Monthly Archives: November 2018

In late-November, I warned that plunging oil prices and the bursting of a Fed-driven bubble in the shale energy industry would also cause a bust in high-yield or “junk” bonds (because the shale bubble is financed by high-yield bonds). High-yield bonds continued to plunge into late-December along with crude oil and stocks. Since Christmas, however, all three markets have rebounded sharply as many market participants think the worst is now over. But is it?

Fundamentally, nothing has changed. The bursting of the corporate debt bubble I’ve been warning about is still ahead and is unavoidable at this point. From a technical perspective, the breakdown that occurred in the
HYG high yield corporate bond ETF is still very much intact. Right now, the current rally is simply a re-test back to the key level known as a “neckline,” which was once a support level and is now a resistance level. If HYG bumps its head at this level (ie., can’t break back above), another powerful sell-off is very likely.

Billionaire “bond king” Jeff Gundlach feels the same way I do – “Use the strength we’ve seen in junk bonds as a gift and get out of them. Investors need to go into strong balance sheets…to survive the zigzag of 2019.” The recent bounce in high-yield bonds has helped to underpin the stock market rebound, but should the HY bond rally falter at the nearby resistance level, expect to see stocks head lower again. I’m taking a “wait-and-see” approach for now.

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

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

The Kansas City Federal Reserve posted the Twitter comment and graph below highlighting a very important economic theme. Although productivity is a basic building block of economic analysis, it is one that few economists and even fewer investors seem to appreciate.

The Kansas City Fed’s tweet is 100% correct in that wages are stagnating in large part due to low productivity growth. As the second chart shows, it is not only wages. The post financial-crisis economic expansion, despite being within months of a record for duration, is by far the weakest since WWII.

Productivity growth over the last 350+ years is what allowed America to grow from a colonial outpost into the world’s largest and most prosperous economic power. Productivity is the chