valuations due to changes in accounting rules, propensity for share buybacks, and a greater adoption by the public of investing (aka ETF’s).

This apparent shift to valuations is shown in the chart below.

There are two important things to consider with respect to the chart above.

  1. The shift higher in MEDIAN valuations was a function of falling economic growth and inflationary pressures.
  2. Higher prices were facilitated by increasing levels of leverage and debt, which eroded economic growth. 

The chart below tracks the cumulative increase in “excess” Government spending above revenue collections. Notice the point at which nominal GDP growth stopped rising. It is also the point that valuations shifted higher.

Given that economic leverage (corporate, consumer, financial, and Government debt) is at all-time records, and rising, the ability to create stronger, sustainable, economic growth (which would lead to higher rates of inflation) remains little more than a hopeful goal.

The issue with the idea that valuations have had a permanent shift upward is that the assumption is based on a market anomaly form 1990-2000 which temporarily skewed valuations above the long-term medians. However, economic growth set to remain near 2% over the long-term, the average valuation ranges will most likely trend lower in the future.

Ed Easterling at Crestmont Research made a great point recently in this regard:

“However, as real economic growth significantly declined over the past two decades, it triggered a series of adjustments that represent the forces behind The Big Shift. Most importantly, the downshift in real economic growth disrupted the financial relationship of profits, future growth, and market value.

Slower growth drives P/E downward for similar reasons that it drives EPS upward.”

Of course, much of the shift upward to EPS has been a function of wage suppression, buybacks and tax cuts more than actual top-line revenue growth as I discussed just recently. Ed continues.

“Therefore, since future economic growth is expected to be slower, it is only consistent that the future average for the market P/E will be lower. The new normal growth rate (i.e., slower) for the economy will drive slower overall earnings growth. Such slower growth will drive market P/E lower, just as previously higher growth supported the market’s P/E at a higher level.

The inflation rate also drives the level of market P/E, but it occurs within the range driven by the growth-rate environment. Higher inflation drives P/E lower; deflation drives P/E lower. The level of P/E peaks when the inflation rate is low and stable. Thus, while the growth rate drives the level of the P/E range, the inflation rate drives the relative position of P/E within the range. 

Figure 6 illustrates these effects. The bar on the left illustrates the range for P/E under a historically average level of growth. The bar to its right illustrates the range for P/E under slower growth. Not only does the range downshift, the expected long-term average P/E also downshifts. This has major implications for analyzing the stock market.”

“Going forward, we should expect a new paradigm. Slower growth drives the ranges for P/E lower, which will affect future assessments of fair value. Keep in mind that, had real economic growth averaged 2% instead of 3.3% over the past century, the historical average for P/E would have been near 11—not 15 or 16. In the future, the fair value for P/E when the inflation rate is low will be 13 to 15. With average inflation, expect P/E to be near 11. During periods of high inflation and significant deflation, expect the low range for P/E to be 5 to 8.”

With the markets still currently trading near 30x earnings, a revaluation of markets will likely be just as painful to investors in the future as they have in the past.

While this time may indeed appear to be different, it will most likely end the same as every other period in history.

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


Economy, 2008 & Fed


Markets


Most Read On RIA


Research / Interesting Reads


“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” – Warren Buffett

Questions, comments, suggestions – please email me.

Unscrupulous stockbrokers and advisers are always dangling yield in front of unsuspecting clients. “I can get you (fill in the blank with a percentage),” they say to yield-starved investors. But capturing current yield is one thing; buying shares of a firm that can sustain a dividend beyond the next quarter or two is something else.

I ran a screen on REITs using two factors – enterprise value/EBIT of 25 or less and a dividend yield of 6% or higher. I got 12 companies back. And EV/EBIT of 25 is quite high, which tells you something about how REITs are priced right now. Also, the screen was just the beginning of the process. The fun part is examining each company to see if dividends were sustainable and if it had any other warts such as a high debt load, a declining business, competition from Amazon, etc…

Here’s the list of the original screen followed by comments on some of the companies.

The Good

After compiling the names from the screen, I included FFO or Funds from Operations, a REIT cash flow metric, and calculated Price/FFO, a common, though imperfect, REIT valuation metric. Funds from operations or FFO is a measure of REIT cash flow calculated by adjusting net income for property sales and depreciation. A big depreciation charge runs through a REIT income statement, and it usually doesn’t correspond to economic reality. FFO isn’t perfect because some depreciation should be calculated for any property, but FFO is uniform and allows for some comparison between companies.

FFO is also useful for understanding dividend coverage. For every company on our list except for two (Gaming and Leisure Properties and The GEO Group) FFO covers the dividend. When FFO is less than the dividend it can be a sign of a dividend cut coming. Companies not covering the dividend with FFO have to hope for FFO-per-share growth or borrow to pay the dividend. Still, all the Price/FFO metrics were reasonable or downright cheap in some cases. None of the stocks on this list is outrageously expensive in my opinion.

Also, despite some tightness on dividend coverage, the companies on this list are surprisingly healthy in terms of their debt levels. None of them is in financial distress or unable to pay its interest and preferred dividends in my opinion.

The Bad And Ugly

Despite being financially stable and not inordinately expensive, the companies on this list don’t have what anyone would call outstanding, irreplaceable real estate. Buying shares in them arguably violates the old “location, location, location” rule of real estate investing with the exception of a few properties in the hotel portfolios. None of the companies own trophy office buildings in New York or San Francisco, Rodeo Drive retail space (which had some vacancies the last time I was there), or upscale apartments on the coasts where it’s hard to build. Instead the list is filled with strip mall retail space under attack from Amazon (KIMCO, Brixmor, and Tanger) hotel companies that are economically sensitive and always trade with lower valuation multiples than other property types (Hospitality Properties Trust and Sotherly), casinos under pressure from states allowing their proliferation (Gaming and Leisure Properties),  medical facilities including nursing homes (Medical Properties Trust and Sabra), and prisons (The GEO Group and CoreCivic). In other words, these are cheap, high-yielding REITs because they arguably deserve to be based on the quality of their property.

Conclusion

Although these companies don’t own the best property, their stocks are reasonably priced, and in most cases their dividends are sustainable. Investors who understand that REITs are stocks, not bonds, in terms of risk and volatility can own a basket from this list as a small part of an income-generating portfolio. Nobody should bet the ranch on any of these stocks or on a basket of these stocks. Investors should also understand that monitoring that basket is required – not just in terms of how the stocks are performing, but also in terms of how the businesses are performing, including debt levels, occupancy, natural disasters potentially damaging the assets, management decisions, and many other things.

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

Disclosure: We are long SKT in some portfolios.

This morning the futures (S&P and Nasdaq) are, as is the custom, higher.

The markets continue to ignore a number of cautionary signposts/macroeconomic events/concerns and are benefiting from the float shrink of 5-7 years of corporate share buybacks, the dirty water of liquidity (contributed by the world’s central bankers), the heightened role of price momentum based and other (risk parity) quant strategies and the rising popularity of passive, index funds.

Adding significantly to the demand for stocks are central banks (most notably BOJ and the Swiss National Bank) who, through their active equity investing, make them the sovereign equivalent of Fidelity Management as they have become one of the dominant investors of our time.

Moreover, in a backdrop of reduced retail activity (in individual stocks, save whatever is the speculative play du jour), materially reduced mutual fund turnover and the lower role of active hedge funds (they too have mostly become quants) the demand v. supply equation for equities continues to favor buying over selling.

Bouts of selling are quick – and when stocks trade lower the buy on the dip crowd makes its rescue and arrests the drop.

Finally, probably 4-8 very large (long biased) macro funds are likely dominating what little activity/volume there is, buoying stocks as the water sloshes around in the bathtub of equities.

The sort of cautionary technical signs – like a lagging Russell Index (yesterday) – no longer provide the historical predictive role that has been the case in the past. Iomega-like speculation in stocks like NIO and TLRY are viewed as normal. And the breakdown in selected, market leading technology stocks and the lackluster performance of financials are dismissed as “one offs” by the bullish cabal.

Reactionary technicians find the markets to be titillating (scoffing at the anticipation of untoward fundamentals) and unconcerned about reward v. risk or, arguably rising economic ambiguities (low interest rates and a narrowing yield curve), the unprecedented lack of cooperation between world powers (in a flat and interconnected world), large public and private debtloads, the unstable political setting, the failure of fiscal policy to trickle down, the divergence between the S&P Index and other world (emerging) markets, orange and black swans and the global pivot of monetary policy.

In particular, the fact that the rising wave of debt and central bankers’ liquidity injections have failed to produce steady wage growth and productive investments in the real economy go unnoticed by those that worship at the altar of stock price momentum.

And I will remind everyone, what caused the ten percent correction in late January/early February was the rise in interest rates. Well, today, we are right back a fresh ten year high in the yield on the two year note and the ten year Treasury yield is back to 2.99%.

How long this investment bliss and consistent buying continues is anyone’s guess but the degree of complacency (and the absence of fear and doubt) are off the charts.

Signs Of A Problem

In “The Bear in the Market Is Roving Right Now,” Jim “El Capitan” Cramer zeroes in on the developing carnage in selected groups.

“We’ve got roving bear and bull markets all over the place and they have come to define what happens every day including today.

That’s a big change from my previous view of this market where I had held that there are roving bull markets and when stocks weren’t in bull mode, they rested.

No, I am not saying that the market’s become too treacherous for most people to handle.

I am saying that there are some incredible declines that must be addressed because they are so glaring and, at times, so nasty, particularly when they occur intraday.”

The bear market not only can be seen in Intel (INTC) , Micron (MU) and Facebook (FB); it can be seen, as I have cautioned, in other regions in the world. Indeed, the divergence between the S&P 500 Index and the MSCI Emerging Markets Index hit a 15-year high this week. As meaningful and looking out over the last seven years, the S&P Index is up by nearly 180% while the emerging markets are only up 14%:

Source: Pension Partners

Again, from Jim:

“If you want to see what a textbook bear market looks like, consider the emerging markets with the Hang Seng from Hong Kong, down 21%, Russian, down 20%, Greece, off 29%, the Shanghai index of mostly larger capitalization stocks is off 26%, and the Shenzhen, with smaller cap stocks is off 31%.”

As I wrote late yesterday, Wednesday’s strength in consumer staples (such as Kraft Heinz (KHC) , PepsiCo (PEP) , Unilever (UN) and Procter & Gamble (PG) ) and a drop of two basis points in bond yields may be construed as a risky backdrop and indicative of concerns regarding a slowdown in the rate of domestic economic growth. Also, weakness in regional bank stocks (I issued a cautious warning yesterday on bank third-quarter earnings) and the foundering FANG are not healthy signposts.

While the constant flow of corporate buybacks and the stronghold of fearless investors in ETFs continue to provide a tailwind to our markets, it remains my belief that the large stock declines Jim mentions above may broaden out and that we already may have experienced the highs in the Nasdaq and the S&P indices for the year.

Both the bull market and the economic recovery are long in the tooth and face the challenges of a pivot in global monetary policy, competition from ever-higher risk-free rates of return (the one-month Treasury bill yields more than 2.00% compared to the S&P 500 dividend yield of about 1.80%) and a number of other possible adverse outcomes in the economic, political and policy spheres.

Bottom line

Regardless of one’s market view, if you left early please make sure to read El Capitan’s late Wednesday synopsis of the market. It has a lot of merit, it’s a great read and provides pithy food for thought.

Market tops are processes and, from my perch, I believe that since late January 2018 we have been making an important one

We have made it clear on numerous occasions that there are not many value propositions available in the equity markets for long-term shareholders. Most recently in Allocating on Blind Faith, we highlighted how three widely followed valuation levels portend low single-digit returns for the coming decade. While a dismal outlook that does not mean that opportunities do not exist.

One asset class in particular that continues to catch our attention is commodities. The following graph shows how cheap the Goldman Sachs Commodity Index (GSCI) has become compared to the S&P 500. In the same way that a metal detector can identify the location of possible treasures, this graph provides a strong signal there is potential value in commodity-linked investments. Those inclined must simply “dig.”

Within the commodity sector, we have a few stocks that are on our watch list for possible investment. In this article, we explore one of them, Southwestern Energy Company (SWN). SWN is a natural gas exploration and production company headquartered in Texas. It is somewhat unique in the energy sector as it is one of a few publically traded companies that are almost entirely focused on natural gas. Most of SWN competitors have much higher exposures to oil and other energy products. In 2017, for instance, 97% of SWN’s revenue was derived from the production, transportation, and marketing of natural gas (NG).

By using both a technical and fundamental examination, we can better assess whether SWN is worth owning.

Technical Study

We start our technical study with a short-term graph covering the last 12 months and then expand further back in time for a broader context as to where SWN has traded, relevant trends, support and resistance levels, and what that might portend for the future.

SWN appears to have bottomed following a significant decline over the last few years. There is reason to believe a true bottom has formed as shown in the one-year graph below. Three bullish buy signals based on the Moving Average Convergence Divergence (MACD) indicator have occurred as indicated by the dotted vertical lines. Additionally, the 50-day moving average crossed over the 200-day moving average in July. Further a strong support line (gold dotted line) has formed and has been tested successfully on numerous occasions. Currently, the support line is near $4.70 which provides a solid level to establish risk parameters for a potential trade. That price level, less a 3% cushion ($4.55), should serve well as a stop loss acting as a trigger to reduce or eliminate the position and risk if SWN closes below that price level.

The longer term, 10-year chart below provides a different perspective of SWN. Since 2014, SWN has declined by almost 90%. However, since March it has shown signs of bottoming. While the shorter-term chart leaves room for optimism, the longer-term chart certainly gives reason for pause.

The current price ($5.00) is not far from the 3-year downtrend resistance line ($5.74) which has capped every rally since 2014.  If SWN were to convincingly close through that 3-year resistance line, it would greatly improve our longer-term confidence and appetite for risk.

Also of concern, the stock is considered overbought based on the Williams % Ratio (momentum indicator). We are not overly concerned with the Williams % Ratio as the ratio can stay at extreme levels for long periods without resulting in a meaningful change in the direction of a security’s price.

If SWN is reversing the decline of the prior years, we would like to see it establish a pattern of higher highs and higher lows. Thus far, that has only recently begun to occur but six months certainly does not make a dependable trend.

The technical picture for SWN is tilted somewhat favorably as it allows us to establish guardrails for taking additional risk. Using the charts as a framework, one can enter a long SWN position with a downside stop loss of 4.55 (4.70 less a 3% cushion). At the same time, if the upside trendline is broken the next price target is the November 2017 high of 6.72. The gain/loss ratio of the potential short-term upside target (6.72) to the downside stop loss target (4.55) is over 4:1, a compelling data point.

Fundamentals

The sharp decline in the share price of SWN compressed the valuation multiples that investors were willing to pay. In 2007, for instance, SWN’s price to sales ratio was over 10. Since then it has steadily eroded to its current level of 1. Price to trailing 12 months earnings (P/E) has also cheapened significantly, having steadily dropped from the mid 20’s to its current level of 8.80.

As a point of comparison, consider that SWN reported revenue of $763.11mm and EBITDA of $397.17mm in the fourth quarter of 2006. In the most recent earnings release, revenue was reported at $3,282mm (3.3x greater than 2006) and EBITDA was $914mm (1.3x greater than 2006). At the same time, the market cap (number of shares outstanding times the stock price) is currently $3,296mm versus $5,897mm at the end of 2006. Simply put, investors are getting a lot more for their money than in prior years.

From a liquidity perspective, SWN total liabilities have declined significantly over the last four years. Its ratio of long-term debt to equity now stands at 158% versus over 1000% in 2015. While financial leverage is not as great as it was, we are in turn provided a greater level of comfort in their ability to service the debt.

Among the many fundamental indicators we use to evaluate stocks for inclusion in our portfolios, two are worth emphasizing. They are the Piotrosky F Score and Mohanram Score.

  • The Piotrosky F Score uses nine factors to determine a company’s financial strength in profitability, financial leverage and operating efficiency. Currently, SWN scores a very favorable 8 on a scale of 1 to 9.
  • The Mohanram Score uses eight factors to determine a company’s financial strength in earnings and cash flow profitability. SWN scores a 5 on a scale of 1 to 8.

Of additional interest Zacks has strong ratings in various metrics as follows:

  • Zacks Rank 2  (1-5, 1 being the highest)
  • Growth Score B (A-F, with A being the highest)
  • Value Score A (A-F, with A being the highest)
  • Momentum Score A (A-F, with A being the highest)
  • VGM Score A (A-F, with A being the highest)

SWN is trading at a much cheaper valuation compared to years past. That said, we must remain vigilant as SWN relies on one product, NG. Swings in the price of NG due to ever-changing supply and demand variables can be violent and earnings can change sharply.

Seasonals

Our time-tested, long-range formula is pointing toward a very long, cold, and snow-filled winter,” -Peter Geiger in a statement on the Farmers’ Almanac website.

We start this section with the obvious disclaimer that we are not weathermen. Nor would we recommend an investment based on a weather forecast. That said the weather outlook can greatly affect sentiment and the demand for NG and therefore affect SWN’s earnings and stock price.

In the short run, it behooves us to understand how the expectations for a cold winter, as is expected by some long-range meteorologists, and the potential for rising NG prices might affect the price of SWN. The graph below shows a significant one-year rolling correlation between the prices of NG and SWN and therefore short-term holders should consider that weather could easily play an outsized role in the pricing of SWN.

Next, we compare how NG has performed by month. In particular, we are looking for seasonal outperformance or underperformance patterns in respective months that might be weather-related.

As shown, NG has produced the highest average gains in September and October over the past 27 years. This is likely due to a combination of pre-winter expectations for higher NG prices as well as hedging activity taking place in NG. Further, those months were also affected in certain years by seasonal hurricane activity which can temporarily boost the price of NG.

Interestingly, note that the months of January and February, despite what is frequently peak NG usage, tend to be poor months for NG price performance. The winter months are when the rubber hits the road and NG prices fail, at times, to live up to the expectations formed in the summer and fall months.

Given SWN’s strong correlation to NG, we should keep these seasonal tendencies in mind.

Summary

In a market dearth of value, we think SWN provides an interesting opportunity. While its longer-term trend is poor, its recent trading performance and solid fundamentals provide what appears to be a constructive asymmetry of risk and reward. Further seasonal patterns in NG and speculative forecasts for a cold winter argue for a boost in the short-term.

On the basis of those factors, SWN appears more than fairly priced and cheap compared to most other stocks with a compelling upside-to-downside ratio. Despite the seasonal volatility associated with the weather, the fundamentals argue that SWN represents decent value and might prove to be a good long-term hold. Further, it provides some measure of diversification as it tends to be poorly correlated with the stock market.

All data in the article was provided by Zacks and the graphs from Stockcharts.com

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.

 

Last week, the Bureau of Labor Statistics (BLS) published the August monthly “employment report” which showed an increase in employment of 201,000 jobs. It was also the 94th consecutive positive jobs report which is one of the longest in U.S. history.

There is little argument the streak of employment growth is quite phenomenal and comes amid hopes the economy is beginning to shift into high gear.

But while there were a reported 201,000 jobs created in the month of August, the two prior months were quietly revised lower by 50,000 jobs. For the 3-months combined, the average rate of job growth between June and August was just 185,333 which stands decently below the 211,000 average rates of job growth over the last five years.

Then there is the whole issue of seasonal adjustments which try to account for temporary changes to employment due to seasonal workers. The chart below shows the swings between the non-seasonally adjusted and seasonally adjusted data.

But while most economists focus at employment data from one month to the next for clues as to the strength of the economy, it is actually the “trend” of the data which is far more important to understand.

The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current annual rate of employment growth is 1.6% which is lower than any previous employment level prior to a recession in history.

But while this is a long-term view of the trend of employment in the U.S., what about right now? The chart below shows employment from 1999 to present.

While the recent employment report was slightly above expectations, the annual rate of growth is slowing. The chart above shows two things. The first is the trend of the household employment survey on an annualized basis. Secondly, while the seasonally-adjusted reported showed 201,000 jobs being created, the actual household survey showed a loss of 423,000 jobs which wiped out all of the job gains in June and July as summer workers returned to school. 

There are many that do not like the household survey for a variety of reasons. However, even if we use the 3-month average of the seasonally-adjusted employment report, we see the exact same picture. (The 3-month average simply smooths out some of the volatility.)

But here is something else to consider.

While the BLS continually adjusts and fiddles with the data to mathematically adjust for seasonal variations, the purpose of the entire process is to smooth volatile monthly data into a more normalized trend. The problem, of course, with manipulating data through mathematical adjustments, revisions, and tweaks, is the risk of contamination of bias. A simpler method to use for smoothing volatile monthly data is using a 12-month moving average of the raw data as shown below.

Notice that near peaks of employment cycles the employment data deviates from the 12-month average but tends to reconnect as reality emerges.

Sometimes, “simpler” gives us a better understanding of the data.

Importantly, there is one aspect to all the charts above which remains constant. No matter how you choose to look at the data, peaks in employment growth occur prior to economic contractions rather than an acceleration of growth. 

But there is more to this story.

A Function Of Population

One thing which is never discussed when reporting on employment is the “growth” of the working age population. Each month, new entrants into the population create “demand” through their additional consumption. Employment should increase to accommodate for the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The chart below shows the total increase in employment versus the growth of the working age population.

The missing “millions” shown in the chart above is one of the “great mysteries” about one of the longest economic booms in U.S. history. This is particularly a conundrum when the Federal Reserve talks about the economy nearing “full employment.” The Labor Force Participation Rate below shows this great mystery.

Of course, as we are all very aware, there are many people who are working part-time, going to school, etc. But even when we consider just those working “full-time” jobs, particularly when jobless claims are reaching record lows, the percentage of full-time employees is still well below levels of the last 35 years.

“With jobless claims at historic lows, and the unemployment rate at 4%, then why is full-time employment relative to the working-age population at just 49.82% which is down from 49.9% last month?”

It’s All The Baby Boomers Retiring

One of the arguments often given for the low labor force participation rate is that millions of “baby boomers” are leaving the workforce for retirement. This argument doesn’t carry much weight given that the “Millennial” generation, which is significantly larger, is simultaneously entering the workforce. The other problem is shown below, there are more individuals over the age of 55, as a percentage of that age group, in the workforce today than in the last 50-years.

Of course, the reason they aren’t retiring is that they can’t. After two massive bear markets, weak economic growth, questionable spending habits,and poor financial planning, more individuals over the age of 55 are still working because they simply can’t “afford” to retire.

However, for argument sake, let’s assume that every worker over the age of 55 retires. If the “retiring” argument is valid, then employment participation rates should soar once that group is removed. The chart below is full-time employment relative to the working-age population of 16-54.

Importantly, note in the first chart above the number of workers over the age of 55 increased last month. However, employment of 16-54 year olds declined from 50.43% to 50.35%. It is also, the lowest rate since 1985, which was the last time employment was increasing from such low levels.

The other argument is that Millennials are going to school longer than before so they aren’t working either. (We have an excuse for everything these days.) The chart below strips out those of college age (16-24) and those over the age of 55.

With the prime working age group of labor force participants still at levels seen previously in 1988, it does raise the question of just how robust the labor market actually is?

Low initial jobless claims coupled with the historically low unemployment rate are leading many economists to warn of tight labor markets and impending wage inflation. If there is no one to hire, employees have more negotiating leverage according to prevalent theory. While this seems reasonable on its face, further analysis into the employment data suggests these conclusions are not so straightforward.

Strong Labor Statistics

Michael Lebowitz recently pointed out some important considerations in this regard.

“The data certainly suggests that the job market is on fire. While we would like nothing more than to agree, there is other employment data which contradicts that premise.”

For example, if there are indeed very few workers in need of a job, then current workers should have pricing leverage over their employers.  This does not seem to be the case as shown in the graph of personal income below.

Furthermore, a closer inspection of the BLS data reveals that, since 2008, 16 million people were reclassified as “leaving the workforce”. To put those 16 million people into context, from 1985 to 2008, a period almost three times longer than the post-crisis recovery, a similar number of people left the workforce.

Why are so many people struggling to find a job and terminating their search if, as we are repeatedly told, the labor market is so healthy? To explain the juxtaposition of the low jobless claims number and unemployment rate with the low participation rate and weak wage growth, a calculation of the participation rate adjusted unemployment rate is revealing.

When people stop looking for a job, they are still unemployed, but they are not included in the U-3 unemployment calculation. If we include those who quit looking for work in the data, the employment situation is quite different. The graph below compares the U-3 unemployment rate to one that assumes a constant participation rate from 2008 to today. Contrary to the U-3 unemployment rate of 3.90%, this metric implies an adjusted unemployment rate of 8.69%.

Importantly, this number is much more consistent with the data we have laid out above, supports the reasoning behind lower wage growth, and is further confirmed by the Hornstein-Kudlyak-Lange Employment Index.

(The Hornstein-Kudlyak-Lange Non-Employment Index including People Working Part-Time for Economic Reasons (NEI+PTER) is a weighted average of all non-employed people and people working part-time for economic reasons expressed as the share of the civilian non-institutionalized population 16 years and older. The weights take into account persistent differences in each group’s likelihood of transitioning back into employment. Because the NEI is more comprehensive and includes tailored weights of non-employed individuals, it arguably provides a more accurate reading of labor market conditions than the standard unemployment rate.)

One of the main factors driving the Federal Reserve to raise interest rates and reduce its balance sheet is the perceived low level of unemployment. Simultaneously, multiple comments from Fed officials suggest they are justifiably confused by some of the signals emanating from the jobs data. As we have argued in the past, the current monetary policy experiment has short-circuited the economy’s traditional traffic signals. None of these signals is more important than employment.

As Michael noted:

“Logic and evidence argue that, despite the self-congratulations of central bankers, good wage-paying jobs are not as plentiful as advertised and the embedded risks in the economy are higher. We must consider the effects that these sequences of policy error might have on the economy – one where growth remains anemic and jobs deceptively elusive.

Given that wages translate directly to personal consumption, a reliable interpretation of employment data has never been more important. Oddly enough, it appears as though that interpretation has never been more misleading. If we are correct that employment is weak, then future rate hikes and the planned reduction in the Fed’s balance sheet will begin to reveal this weakness soon.”

As an aside, it is worth noting that in November of 1969 jobless claims stood at 211,000, having risen slightly from the lows recorded earlier that year. Despite the low number of claims, a recession started a month later, and jobless claims would nearly double within six months. This episode serves as a reminder that every recession followed interim lows in jobless claims and the unemployment rate. We are confident that the dynamics leading to the next recession will not be any different.

But then again, maybe the yield-curve is already giving us the answer. With the Fed already slated to hike interest rates further, the only question is “what breaks first?”

We want capitalism and market forces to be the slave of democracy rather than the opposite.” – Thomas Piketty

The essential underlying elements of supply, demand, scarcity, and prosperity described in our first article in this series, The Forgotten Path to Prosperity, are keys to gaining a better understanding of what constitutes a well-functioning economy. In this article, we further consider those dynamics and within that context begin to evaluate why current economic growth is stagnating. Our view necessarily advocates for a focus on supply-side economics. In other words, the talent, skills, and work that people do to acquire resources and how the resulting productivity growth from those endeavors most effectively relieves scarcity and poverty.

In his best-selling book Capitalism in the 21st Century, Thomas Piketty advocates for a mandated redistribution of wealth through a progressive global tax. His perspective of economics centers on the allocation of resources and making sure that it is fair and just. What is made very clear in Piketty’s arguments is that he and a few other intellectual elites, so-called “Davos-men,” ultimately know better than the collective decision-making of the citizens of a nation about how resources should be allocated and what should be mandated as “fair and just.” Piketty and many other economists elect to ignore the fact that the world runs most fairly and efficiently when individuals are free to pursue their separate interests. Said differently, free-market capitalism, although imperfect, remains the single best means of relieving people from the ubiquity of scarcity. As we have repeatedly seen throughout history, nations that relinquish their liberties to oligarchs crumble from the inside-out.

Importantly, Piketty’s idea runs perfectly counter to the central precepts laid out in the United States Constitution, the Declaration of Independence, the Pledge of Allegiance, and scores of other important documents that foster the basic tenets of life, liberty and the pursuit of happiness in this country.  The challenges capitalism and free markets face are not due to a lack of government imposition of laws and regulation to ensure fairness and justice, they are due to the failure of the United States government to do the primary thing incumbent upon it – defend the rights of liberty as laid out in the founding documents of our country. What Piketty suggests implies a massive expansion of government power in ways that would at a minimum erode and at worst destroy the vitality and dynamism of a capitalistic and free market society. What is most worrisome is that these concepts are not just the ruminations of the latest economic “rock star,” they are fully in play in every developed nation and go a long way toward explaining the accumulation of sovereign debt and the deterioration of economic growth in those countries.

Data Courtesy: Bank of International Settlements (BIS)

Unwanted Intrusions

Economic inequality is and always has been a feature of human existence. The degree of inequality ebbs and flows across time and geography but will never be eradicated because scarcity is also a permanent feature of human existence. Yet, for a variety of complex reasons, western civilization enjoyed an economic system that delivered unmatched prosperity and economic equality over the last 500 years and nowhere was it more pronounced than in the United States of America.

Capitalism does not solve the perpetual and age-old problem of poverty, but it offers an advantage to those societies who trust in it and depend on the government to protect against unwanted intrusions, especially those emanating from the government itself. Societies are most prosperous where individuals are incentivized to be productive because their individual liberties and private property are protected. Those societies imposed upon by over-bearing governments issuing mandates about how earnings and property will be re-directed are less prosperous and eventually bankrupt themselves.

Free Markets and the Freedom to Choose

As described in The Forgotten Path to Prosperity, everyone has a set of ideas about how markets function.  These ideas are established on the basis of our everyday experiences about how we will use our resources.  Our decision-making is prioritized by attending to those things we need first and then, provided the budget allows, moving on to those things we want – needs and desires. Whether at the grocery store or in the executive suite of a multi-national corporation, economic choices are framed in the context of economic reasoning.

Resources are limited so individuals must make decisions – choices – about how to best use the resources he or she has.  At the same time, we accumulate resources by engaging in productive activities, through the use of the factors of production – land, labor and capital – and productive activities are enabled and enhanced by the freely collaborative efforts among and between people.

With Liberty and Justice for All

So how does one go about being “freely collaborative”? What is it about a culture or society that is constrained from being so? We take such benefits for granted in the United States but even here many of those foundational freedoms are eroding.  What is really being described here is liberty which means “I rule myself.” It is a “negative right” that restrains other people or governments by limiting their actions toward the right holder.  By contrast, a “positive right” provides someone with a claim against another person or the state for some good or service (i.e., housing, healthcare, education). Liberty represents an individual’s freedom from oppressive restrictions imposed by authority on one’s way of life, behavior or political views. In other words, liberty (and freedom) can best be defined as a condition in which a man’s will regarding his own person and property is unopposed by any other will. The limits to liberty, according to Thomas Jefferson, are “drawn around us by the equal rights of others.”

The 17th-century philosopher (and indirect contributor to the Declaration of Independence), John Locke framed it this way:

“All men are naturally in a state of perfect freedom to order their actions and dispose of their possessions and persons as they think fit, within the bounds of the law of Nature, without asking leave or depending upon the will of any other man.”

Paraphrasing Jefferson and Locke, we should be allowed to do whatever we want, so long as we do not impose upon or hurt others in doing it.

Reflecting for a moment on those important closing words in the Pledge of Allegiance, “with liberty and justice for all,” we may now have a grasp on liberty but what does this have to do with justice or Thomas Piketty, for that matter?

Thomas Piketty envisions a world, quite literally a global government authority, which actively redistributes wealth, resources and property as that authority sees fit and fair without regard for the liberties of individuals. Social justice does not and cannot reconcile with the form of justice that is referenced in The Pledge of Allegiance precisely because it is adjoined to liberty. Social justice requires an imposition on some members of society in order for others to receive positive rights assigned to them. It means someone else rules over the choices and resources taken from me. The only justice that can be “for all” involves defending negative rights – prohibitions laid out against others, especially the government, to prevent unwanted impositions and intrusions.

Summary

An increasingly interventionist government, either through un-elected and unaccountable authorities like those at the Federal Reserve or those elected by constituents who demand more positive rights, will continually stray from its delegated authority. The erosion of negative rights in the name of “fairness” and “justice” achieves neither. Free markets are not allowed to function fluidly as Fed officials step in to bailout hedge funds and bankers in the name of “the greater good.” Economic growth deteriorates as capital is used to buy back stock to boost executive compensation instead of being invested in long-term growth and innovation. Entire industries wither kept alive only by artificially low-interest rates leeching resources from others who might use them more productively. Standards of living deteriorate as the cost of housing, healthcare, and education skyrocket while worker pay remains stagnant. All of these examples and many others can be found in today’s post-crisis economy and serve as markers for poor growth, weak productivity, and broad public dissatisfaction. They point to misguided policies that subordinate the inalienable, negative rights of liberty to the selfish demands of a society that risk losing her most precious asset – the talents and contributions of an inspired and motivated population.

If, as Piketty advocates in the opening quote, capitalism and market forces are to be the slave of democracy, then democracy will most assuredly be the slave to corruption. Piketty’s wish is to subordinate the cumulative independent decisions and property rights of billions of human beings – basic liberties – to a few pious intellectual elites claiming to know what is best for the global population. Without these liberties, capitalism and market forces will be neither subject to honest men elected to represent a constituency nor capable of carrying out the duties of sponsoring free collaboration. The Davos Men will rule and they will direct markets and capital as they wish (and to their benefit) picking their winners until the façade collapses under the weight of the bulging obligations of socialism. The problem with socialism, as Margaret Thatcher pointed out, is that you eventually run out of other people’s money.

To restate Milton Friedman yet again:

There is no alternative way so far discovered of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.”

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

Use the season to breathe fresh perspective into your finances and prepare for a prosperous 2019.

Here are the 8-steps to fiscal fitness.

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

Most likely your long-term asset allocation or the mix of stocks, bonds and cash you maintain or add to on a regular basis, has been ignored. With most of the major stock indices almost at new highs, it’s possible your personal allocation to stocks has grown disconnected from your tolerance for risk.

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

A financial professional, preferably a fiduciary, can help make sense of how the risk profile of your portfolio has changed, provide input on how to rebalance or sell back to targets, and ground your allocation for what could be a different 2019.

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

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

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

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

#3: Fire your stodgy brick & mortar bank.

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

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

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

#4: Get an insurance checkup.

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

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

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

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

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

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

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

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

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

Health Savings Accounts allow individuals and families to make (and employers to match) tax-deductible contributions up to $3,500 and $7,000, respectively for 2019. Those 55 and older are allowed an additional $1,000 in “catch-up” contributions.

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

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

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

Want to make smarter choices during open enrollment season? Check out my post next week – “5 Smart Steps to Successful Open Enrollment,” for guidance.

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

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

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

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

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

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

For those who carry credit card balances and unfortunately, it’s all too common, consider contacting your credit card issue to negotiate a lower, perhaps a balance transfer rate or threaten to take your business (and your balance), elsewhere. Keep in mind, on average an American family maintains more than $8,300 in credit card debt and the national average annual percentage rate is a whopping 19.05%!

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

Start 2019 on the right financial foot by increasing payroll deferrals to your company retirement accounts and bolstering emergency cash reserves. Consider a formidable step, an overall 5% boost and prepare your 2019 household budget now to handle the increase.

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

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

When it comes to money, we can all learn from the power, beauty and resiliency of Mother Nature.

Use the season to gain a fresh perspective and improve your financial health.

On September 7th we were one of three investment professionals interviewed on Seeking Alpha’s Marketplace about the markets, the Federal Reserve and other topical issues. Please enjoy our contribution to the conversation.

Summary

The Fed’s annual Jackson Hole Symposium is over; what should investors look out for now?

For the near term, interest rates will continue their steady, gradual rise, says Chairman Powell. Our authors agree.

The markets’ trajectory keeps going up – when will it fall, and what will be the catalyst?

Look for opportunities in high yield and China.

With the Federal Reserve’s 2018 Jackson Hole Economic Symposium now over, markets continuing to hit new highs, and the economy seemingly humming on all cylinders (lots of people are employed, corporate profits are strong, and the Q2 gross national product was just north of 4%), we thought it would be a good time to check in with some of our macro-minded experts on Marketplace to get their take on interest rates, inflation, and where the economy might be headed next (just how close are we to a recession, anyway?). The authors we spoke to agree that rates will continue to rise gradually and steadily in the near term; that inflation risk, while small at this point, would be problematic for investors; and that, as common sense would dictate, the timing and severity of recessions is tough to pin down. They also propose some timely investing ideas to consider in the current environment, including high-yield instruments and a contrarian play on Chinese stocks. To find out more about how our authors are thinking about the current state of the economy and what investors should be watching for, keep reading.


Seeking Alpha: Federal Reserve Chairman Jerome Powell said at Jackson Hole that he expects rate hikes to continue. Do you foresee the two planned additional hikes coming this year? When do you think the Fed will stop raising interest rates?

Lance Roberts: The Fed under Jerome Powell has been very clear that they intend to keep raising rates at a gradual but steady pace. Real rates remain very low and stimulative relative to the extent of the economic recovery. That should fuel rising levels of inflation, especially given the recent rounds of fiscal stimulus at a time of full employment. The current circumstance offers further incentive for the Fed to maintain the path of rate hikes. Powell likely wants to build room to employ traditional monetary policy stimulus while the economy is giving him the latitude to do so. Ultimately, the stock market is the Fed’s barometer on terminal Fed Funds and will tell Powell when enough is enough.


SA: Why are market expectations different from the Fed’s expectations, according to the Fed’s most recent dot plot?

LR: We recently wrote extensively about this divergence in an article we penned for our Marketplace community: “Everyone Hears The Fed… But Few Listen.” One of the key takeaways from the article was as follows: “Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.” In short, since the financial crisis, the market has become accustomed to a Fed that has failed to deliver on rate hike promises. That seems to have changed with plain-speaking Chairman Powell.


SA: What’s the deal with inflation? Is the Fed being too complacent about inflation risk and their ability to “control it” at all costs? What are the odds of inflation upside?

LR: Yes! Yes! And who knows. First, it is important to clarify that rising prices are a symptom of inflation caused by too much money in the economic system. Given the actions of central bankers over the past 10 years, there is no question that condition exists on a global scale as never before. The manifestation has been different in this cycle than in the past and is showing itself in asset prices as opposed to the costs of goods and services. The biggest risk, albeit small at this point, is the combination of inflation and recession (stagflation). In this event, the Fed would be forced to reduce liquidity and raise rates. This is a scenario that has not been witnessed in decades and would be a difficult combination for most stock/bond investors.


SA: There’s a chart we saw recently that shows the S&P 500 steadily climbing to dizzying heights over the past decade. At what point do you think the Fed tightening will derail the S&P 500 and the bull market?

LR: Market valuations are clearly at historical peaks. It is being driven largely by behavioral tendencies and importantly central bank liquidity. As the Fed further reduces liquidity and the ECB and BOJ begin to take similar steps, the odds increase that equity markets falter. We are already seeing the effects of reduced liquidity in Turkey and other emerging market nations. That said, picking a date is a fool’s game as this market seems to be very good at ignoring reality.


SA: Recession: are we there yet? How close (or far) are we from an economic slump?

LR: We have had some close calls since 2010, especially in late 2015 and early 2016, but central bank intervention has delayed the rhythm of these cycles. In the same way, however, that suppressing forest fires eventually result in even more uncontrollable outbreaks, this seems to be a similar likelihood for the global economy. Debt (and leverage) is the lowest common denominator as a determinant for a recession and, again, the level of interest rates will eventually be the trigger. Rate hikes naturally are bringing us closer to that point, but the trigger is unknowable. Watch real rates, the yield curve, and credit spreads.


SA: The US dollar is key for many asset classes and critical for potential emerging market issues. What’s your outlook for the US dollar both near and long term?

LR: Given the global demand dynamics and the pressures being imposed by a Fed that maintains a path of rate hikes, the dollar should sustain it recent strength and continue to move higher in the short to intermediate term. Long term, the dollar outlook is problematic due to the amount of U.S. debt outstanding, the extent of money printing that will likely have to occur in order to avert a default and the converging global efforts by major economies (especially China) to reduce their reliance on dollar-based transactions.


SA: What would you say to investors who are looking to protect themselves against potential market and inflation risks?

LR: We own house and car insurance for events that are highly unlikely. Why shouldn’t we consider owning financial insurance, especially when the risks of a significant drawdown are substantial? As Falstaff said in Shakespeare’s King Henry the Fourth, “Caution is preferable to rash bravery.”

At the end of March, the institutional share class of famed value investor Joel Greenblatt’s Gotham Index Plus fund (GINDX) passed its three-year mark and garnered a 5-star rating from Morningstar. That means, over its first three years, the long-short stock fund landed in the top-20% of the large blend fund category for its volatility-adjusted return.

Long-short funds have high fees because they pay dividends and margin costs on short positions, and this fund is no exception with an eye-watering 3.61% expense ratio. But it’s a good time to look under this fund’s hood to see if it still deserves a place in some portfolios.

Background on Greenblatt and the “Magic Formula”

As I wrote in a previous article, Joel Greenblatt began his career has a hedge fund manager using a strategy that could be described as special situations. He looked for corporate restructurings including spinoffs and bankruptcies and managed to post a 50% annualized return for a decade, albeit with significant volatility as he tells it. Greenblatt likes to write and teach, including holding a position as an adjunct professor at Columbia Business School, and the book that emerged from that experience became a hedge fund cult classic, You Can Be a Stock Market Genius.

After closing his fund, Greenblatt devised a strategy that could accommodate more assets called the “Magic Formula.” The strategy is really a simple smart beta two-factor model, picking stocks with the best combination of EBIT yield and return on invested capital. Greenblatt ran a backtest and realized picking the stocks that scored best on these two factors at the start of each year would have beaten the index by 4 percentage points annualized over a quarter century. Three books came out of testing this strategy – The Little Book that Beats the Market, The Little Book that Still Beats the Market, and The Big Secret for the Small Investor.

When I was at Morningstar I calculated that the strategy beat the S&P 500 Index, including dividends, by 10 percentage points annualized from 1988 through September of 2009, based on Greenblatt’s back-tested numbers from his first book on the strategy and funds he was running at that time. That doesn’t mean the formula beat the index every single calendar year. In fact, it showed patterns of underperforming for as many as three straight years before recovering and overtaking the index again. Value investors must tolerate fallow periods. In fact, value strategies work over the long run precisely because they don’t work over shorter periods. Everyone piles out when the strategy is faltering, leaving stocks poised for outperformance. The “magic” of the formula is really based on the human psychology or behavior that causes many of us to be bad investors.

Using the Magic Formula to Go Long & Short

Now Greenblatt and his partner Robert Goldstein have based a series of long-short funds on the strategy, which, to varying degrees, own the stocks that score best on his formula and short the stocks that score the worst on it. For each dollar invested, the Gotham Index Plus fund gains 100% exposure to the S&P 500 Index. It also selects long and short positions from the 500-700 larges U.S stocks that are that most expensive or cheapest on Gotham’s assessment of value or the Magic Formula. The resulting portfolio is 190% long and 90% short.

So the fund combines full exposure to the index with active management. Part of the fund tracks the market, and another part of the fund uses a value strategy to own and short stocks. The benefit of having both market exposure and exposure to an active strategy is that investors who still want to beat the market don’t have to withstand such severe fallow periods that every value investor endures and that the fund would likely have if it were just invested in the magic formula strategy.

The Verdict

With such a high expense ratio, however, the fund must outperform significantly when the strategy is working – and not underperform significantly when it’s not. The avoidance of underperformance versus the index is especially true since one of Greenblatt’s objectives is to provide an index-like experience for investors so that they won’t get shaken out when the active strategy is out of favor. That seems like a tall order. Nevertheless, for the 41 months the fund has been in existence it has outperformed the index. Over that period, the fund’s compounded annualized return is 14.54%, while the S&P 500 Index’s return is 12.75%.

 

Over long periods of time that difference – 1.79 percentage points – adds up to serious returns. For example a $100,000 investment earning 7% for 25 years would grow to around $540,000, while the same investment for the same period of time earning 8.79% would growth to around $820,000,

Interestingly, the Gotham Index Plus fund has a 1.42% Sharpe Ratio for the past 36 months according to Morningstar, while the index has a Sharpe Ratio of 1.55%. This implies that the index has a slightly better volatility adjusted performance. But the Sharpe Ratio views all volatility (up and down) as the same, whereas investors obviously don’t. Indeed, the Sortino Ratio of the fund, which penalizes an investment only for downside volatility, is higher – 3.42% — than the index’s 3.30%. Additionally, the fund has captured 105% of the index’s upside moves and 77% of the downside moves.

So far, despite its breathtaking expense ratio, the Gotham Index Plus fund has delivered on its promise – outstripping the index by a decent amount over a 41-month period, while delivering a roughly similar volatility experience. Investors should consider that other long-short funds must pay dividends and margin costs too. It’s noteworthy though that if the stock market endured a steep decline, the fund would then be paying even higher fees assuming dividends weren’t cut too badly in that event. If the expense ratio on the fund reached, say, nearly 6% instead of nearly 4% now, the fund might do fine, but would it overcome the index as easily? Of course, such a big decline in the stock market itself, although painful in absolute terms, might be a relative boon for the fund as both its long and short magic formula components could outperform the index during a big drop. And stocks would be cheaper after such a decline, arguably favoring the fund’s strategy.  But 6% or more seems like a rather high hurdle.

It’s difficult to recommend a fund this expensive. But paying dividends and margin costs is part of shorting. And if you aim to find a mechanical, smart beta-like long-short fund that can beat the market over the longer haul, this fund’s strategy has a decent chance.

A couple of weeks ago, I discussed the recent breakout to “all-time” highs and the potential run to 3000 for the S&P 500 index.

“Regardless of the reasons, the breakout Friday, with the follow through on Monday, is indeed bullish. As we stated repeatedly going back to April, each time the market broke through levels of overhead resistance we increased equity exposure in our portfolios. The breakout above the January highs now puts 3000 squarely into focus for traders. 

This idea of a push to 3000 is also confirmed by the recent ‘buy signal’ triggered in June where we begin increasing equity exposure and removing all hedges from portfolios. The yellow shaded area is from the beginning of the daily ‘buy signal’ to the next ‘sell signal.'”

Importantly, at that time I specifically noted:

“However, with the markets VERY overbought on a short-term basis, we are looking for a pullback to the previous ‘breakout’ levels, or a consolidation of the recent gains, to increase equity exposure further.”

That pullback occurred last week providing a very short-term trading opportunity with a higher reward/risk ratio than existed previously.

The only short-term concern is the warning signal in the lower panel. Just like in early August, when a warning was issued, it never matured into a deeper correction. While I am not dismissing the current warning, given Monday’s bounce off of support combined with a very short-term oversold condition, and very high levels of bullish “optimism,” the most likely outcome currently remains a push towards 3000 through the rest of this year. This high level of “optimism” is shown in the chart below which compares the S&P 500 to investors in bearish funds, money markets, and bullish funds. (Investors are “all in.”)

Remember, in the very “short-term,” it is all about “psychology.”

In the long-term, it is all about “fundamentals.”

Over the next several weeks to the next couple of months, the “bullish bias” is clearly in control.

Weekly Data Is Bullish Too

If we smooth out daily volatility by using weekly data, much of the same picture currently emerges. The market has broken out to all-time highs and the accelerated “bullish trend line” from the 2016 correction was successfully tested in March and April.

Several weeks ago we upgraded our portfolio allocations back to 100% of model weights as the weekly “buy signal” suggested a return to a more bullish backdrop for investors.

As we have repeatedly noted in our weekly missives, while we remain concerned about the longer-term prospects for the markets due to valuations, late-stage economic dynamics, and normalized profit cycles, our portfolios remain nearly fully allocated in the short-term.

Adding Exposure Cautiously

With the recent pullback to support, which confirms the recent breakout above the January highs, we are adding some additional exposure this week.

In the Equity and Equity/ETF Blend Portfolios we are taking the following actions:

  • MU & KLAC or are SELL ALERTS with both companies flirting with their trailing stop-loss levels. While we like both companies from a fundamental basis, the technical backdrop has weakened considerably in the short-term.
  • We are looking to bring our current number of holdings up to the maximum of 30 companies in the next couple of days. We will report the actual positions shortly after we add them to our client accounts.

In the ETF Portfolio:

  • We have been underweight equity in the ETF portfolio due to the lack of international, emerging market, and basic material exposure. This has been a good choice as cash has performed better than these sectors.
  • However, we need to increase domestic exposure if the market is indeed going to advance into the end of the year as we currently expect. Therefore, we will be adding to our core domestic exposures in the next couple of days to bring portfolios to full target weights. 
  • We will report additions in the next couple of days once allocations to client accounts are complete.

In case you missed our weekend missive, this doesn’t mean we are just ignoring all risk and neglecting our portfolio management process. As I stated:

“It is worth remembering that portfolios, like a garden, must be carefully tended to otherwise the bounty will be reclaimed by nature itself.

  • If fruits are not harvested (profit taking) they ‘rot on the vine.’ 
  • If weeds are not pulled (sell losers), they will choke out the garden.
  • If the soil is not fertilized (savings), then the garden will fail to produce as successfully as it could.

So, as a reminder, and considering where the markets are currently, here are the rules for managing your garden:

1) HARVEST: Reduce “winners” back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole plant from the ground.

2) WEED: Sell losers and laggards and remove them from the garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing “nutrients” that could be used for more productive plants. The first rule of thumb in investing “sell losers quickly.”

3) FERTILIZE AND WATER: Add savings on a regular basis. A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NEVER LOSE money investing in the markets…then shouldn’t be investing to begin with.

4) WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn’t occur. Likewise, a portfolio protected against ‘risk’ in the short-term, never harmed investors in the long-term.

With the overall market trend still bullish, there is little reason to become overly defensive in the very short-term. However, there are plenty of warning signs the ‘good times’ are nearing their end, which will likely surprise most everyone.”

Again, we are moving cautiously. With the trend of the market positive, we realize short-term performance is just as important as long-term. It is always a challenge to marry both.

The Fly In The Ointment

The one thing that continues to weigh on us is the deviation in international performance relative to the U.S. As discussed this past weekend:

“Emerging and International Markets were removed in January from portfolios on the basis that ‘trade wars’ and ‘rising rates’ were not good for these groups. With the addition of the ‘Turkey Crisis,’ ongoing tariffs, and trade wars, there is simply no reason to add ‘drag’ to a portfolio currently. These two markets are likely to get much worse before they get better. Put stops on all positions.

The recent bounce again failed at the declining 50-dma. Positions should have been sold on that failed rally. Stops at the recent lows were triggered on Friday and suggests positions be closed out as lower levels are likely at this time.”

This has been the right call, despite the plethora of articles suggesting the opposite.

Over the last 25-years, this has remained a constant.

In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)

With emerging markets diverged from domestic markets, it suggests economic growth may not be as robust as many believe. While a 2-quarter divergence certainly isn’t suggesting a ‘financial crisis’ is upon us, it does suggest that something isn’t quite right with the global economic backdrop.

This underperformance in international markets combined with a bond market which continues to “NOT buy” the rally in stocks also keeps us on guard. Such suggests capital continues to seek “safety” over “risk” in the short term. More importantly, the 10-year Treasury rate has a strong history of warning of dangers in the market over the longer-term time frame.

The point here is simple.

While bullish sentiment very much controls the short-term trend and direction of the market, in which we must participate, the longer-term dynamics still remain clearly bearish.

Peak earnings, employment, economic and profits growth all suggest the next leg of the market will likely be lower rather than higher.

But that is an article, and portfolio management and allocation change, which is yet to be written.

Recently we received the following question from a reader and thought it might be helpful to answer it for all of our subscribers. The question is as follows:

“Who buys a French bond with a negative yield when they can buy a safer U.S. Treasury bond yielding over 2%?”

The simple answer: the economic incentive for a foreigner to own higher yielding U.S. Treasuries is significantly diminished or entirely erased when adjusted for currency and credit risks.

Following is a detailed analysis explaining the answer.

That question was recently posed following the publishing of Deficits Do Matter. In that article, we presented data showing the pace of foreign buying of U.S. Treasury securities had slowed considerably in recent years. Of concern, the amount of debt foreigners are currently buying is not keeping up with the increasing issuance of Treasury debt. Given that foreign holders are the largest investors in U.S. Treasuries, accounting for over 40% ownership, as well as their large holdings of corporate and securitized individual debts, this change in behavior should be followed closely.

Why are foreign investors shunning U.S. Treasuries despite significantly higher yields than many other sovereign debt issuers? The question is even more perplexing when one considers that U.S. Treasury securities are believed to be safer from a credit perspective and offer more liquidity than any bond outstanding, sovereign or otherwise.

When considering bonds of different countries, the analysis is not as simple as comparing yields. When factors such as foreign exchange (FX) rates and credit quality are factored in, the math becomes more complicated, and the results tell a very different story.

Buy and Hold

In this article, we walk through the calculations that buy and hold investors of sovereign bonds use to effectively compare yields on bonds from different countries. Before going into details, it is important to note that there are two other types of buyers and their decision making is different from that discussed in this article. One investor grouping consists of the banks, brokers and hedge funds that speculate on a short-term basis to take advantage of an expected change in yields. The other type of “investors” are the central banks and/or treasuries of countries that hold U.S. dollars for trade purposes. These dollar reserves are typically invested in highly liquid fixed income securities, with U.S. Treasuries generally the most desired.

Global bond mutual funds, pension funds and other types of institutional investors that buy foreign government bonds tend to hold them to maturity. These investors are constantly assessing yields, credit risk, liquidity status and many other factors to help them achieve the highest returns possible. This task is not as simple as comparing the stated yield of a German bund to a U.S. Treasury bond of similar maturity. As mentioned, two other important risk factors one must consider, assuming the investor holds to maturity, are expected currency exchange rate changes and credit risk.

Assume the perspective of a German-based sovereign bond fund. The German portfolio manager, when valuing various sovereign bonds, must take two steps to re-calculate yields so they are comparable on a risk-adjusted basis.

The first step is to quantify the credit risk. This is a relatively easy task as credit default swaps (CDS) provide a real-time market assessment of credit risk. These swaps are essentially insurance policies where the writer/seller of the swap receives semi-annual premium payments, and the buyer of the swap is entitled to be made whole if the bonds default. The less risky the bond, the lower the premium. Our German investor might buy a related CDS in conjunction with a Treasury bond to hedge the credit risk.

The second step is to gauge the foreign exchange risk. For our German portfolio manager to buy a U.S. dollar bond, he must first convert his Euros to U.S. Dollars. Going forward, each interest payment and the ultimate payment of principal the portfolio manager receives must be converted back from U.S. Dollars to Euros. The risk the portfolio manager bears is the changing FX conversion rate of future interest and principal payments from U.S. dollars back into Euros.

Our manager can assess and hedge the risk, if he chooses, using FX forward swaps. These swaps represent the “price” at which an investor can lock in an exchange rate between two currencies in the future. Investment banks facilitate a swap where mutually agreed upon future exchange rates can be negotiated. This transaction allows the investor to buy the foreign bond and establish certainty around the exchange rate at which future payments will be received and converted.

To walk through a transaction, let’s compare a 2-year German bund to a 2-year U.S. Treasury note. The yield on the German bund is currently -0.58% and the U.S. note yields +2.64%. At first blush, one might surmise that a German investor can pick up 3.22% (2.64% – (-0.58%) buying the 2-year U.S. Treasury. However, as we stated, the investor would then be assuming foreign exchange risk.

Currently, the two-year forward euro/dollar exchange rate is priced at 6.57% (3.23% annualized) higher than the spot exchange rate. If the Euro were to appreciate 3.23% each year, the previously stated 3.22% annual pickup in yield (benefit) would be entirely offset with a 3.23% currency loss, resulting in the German portfolio manager being largely indifferent between the two bonds.

In selecting the German bund over the U.S. Treasury, the investor is also taking on additional credit risk, as Germany is considered slightly riskier than the U.S. The current German two-year credit default swap (CDS) swap costs five basis points a year more than U.S. CDS. Factoring in the CDS swap, the new rate differential slightly favors the U.S. Treasury by 0.04%.

The table below provides this same analysis for Germany and four other countries.

As highlighted above in the Net Yield Difference column, investors in Japan are better off on a risk-adjusted basis (.21%) by buying their domestic 2-year bonds with a negative yield than buying 2-year U.S. Treasury notes at 2.64%. German and French investors are indifferent, while Italian and UK investors should favor U.S. bonds.

While the math can get confusing the important takeaway is as follows: For the countries shown above and many others not included in the table, the economic incentive to own higher yielding U.S. Treasuries is significantly diminished or entirely erased when adjusted for currency and credit risks.

Interest Rate Parity

This article is based on what economists call interest rate parity, a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

Financial theory, in general, rests on a bedrock that states that risk-free arbitrage opportunities, such as those shown above, should not exist. In reality, there are other factors such as capital requirements, liquidity concerns, and regulations that add costs and preclude some investors from participating in such opportunities and thus allow them to exist as highlighted above.

Summary

This analysis addresses the common misconception that U.S. Treasury bonds and notes offer significant relative value based solely on yield levels. As exhibited, there is little if any financial incentive currently for foreign buyers to choose U.S. bonds over European, British or Japanese bonds despite significantly higher yields on U.S. Treasuries. Required adjustments incorporating the foreign exchange component into the equation negates any optical advantage of higher yields in the U.S.

While there is certainly a yield that is attractive to foreign investors and will incentivize foreigners to fund U.S. deficits, based on the math that yield resides somewhere north of current levels. Either that or the U.S. dollar would have to strengthen further to offset the foreign exchange adjustments in play. A stronger dollar however presents other economic challenges beyond the scope of this discussion.

Considering the size of the current debt overhang in the U.S. and the increased supply of Treasuries projected to be coming forth over the next several quarters, this is an important and largely overlooked challenge. Each additional basis point required to meet funding needs raises the interest expense on the debt as well as the interest expense on all corporate, muni and individual new issues and floating rate debt. Given the excessive financial leverage employed by the U.S. economy, every basis point has a detrimental economic effect.

A couple of weeks ago, I discussed the recent breakout to “all-time” highs and the potential run to 3000 for the S&P 500 index.

“Regardless of the reasons, the breakout Friday, with the follow through on Monday, is indeed bullish. As we stated repeatedly going back to April, each time the market broke through levels of overhead resistance we increased equity exposure in our portfolios. The breakout above the January highs now puts 3000 squarely into focus for traders. 

This idea of a push to 3000 is also confirmed by the recent ‘buy signal’ triggered in June where we begin increasing equity exposure and removing all hedges from portfolios. The yellow shaded area is from the beginning of the daily ‘buy signal’ to the next ‘sell signal.'”

Importantly, at that time I specifically noted:

“However, with the markets VERY overbought on a short-term basis, we are looking for a pullback to the previous ‘breakout’ levels, or a consolidation of the recent gains, to increase equity exposure further.”

That pullback occurred last week providing a very short-term trading opportunity with a higher reward/risk ratio than what existed previously.

The only short-term concern is the warning signal in the lower panel. Just like in early August, when a warning was issued, it never matured into a deeper correction. While I am not dismissing the current warning, given Monday’s bounce off of support combined with a very short-term oversold condition, and very high levels of bullish “optimism,” the most likely outcome currently remains a push towards 3000 through the rest of this year. This high level of “optimism” is shown in the chart below which compares the S&P 500 to investors in bearish funds, money markets, and bullish funds. (Investors are “all in.”)

Remember, in the very “short-term,” it is all about “psychology.”

In the long-term, it is all about “fundamentals.”

Over the next several weeks to the next couple of months, the “bullish bias” is clearly in control.

Weekly Data Is Bullish Too

If we smooth out daily volatility by using weekly data, much of the same picture currently emerges. The market has broken out to all-time highs and the accelerated “bullish trend line” from the 2016 correction was successfully tested in March and April.

Several weeks ago we upgraded our portfolio allocations back to 100% of model weights as the weekly “buy signal” suggested a return to a more bullish backdrop for investors.

As we have repeatedly noted in our weekly missives, while we remain concerned about the longer-term prospects for the markets due to valuations, late-stage economic dynamics, and normalized profit cycles, our portfolios remain nearly fully allocated in the short-term.

Adding Exposure Cautiously

With the recent pullback to support, which confirms the recent breakout above the January highs, we are adding some additional exposure this week.

(If you want to see our model portfolios click here and subscribe for a free trial.)

In case you missed our weekend missive, this doesn’t mean we are just ignoring all risk and neglecting our portfolio management process. As I stated:

“It is worth remembering that portfolios, like a garden, must be carefully tended to otherwise the bounty will be reclaimed by nature itself.

  • If fruits are not harvested (profit taking) they ‘rot on the vine.’ 
  • If weeds are not pulled (sell losers), they will choke out the garden.
  • If the soil is not fertilized (savings), then the garden will fail to produce as successfully as it could.

So, as a reminder, and considering where the markets are currently, here are the rules for managing your garden:

1) HARVEST: Reduce “winners” back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole plant from the ground.

2) WEED: Sell losers and laggards and remove them from the garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing “nutrients” that could be used for more productive plants. The first rule of thumb in investing “sell losers quickly.”

3) FERTILIZE AND WATER: Add savings on a regular basis. A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NEVER LOSE money investing in the markets…then shouldn’t be investing to begin with.

4) WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn’t occur. Likewise, a portfolio protected against ‘risk’ in the short-term, never harmed investors in the long-term.

With the overall market trend still bullish, there is little reason to become overly defensive in the very short-term. However, there are plenty of warning signs the ‘good times’ are nearing their end, which will likely surprise most everyone.”

Again, we are moving cautiously. With the trend of the market positive, we realize short-term performance is just as important as long-term. It is always a challenge to marry both.

The Fly In The Ointment

The one thing that continues to weigh on us is the deviation in international performance relative to the U.S. As discussed this past weekend:

“Emerging and International Markets were removed in January from portfolios on the basis that ‘trade wars’ and ‘rising rates’ were not good for these groups. With the addition of the ‘Turkey Crisis,’ ongoing tariffs, and trade wars, there is simply no reason to add ‘drag’ to a portfolio currently. These two markets are likely to get much worse before they get better. Put stops on all positions.

The recent bounce again failed at the declining 50-dma. Positions should have been sold on that failed rally. Stops at the recent lows were triggered on Friday and suggests positions be closed out as lower levels are likely at this time.”

This has been the right call, despite the plethora of articles suggesting the opposite.

Over the last 25-years, this has remained a constant.

In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)

With emerging markets diverged from domestic markets, it suggests economic growth may not be as robust as many believe. While a 2-quarter divergence certainly isn’t suggesting a ‘financial crisis’ is upon us, it does suggest that something isn’t quite right with the global economic backdrop.

This underperformance in international markets combined with a bond market which continues to “NOT buy” the rally in stocks also keeps us on guard. Such suggests capital continues to seek “safety” over “risk” in the short term. More importantly, the 10-year Treasury rate has a strong history of warning of dangers in the market over the longer-term time frame.

The point here is simple.

While bullish sentiment very much controls the short-term trend and direction of the market, in which we must participate, the longer-term dynamics still remain clearly bearish.

Peak earnings, employment, economic and profits growth all suggest the next leg of the market will likely be lower rather than higher.

But that is an article, and portfolio management and allocation change, which is yet to be written.

Jason Zweig, a neuroscience and Benjamin Graham expert, re-published an article last year entitled: “Ben Graham, The Human Brain, And The Bubble.” The entire article is a worthy read but there were a few points in particular he made that are just as relevant today as they were when he wrote the original essay in 2003.

“At the peak of every boom and in the trough of every bust, Benjamin Graham‘s immortal warning is validated yet again: ‘The investor’s chief problem — and even his worst enemy — is likely to be himself.'” 

I have written about the psychological issues which impede investors returns over longer-term time frames in the past. They aren’t just psychological, but also financial. To wit:

“Another common misconception is that everyone MUST be saving in their 401k plans through automated contributions. According to Vanguard’s recent survey, not so much.

  • The average account balance is $103,866 which is skewed by a small number of large accounts.
  • The median account balance is $26,331
  • From 2008 through 2017 the average inflation-adjusted gain was just 28%. 

So, what happened?

  • Why aren’t those 401k balances brimming over with wealth?
  • Why aren’t those personal E*Trade and Schwab accounts bursting at the seams?
  • Why are so many people over the age of 60 still working?

While we previously covered the impact of market cycles, the importance of limiting losses, the role of starting valuations, and the proper way to think about benchmarking your portfolio, the two biggest factors which lead to chronic investor underperformance over time are:

  • Lack of capital to invest, and;
  • Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. It is also difficult to ‘invest’ when the majority of Americans have an inability to ‘save.'”

“These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.”

While “buy and hold” and “dollar cost averaging” sound great in theory, the actual application is an entirely different matter. Ultimately, as individuals, we do everything backwards. We “buy” when market exuberance is at its peak and asset prices are overvalued, and we “sell” when valuations are cheap and there is a “rush for the exits.” 

Behavioral biases are an issue which remains little understood and accounted for when individuals begin their investing journey. Dalbar defined (9) nine of these behavioral biases specifically:

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

Cognitive biases impairs our ability to remain emotionally disconnected from our money.

But it isn’t entirely your fault. The Wall Street marketing machine, through effective use of media, have changed our view of investing from a “process to grow savings over time” to a “get rich quick scheme” to offset the shortfall in savings. Why “save” money when the market will “make you rich?”

As I addressed in “Retirees Face A Pension Crisis Of Their Own:”

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating future returns, future retirement values are artificially inflated which reduces the required saving amounts need by individuals today. Such also explains why 8-out-of-10 American’s are woefully underfunded for retirement currently.”

The Illusion Of Control

Jason discussed another important psychological barrier to our success.

Online trading firms went further, blowing the traditional brokerage model to bits. With no physical branch offices, no in-house research, no investment banking, and no brokers, they had only one thing to offer their customers: the ability to trade at will, without the counterweight of any second opinion or expert advice. Once, that degree of freedom might have frightened investors. But the new Internet brokerages cleverly fostered what psychologists call ‘the illusion of control’ — the belief that you are at your safest in an automobile when you are the driver. Investors were encouraged to believe that the magnitude of their portfolio’s return would be directly proportional to the amount of attention they paid to it — and that professional advice would reduce their return.”

The “illusion of control,” is another behavioral bias that individuals regularly face. When stock prices are rising, especially in a momentum-driven market, individuals believe that have it “all figured out.” The inherent problems which arise from this “over-confidence” are the layering of “risks” in portfolios which are misunderstood until a correction process begins. As I wrote previously:

“Bull markets hide investing mistakes, bear markets reveal them.” 

The reality is that as individuals we are NOT investors, but rather just speculators hoping the share of stock we purchased today, will be able to be sold at a higher price later. Unfortunately, since individuals are told to “buy,” but never “sell,” only one-half of the investment process is completed.

In other words, the illusion we are in “control” is simply that. Logically, we know we should “buy low” and “sell high.” Yet it is the entirety of our other behavioral biases that keep us from doing so. But most importantly, it is the consistent message from the mainstream media which “feeds our greed” that asset prices will only move higher…and you surely don’t want to miss out on that.

(Read: Experience Is The Only Cure)

The Video Game 

Another risk Jason points out is our “addiction.”

“Psychologist Marvin Zuckerman at the University of Delaware has written about a form of risk called ‘sensation-seeking’ behavior. This kind of risk — people daring each other to push past the boundaries of normally acceptable behavior — is largely a group phenomenon (as anyone who has ever been a teenager knows perfectly well). People will do things in a social group that they would never dream of doing in isolation.”

As individuals, we are “addicted” to the “dopamine effect.” It is why social media has become so ingrained in society today as individuals constantly look to see how many likes, shares, retweets, or comments they have received. That instant gratification and acknowledgment keep us glued to our screens and less involved in the world around us.

We are addicted.

As Jason notes, a team of researchers have proved this point:

“Wolfram Schultz at Cambridge and Read Montague at Baylor in Houston, Texas, have shown that the release of dopamine, the brain chemical that gives you a ‘natural high,’ is triggered by financial gains. The less likely or predictable the gain is, the more dopamine is released and the longer it lasts within the brain. Why do investors and gamblers love taking low-probability bets with high potential payoffs? Because, if those bets do pay off, they produce an actual physiological change — a massive release of dopamine that floods the brain with a soft euphoria.

After a few successful predictions of financial gain, speculators literally become addicted to the release of dopamine within their own brains. Once a few trades pay off, they cannot stop the craving for another ‘fix’ of profits — any more than an alcoholic or a drug abuser can stop craving the bottle or the needle.”

Fortunately, we have support groups to help with most of our addictions from alcohol to gambling. While these groups are there to help us curb our addictive and destructive behaviors for some things, the investing world is full of groups which exist to “feed” our investing addiction.

“Until the advent of the Internet, there was simply no such thing as a network or support group for risk-crazed retail traders. Now, quite suddenly, there was — and with every gain each of them scored, they goaded the other members of the group on to take even more risk. Comments like ‘PRICE IS NO OBJECT’ and ‘BUY THE NEXT MICROSOFT BEFORE IT’S TOO LATE’ and ‘I’LL BE ABLE TO RETIRE NEXT WEEK’ became commonplace.

And the public was urged to hurry. ‘EVERY SECOND COUNTS,’ went the slogan of Fidelity’s discount brokerage — implying that investors could somehow achieve their long-term goals by engaging in short-term behavior.”

By using technology to turn investing into a video game — lines snaking up and down a glowing screen, arrows pulsating in garish hues of red and green — the online brokerages were tapping into fundamental forces at work in the human brain.”

What are the most popular apps on our “smartphones?” 

Video games and social media.

Why, because of the “dopamine” our brain releases.

This is why apps like “Robinhood” and “Stash” that allow for online trading straight from our phones have gained in such popularity. The “immediacy effect” of instant feedback on success or failure keeps us clicking for next winner. Wall Street has become a full-blown casino with individuals lining up to pull the lever to see if they are the next big winner. But, just as it is in Las Vegas, the “house usually wins.” 

The Prediction Addiction

Adding to our list of behavioral flaws and biases when it comes to investing, Jason points out another:

“In 1972, Benjamin Graham wrote: ‘The speculative public is incorrigible. In financial terms it cannot count beyond 3.  It will buy anything, at any price, if there seems to be some ‘action’ in progress.’ – Graham, The Intelligent Investor, pp. 436-437.

In a stunning confirmation of his argument, the latest neuroscientific research has shown that Graham was not just metaphorically but literally correct that speculators ‘cannot count beyond 3.’ The human brain is, in fact, hard-wired to work in just this way: pattern recognition and prediction are a biological imperative.

Scott Huettel, a neuropsychologist at Duke University, recently demonstrated that the anterior cingulate, a region in the central frontal area of the brain, automatically anticipates another repetition after a stimulus occurs only twice in a row. In other words, when a stock price rises on two consecutive ticks, an investor’s brain will intuitively expect the next trade to be an uptick as well.

This process — which I have christened ‘the prediction addiction’ — is one of the most basic characteristics of the human condition. Automatic, involuntary, and virtually uncontrollable, it is the underlying neural basis of the old expression, ‘Three’s a trend.’ Years ago, when most individual investors could obtain stock prices only once daily, it took a minimum of three days for the ‘I get it’ effect to kick in. But now, with most websites updating stock prices every 20 seconds, investors readily believed that they had spotted sustainable trends as often as once a minute.”

While individuals regularly proclaim to be “long-term investors,” the average holding period for stocks has shrunk from more than 6-years in the 1970’s to less than 6-months currently.

The Advisor’s Role

These psychological and behavioral issues are exceedingly difficult to control and lead us regularly to making poor investment decisions over time. But this is where the role of an “advisor” should be truly defined and valued.

While the performance chase, a by-product of the very behavioral issues we wish to control, leads everyone to seek out last years “hottest” performing manager or advisor, this is not really the advisor’s main role. The role of an Advisor is NOT beating some random benchmark index or to promote a “buy and hold” strategy. (There is no sense in paying for a model you can do yourself.)

Jason summed it well:

“The only legitimate response of the investment advisory firm, in the face of these facts, is to ensure that it gets no blood on its hands. Asset managers must take a public stand when market valuations go to extremes — warning their clients against excessive enthusiasm at the top and patiently encouraging clients at the bottom.”

Given that individuals are emotional and subject to emotional swings caused by market volatility, the Advisors role is not only to be a portfolio manager, but also a psychologist. Dalbar suggested four successful practices to reduce harmful behaviors:

  1. Set Expectations below Market Indices: Change the threshold at which the fear of failure causes investors to abandon an investment strategy. Set reasonable expectations and do not permit expectations to be inferred from historical records, market indexes, personal experiences or media coverage. The average investor cannot be above average. Investors should understand this fact and not judge the performance of their portfolio based on broad market indices.
  2. Control Exposure to Risk: Include some form of portfolio protection that limits losses during market stresses.
    Explicit, reasonable expectations are best set by agreeing on a goal that consists of a predetermined level of risk and expected return. Keeping the focus on the goal and the probability of its success will divert attention away from frequent fluctuations that lead to imprudent actions
  3. Monitor Risk Tolerance: Periodically reevaluate investor’s tolerance for risk, recognizing that the tolerance depends on the prevailing circumstances and that these circumstances are subject to change.
    Even when presented as alternatives, investors intuitively seek both capital preservation and capital appreciation. Risk tolerance is the proper alignment of an investor’s need for preservation and desire for capital appreciation. Determination of risk tolerance is highly complex and is not rational, homogenous nor stable.
  4. Present forecasts in terms of probabilities: Simply stating that past performance is not predictive creates a reluctance to embark on an investment program.
    Provide credible information by specifying probabilities or ranges that create the necessary sense of caution without negative effects. Measuring progress based on a statistical probability enables the investor to make a rational choice among investments based on the probability of reward.

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.

One thing that all the negative behaviors have in common is that they can lead investors to deviate from a sound investment strategy that was narrowly tailored towards their goals, risk tolerance, and time horizon.

The best way to ward off the aforementioned negative behaviors is to employ a strategy that focuses on one’s goals and is not reactive to short-term market conditions. The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.

The reality is that the majority of advisors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

When the impact event occurs, advisors who are prepared to handle responses, provide clear messaging, and an action plan for both conserving investment capital and eventual recovery will find success in obtaining new clients.

The discussion of why “this time is not like the last time” is largely irrelevant. Whatever gains that investors garner in the between now and the next impact event by chasing the “bullish thesis” will be largely wiped away in a swift and brutal downdraft. 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.


  • It’s Make Or Break
  • Sector & Market Analysis
  • 401k Plan Manager

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Make Or Break?

Two week’s ago I laid out the potential pathways for the market suggesting that with the markets very oversold a pullback to support was likely. To wit:

“While I point out the prevailing risks, and the disconnect between bullish sentiment and hard data, the reality is the bull market remains intact.

Over the last several months we have been tracking the progress of the S&P 500 with pathways back to ‘all-time’ highs. The very quick retest of support, as noted last week, set the stage for the push to market highs.”

“With portfolios still long-biased, the question is what happens next, and how to play it.”

As I noted then, pathway #2a was the most logical probability given the short-term overbought condition of the market.

  • Pathway #2a: Is a bit more of an “exuberant” advance early next week which pulls back to the recent breakout level. The pullback consolidates a bit, works off some of the overbought condition, and then begins the next advance. Such a pullback would turn the previous resistance into support and provide a short-term “buyable” entry. (30%)

Here is the updated chart through Friday:

Currently, it is pathway #2a which continues to play out fairly close to the prediction from two weeks ago. But it is make, or break, next week as to whether pathway #2b comes into play. 

As I have repeatedly noted, we remain primarily allocated in our portfolios. However, we were looking for a pullback to support which holds before increasing our existing holdings further.

We have currently lined up our additions for each of our portfolio models but we will wait until next week to make additions until we are certain the current support levels will hold.

As shown in the bottom part of the chart above, the current “buy” signal has been reversed with the recent sell-off in the market. While these “sell” signals have been fairly short in nature over the past couple of months, they nonetheless denote downward pressure on asset prices currently. More importantly, with the market not entirely oversold, top panel of the chart above, there is room for further downside into early next week.

The other short-term issue that keeps us cautious is the “tech wreck” which has occurred over the last week. Given the technology sector makes up 26% of the S&P 500 currently, it is not surprising that “so goes tech, so goes the market.”

The same goes for Semiconductors which are economically sensitive. Morgan Stanley is suggesting memory markets are worsening going into the 4th quarter with inventory and pricing concerns (read tariffs) and weaker demand for DRAM products (read economy). As shown below, in the last 20-years there are only four other times where the Semiconductor index has been this overbought combined with a “sell” signal. With the index close to a monthly sell signal (we won’t know until the end of the month) the concerns by Morgan Stanley may be justified and may suggest more about the economy than is currently realized.

Important Note

At the end of this month, there will be significant changes to the makeup of the S&P 500 index as a new communications sector (XLC) is added to the mix. After the switch 3 of the 4 original “FANG” (FB, NFLX, & GOOG) companies will be in that group. These changes will have wide-reaching effects as the traditionally defensive telecommunications sector will now be the new “momo” sector and the technology sector will lose some of its “juice.” 

The new sector weightings will be as follows (chart courtesy of LPL.

Just for your reference here are the top-10 holdings of the ETF’s currently which will change on September 28th. I have highlighted the 4-FANG stocks.

But, until the end of the month, technology still leads the market. As shown in the chart above, the current short-term sell signal on the technology sector adds to the concern about potential downside risks early next week. The chart below is a look at technical support levels of a further short-term correction.

Support at 2860 should hold. If the market holds at 2860, which coincides with the current uptrend line (red), the odds of push back to recent highs is likely. A failure at 2860 will find support at 2825, 2800 and 2775.  These are key levels in the short-term to watch.

As Dana Lyons noted on Friday:

“The Presidential Cycle refers to the pattern of behavior in stock prices throughout the four years of a presidential term. Specifically, stocks tend to be strong during certain periods of a president’s term and weaker during others. And while there are many factors influencing stock prices during a particular period of a particular presidential term, the cycle has been one of the more historically consistent seasonal patterns.

This may be relevant to the current weakness because, on average, the worst performing month of the cycle, historically, has been September of year 2, i.e., the current month.”

“As the chart shows, since 1900, September of year 2 of the Presidential cycle has returned an average of -1.43%, slightly worse than September of year 3, February and September of year 1 and May of year 4.”

With the President talking about more tariffs against China on Friday, the risk to the market remains elevated with the earnings season boost behind us.

Cautiously Bullish

While we are short-term cautious, the intermediate-term technical outlook remains positive. This is particularly the case as we look to the more seasonally-strong last quarter of the year.

With the weekly “buy signal” intact, any short-term correction that doesn’t violate important support should be used to selectively add exposure as needed. As noted below, the only concern is the rally from the lows earlier this year have already pushed back into more extreme overbought territory. While this does suggest upside is potentially limited, overbought conditions can remain overbought for quite some time given enough momentum. If the indicator breaks below (-20) it would suggest a bigger corrective process is underway.

Again, for now, the bullish trend remains and we need to honor that as such.

That doesn’t mean it won’t change. It will, which means you must not neglect your portfolio management process. It is worth remembering that portfolios, like a garden, must be carefully tended to otherwise the bounty will be reclaimed by nature itself.

  • If fruits are not harvested (profit taking) they ‘rot on the vine.’ 
  • If weeds are not pulled (sell losers), they will choke out the garden.
  • If the soil is not fertilized (savings), then the garden will fail to produce as successfully as it could.

So, as a reminder, and considering where the markets are currently, here are the rules for managing your garden:

1) HARVEST: Reduce “winners” back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole plant from the ground.

2) WEED: Sell losers and laggards and remove them from the garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing “nutrients” that could be used for more productive plants. The first rule of thumb in investing “sell losers short.”

3) FERTILIZE AND WATER: Add savings on a regular basis. A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NEVER LOSE money investing in the markets…then STOP investing immediately.

4) WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn’t occur. Likewise, a portfolio protected against “risk” in the short-term, never harmed investors in the long-term.

With the overall market trend still bullish, there is little reason to become overly defensive in the very short-term. However, there are plenty of warning signs that the “good times” are nearing their end, which will likely surprise most everyone.

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:

As I noted last week:

“Despite the markets breaking out to all-time highs last week, there is definitely signs of rotation from previously leading sectors of the market to the laggards. This is shown below in the 10-week relative-rotation graph which compares performance relative to the S&P 500 index.”

That rotation continued this week with two of the more defensive sectors (healthcare and utilities) leading the S&P 500 while the former leaders of Discretionary, Technology, Small and Mid-Capitalization groups slipped from leading to weakening. Staples, Industrials and Financials are improving which suggest more a more defensive rotation will continue into next week.

We are watching for a potential entry point for the industrial sector which has begun to improve performance-wise, but we remain wary of the “tariff” risk as the White House and China continue to scale up the rhetoric.

Discretionary, Technology, and Staples – all took a breather last week after a strong previous advance. As we noted last week, this is what was needed before trying to add exposure to these areas.

Healthcare and Utilities – as noted above, maintained their strength after a very tough start to the year. As we stated two weeks ago, there is a movement to more defensive sectors of the market (late economic stage sectors) that is still occurring. Use pullbacks to support, and oversold conditions, to add exposure accordingly.

Financial, Energy, Industrial, and Material – while Industrial finally gained a bit of momentum due to earnings season, the risk of an ongoing, and acceleration of, tariffs and “trade wars” keeps us wary at the moment. However, the recent pick up in performance puts industrials back on our radar and we will look for a short-term oversold condition to add some selective exposure. Energy’s recent slump is again testing the 200-dma after failing at the 50-dma. This is not a positive sign and a break below the 200-dma, which will likely coincide with lower oil prices, will not only impair the sector but flash a bigger concern about the economy.  As we stated last week, the 50-dma acted as resistance. Stops should remain at the recent lows. Financials continue to languish along support but not showing much in the way of strength to support overweighting the sector currently.

Small-Cap and Mid Cap we noted last week that these markets were extremely overbought and extended, pullbacks to support is needed to add additional exposure. That pullback started last week, but a decent opportunity to add exposure at this time is not available. We continue to hold our target exposure and will look for opportunity as it comes.

Emerging and International Markets as I have repeated for the last few months:

“These sectors were removed in January from portfolios on the basis that “trade wars” and “rising rates” were not good for these groups. With the addition of the ‘Turkey Crisis,’ ongoing tariffs, and trade wars, there is simply no reason to add “drag” to a portfolio currently. These two markets are likely to get much worse before they get better. Put stops on all positions.”

 

The recent bounce again failed at the declining 50-dma. Positions should have been sold on that failed rally. Stops at the recent lows were triggered on Friday and suggests positions be closed out as lower levels are likely at this time.

Dividends and Equal weight continue to hold their own and we continue to hold our allocations to these “core holdings.” We will overweight these positions on a pullback to support that does not violate that level.

Gold – If you are still hanging onto Gold, we have been consistently providing stop loss levels and sell points since May of this year. These points have continued to decline. Two weeks ago we gave a rally sale point of $114 which was achieved. Stops remain at $111 this week. 

Bonds – bonds sold off on Friday with the employment report which showed an increase in nominal wage growth. That small bit of growth will be wiped away next week when CPI is reported and “real wages” are revealed. This is as good of a trading opportunity as there is to add bonds to portfolios. $118 is the stop with a target of $121.50. 

REIT’s keep bouncing off the 50-dma like clockwork. Despite rising rates, the sector has continued to catch a share of money flows and the entire backdrop is bullish for REIT’s. However, with the sector very overbought, take profits and rebalance back to weight and look for pullbacks to support to add exposure.

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:

Over the last several weeks, I have discussed the increases to equity exposure in portfolios as the market’s momentum has continued to push higher. However, we have done this cautiously by using pullbacks to support, which then subsequently broke out above resistance, to do so.

Last week, the market was able to hold above the “breakout” levels once again, so we will look to take the following actions within the next week or so. The pullback we have been looking for to provide a better entry point has occurred and with the market approaching a short-term oversold condition, this is a decent entry point. We will look for any strength on Monday as an opportunity to add a bit more risk to the mix to be positioned in portfolios for the potential year-end upside bias.

  • New clients: Add 50% of target equity allocations. 
  • Equity Model: Semiconductors (MU & KLAC) are on “Sell Alerts” – we will monitor closely and stop-loss levels have been tightened up. We will add a few new positions as needed. 
  • Equity/ETF blended – Same as with the equity model. 
  • ETF Model: We will overweight core “domestic” indices by adding a pure S&P 500 index ETF to offset lack of international exposure. We remain overweight outperforming sectors to offset underweights in under-performing sectors. 
  • Option-Wrapped Equity Model – Looking to add two new positions to the portfolio.

Again, we are moving cautiously. There is mounting evidence of short to intermediate-term risk of which we are very aware. However, the trend of the market remains positive, and we realize that short-term performance is just as important as long-term. It is always a challenge to marry both.

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


THE REAL 401k PLAN MANAGER

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

A Better Position

Over the last several weeks we have been discussing the issue of the breakout to new highs. We also noted that by the times these things happen the risk/reward set up is not optimal to increase equity exposure immediately. We have been suggesting waiting for a bit of “September” weakness to increase equity positions to full target weights. That weakness occurred last week, and any further weakness into early next week, which doesn’t violate support, will give us an opportunity to add exposure accordingly.

For now, and as we have repeatedly discussed over the last several weeks, just keep following the guidelines for your 401k plan closely.

  • 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 – begin increasing exposure towards domestic equity in small steps. (1/3 of what is required to reach target allocations.)
  • If you are at target equity allocations currently just rebalance weights to focus on domestic holdings.

While we officially upgraded our allocation model back to 100% exposure, there has been no rush to add additional equity risk. However, we are now in a better position to do so.

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

Elon Musk’s erratic behavior and the price of Tesla stock and bonds have been a constant source of news headlines in recent months. The incessant gyrations have been extremely confusing to investors who are caught between excitement about the company and the sector’s potential prospects and the risks that come from the stock’s lofty valuation, increasing competition, and the CEO’s mental state. In this brief piece, I will show key technical levels in Tesla stock that should help traders put the noise into perspective a bit more.

For the past year and a half, Tesla stock has been trading in a range between its $240 – $250 support zone and its $380 – $390 resistance zone. After failing to break above the $380 – $390 resistance zone in June and July, the stock plunged to the $240 – $250 support zone, where it now sits above. After such a sharp decline, there is a high probability of a technical bounce off this support. If the stock eventually closes below this support zone in a convincing manner, it would be a concerning sign that would likely signal even further declines ahead.

Tesla Chart

Doug Kass made an interesting observation about the market yesterday:

“The month of September started with optimism.

That optimism has faded in the last two trading days.

The most notable winners (year to date), FANG, have been particularly weak as investors begin to understand (thanks to the Congressional testimony and hearings) that the component companies’ costs will balloon in order to deliver a product that is palatable to the U.S. government and other authorities – something I have been suggesting for a while. As noted yesterday, many other former market leaders are also falling back in price.

While there has been some rotation (there always is), there have been no notable winning sectors (save the speculative marijuana space).

Meanwhile, over there, the European banks are making new lows as the European bourses dramatically underperform and diverge from the S&P Index. And China’s stock market is moving swiftly into bear market territory.

I continue to believe that we are in an ‘Acne Market’ in which Mr. Market’s complexion is changing for the worse.

Economically, global high-frequency data is growing ambiguous.

In terms of sentiment, investors seem unduly complacent in their optimism and I know no strategists who are even contemplating the possibility of a large market drawdown.

The bottom line is that the economic, policy (trade, etc.), political (midterm elections are only two months away), currency and geopolitical outcomes are numerous and growing: Many of those outcomes are market adverse.

Over the last few years, it has paid to buy the dip.

It might be different this time as a maturing economy and stock market are showing their rough edges – just when global monetary authorities are pivoting and many non-US fiat currencies are imploding.”

I addressed last week, that emerging markets are likely sending a signal which is being largely dismissed by mainstream analysis. At the end of September, unless things markedly improve over the next 3-weeks, emerging markets will trigger the 4th major “sell” signal in the last 20-years.

“In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)”

Currently, there is a high degree of complacency among investors, and Wall Street, the current bull market advance will continue uninterrupted into 2019. Targets are already being set for the S&P 500 to hit 3200, 3300, and higher.

While anything is certainly a possibility, it doesn’t mean that such will occur in a straight line either. The lack of leadership from the technology sector is certainly concerning given its extremely heavy weighting to the overall index. But likewise, the lack of performance from international markets also suggest “something isn’t quite right.” 

This also shows up in the Baltic Dry Index which is just a representation of the demand to ship dry goods. While the index bounced from the lows in 2016, as global central banks infused massive amounts of liquidity into the system, early indications suggest that the cycle of global growth has started to wane.

The biggest concern domestically remains the strength of earnings growth going forward as well. Currently, estimates remain extremely high and the drag from a stronger dollar, tariffs, and rising rates will likely bring estimates lower. As I noted last week:

“But looking forward, year over year comparisons are going to become markedly more troublesome even as expectations for the S&P 500 index continues to rise.”

While I am certainly hopeful the analysts are correct, as bull markets are much easier to navigate, the risk of disappointment is rising. As Doug notes, the contraction of monetary policy is beginning to take effect on the markets and the economy.

Risks are always under-appreciated when bullish enthusiasm prevails. But knowing when to “fall back” and regroup has always been a better strategy than fighting to the last man.

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


Economy & Fed


Markets


Most Read On RIA


Research / Interesting Reads


“I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up.” – Jesse Livermore

Questions, comments, suggestions – please email me.

Here we are, ten years after the bankruptcy of Lehman Brothers, and one would be hard pressed to find evidence of meaningful lessons learned.

“As long as the music is playing, you’ve got to get up and dance,” – Chuck Prince, Citigroup

Chuck’s utterance now sounds more like a quaint remembrance than a stark reminder. Ben Bernanke’s proclamation also sounds more like an “oopsie” than a dangerous misjudgment by a top official.

“We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers …” 

One of the most pernicious aspects of the financial crisis for many investors was that it seemed to come out of nowhere. US housing prices had never declined in a big way and subprime was too small to show up on the radar. Nonetheless, the stage was set by rapid growth in credit and high levels of debt. Today, eerily similar underlying conditions exist in the Chinese residential real estate market. Indeed, a lot of investors might be surprised to hear it called the most important asset class in the world.

China certainly qualifies as important based on rapid credit growth and high levels of debt. The IMF’s Sally Chen and Joong Shik Kang concluded [here],

“China’s credit boom is one of the largest and longest in history. Historical precedents of ‘safe’ credit booms of such magnitude and speed are few and far from comforting.”

The July 27, 2018 edition of Grants Interest Rate Observer assesses,

“Following a decade of credit-fueled stimulus, China’s banking system is the most bloated in the world.”

Jim Chanos, the well-known short seller, adds his own take on RealvisionTV [here], “So comparing Japan [in the late 1980s] to China, I would say Japan was a piker compared to where China is today. China has taken that model and put it on steroids.”

One of the lessons that was laid bare from the financial crisis of 2008 (and from Japan in the 1980s) was the degree to which easily available credit can inflate asset prices. This is especially true of real estate since it is so often financed (at least partially) with debt. The cheaper and easier credit is to attain, the easier it is to buy homes (or any real estate), and the higher prices go.

These excesses provide the foundation for one of the bigger (short) positions of Jim Chanos. He describes:

“China is building 20 million apartment flats a year. It needs about 6 to 8 to cover both urban migration and depreciation of existing stock. So 60% of that 25% is simply being built for speculative purposes, for investment purposes. And that’s 15% of China’s GDP of $12 trillion. Put another way, it’s about $2 trillion. That $2 trillion is 3% of global GDP.”

And so I can’t stress enough of just how important that number is and that activity is to global growth, to commodity demand, and a variety of different things. It [Chinese residential real estate] is the single most important asset class in the world.”

Chanos is not the only one who sees building for “speculative purposes” as an impending problem. Leland Miller, CEO of China Beige Book, describes in another RealvisionTV interview [here],

“The heart of the Chinese model is malinvestment. It’s about building up non-performing loans and figuring out what to do with them.”

The WSJ’s Walter Russell Mead captured the same phenomenon [here],

“Chinese leaders know that their country suffers from massive over-investment in construction and manufacturing, [and] that its real-estate market is a bubble that makes the Dutch tulip frenzy look restrained. Chinese debt is the foundation of the system.”

Increasingly too, household debt is becoming a problem. As the Financial Times reports [here], apparently China’s young consumers have:

“…rejected the thrifty habits of their elders and become used to spending with borrowed money. Outstanding consumer loans — used to buy cars, holidays, household renovations and other household goods — grew nearly 40 per cent last year to Rmb6.8tn, according to the Chinese investment bank CICC. Consumer loans pushed household borrowing to Rmb33tn by the end of 2017, equivalent of 40 per cent of gross domestic product. The ratio has more than doubled since 2011.”

Again, there are striking parallels to the financial crisis in the US. As Atif Mian and Amir Sufi report in their book, House of Debt, “When it comes to the Great Recession, one important fact jumps out: The United States witnessed a dramatic rise in household debt between 2000 and 2007—the total amount doubled in these seven years to $14 trillion, and the household debt-to-income ratio skyrocketed from 1.4 to 2.1.”

The inevitable consequence of unsustainable increases in household debt is that eventually those households will have to cut spending. When they do, “the bottom line is that very serious adjustments in the economy are required … Wages need to fall, and workers need to switch into new industries. Frictions in this reallocation process translate the spending decline into large job losses.”

In addition, just as the composition of consumers of debt affects the ultimate adjustment process, so too does the composition of its providers. For example, debt provided outside of the conventional banking system, such as from shadow banks, is not subject to the same reporting or reserve requirements.

Once again, the landscape of Chinese debt is problematic. Russell Napier states,

“The surge in non-bank lending in China has clearly played a key role in the rise of the country’s debt to GDP ratio and also its asset prices.”

Zerohedge adds [here] that the Chinese central government has become “alarmed at its [shadow banking’s] vast scale, and potential for corruption.”

Further, nebulous practices are not confined to the “shadows” in China. The FT reports [here],

“These [small] banks are quite vague and blurry when it comes to investment receivables … There’s so much massaging of the balance sheet, and they won’t tell you about their internal manoeuvrings.”

As it happens, “Problems at small banks matter because their role in China’s financial system is growing.” While China surpassed the eurozone last year to become the world’s largest banking system, “small and mid-sized banks have more than doubled their share of total Chinese banking assets to 43 per cent in the past decade.”

Nor is the lack of transparency confined to the financial system; it also extends to the entire economy. Miller describes,

“We’re constantly asked about how good Chinese data are. Is it all bad? It’s all bad, but it’s bad and different variations.” 

Chanos shared his opinion as well:

“As much as the macro stuff has intrigued me … what’s so interesting about China is the lower down you get, the more micro you get, the worse it looks, in that the companies don’t seem to be profitable, the accounting is a joke.”

Miller makes clear what the challenge is:

“[China] is the second largest economy in the world. This is probably the most mysterious big economy in the world. And people have been so willing to work on it based on guestimates.”

Normally, investors prefer certainty and discount uncertainty. The pervasive lack of discipline and due diligence echoes that of the structured debt products of the financial crisis.

Just as in the financial crisis, all of these excesses and shortcomings are likely to have consequences. Many of them will sound familiar [here]:

“[A] crisis of some kind is likely. The salient characteristics of a system liable to a crisis are high leverage, maturity mismatches, credit risk and opacity. China’s financial system has all these features.”

That said, the “flavor” of China’s crisis will depend on uniquely Chinese characteristics. Miller identifies an important one:

“I think the problem is that people didn’t understand that this is not a commercial financial system. That’s one of the major takeaways we stress all the time. This [China’s] is not a commercial financial system. What that means is when the Chinese are threatened, they can squash capital from one side of the economy to the other.”

In other words, China has substantial capability to manage liquidity and contagion risks.

As a result, according to Miller,

“We don’t spend a lot of time worrying about an acute crisis. If China falls and China does have the hard landing that a lot of people predicted, it’s not going to look like it did in the United States or in Europe. You have a state system, a state-led system in which almost all the counter-parties are either state banks or state companies. They’re not going to have the same freeze-up of credit that you did in some of these other Western economies.”

That said, there are still likely to be severe consequences. Miller reports,

“China has gotten themselves into a real difficult situation, because you have an enormous economy awash in credit that is leading to lesser and less productivity based on that capital. And that is why, rather than some sort of implosion, which could happen, or any type of miraculous continued prosperity indefinitely — we think that China’s economy is, for the most part, headed towards stasis.” More specifically he says, “So I think that we’re heading towards a Chinese economy which is going to slow down quite dramatically when we’re talking about 10, 15 years time.”

Indeed, it appears that process has started. As noted [here],

“Housing sales in China will peak this year and then begin a long-term decline, an inflection point that will drag on growth in the construction-heavy economy and hit global commodity demand, say economists.”

Throughout the process, Miller expects China to pursue a policy agenda designed to get the country “on a more sustainable track.” In particular, “that means cracking down on some of these bad debt problems, cracking down on shadow lending, becoming more transparent, injecting risk and failure into the system, and trying to build a stronger economy from that.” He is careful to note, however, “But it’s not easy.”

Neither will it be easy for investors to judge the puts and takes of various policy measures in a dynamic and opaque system. Henny Sender at the FT warns international investors [here]

“To take heed as Beijing continues a war against non-bank lenders and fintech companies that is tightening liquidity and spooking investors in mainland China.”

The FT also notes [here],

“New rules for recognising bad loans in China are set to obliterate regulatory capital at several banks” which will disproportionately affect small and mid-sized banks. Further, as reported [here], “the paring back of a state subsidy programme that provided Rmb2tn ($300bn) in cash support to homebuyers since 2014 is adding to structural factors weighing on the market.”

The good news is that investors can take several lessons from China and its residential real estate market. The first is that, like the US subprime market was, the Chinese real estate market is understated and under-appreciated. Perhaps it is because the numbers don’t seem that big. Perhaps it is because so few people have much clarity at all on what the numbers really are. Or perhaps it is just that people are making enough money that they don’t really care to look too hard. Regardless, just like with subprime in the US a decade ago, there are real problems.

Second, those problems will have consequences; investors should expect spillovers. As excesses in the country are unwound, the slowdown in Chinese economic growth will be felt around the world. China has driven global growth for at least a couple of decades. Further, residential real estate, with its strong economic multiplier and high degree of speculation, has been the rocket fuel for that growth. Reversal of those trends will feel like a substantial headwind. Further, lest US investors feel smug at the prospect of Chinese troubles, David Rosenberg warns [here],

“There is not a snowball’s chance in hell [the Chinese weakness] will not flow through to the US stock market.”

Where does all of this leave Chanos?

“Interestingly, we’re less short China now than we have been in eight years in our global portfolio. Because the rest of the world’s catching up. Although China’s been on a tear recently, Chinese stocks over the eight years are basically flat. And I’ve noticed that some of the other stocks have sort have tripled.”

Fundamentals are important, but so are prices paid.

A major complication of figuring out China will be determining the degree to which it’s domestic policy agenda influences actions on tariffs and trade and currency. Almost Daily Grants reported the findings of Anne Stevenson-Yang, co-founder of J Capital Research, on July 27, 2018:

“China’s credit-saturated economy … is the primary force behind the recent gyrations in FX. The reality is that China’s currency is most intimately connected, as with any currency, to the domestic economy – debt, asset prices, real estate prices, and efficiency gains and losses rather than just trade.”

In other words, don’t get distracted by the smaller stuff.

Despite all of these challenges, investors are not without tools to monitor the situation, however. Russell Napier reports [here],

“In general the copper price provides a good lead indicator to the market’s assumptions in relation to global growth. When it [the copper price] weighs the negative impact from an RMB devaluation and the positive impact from a Chinese reflation … the current indications are more negative for global growth than positive.”

The FT goes even further [here]:

“The metal [copper] is giving western investors a clear signal to sell risk assets or at least reduce their portfolio weighting.”

Perhaps the biggest lesson of all is that increasingly we live in a world of debt-fueled growth that shapes the investment proposition of financial assets. That means business cycles are increasingly overwhelmed by credit cycles. It means wider swings in financial assets — from euphoric highs to catastrophic lows. When the debt spigot turns off, it means the only “safe” assets are cash and precious metals. When the sparks fly, it’s hard to tell where they might land. And it means that whichever market has the highest debt and the fastest credit growth will be the “most important asset class in the world”.

Right now, that is Chinese residential real estate.

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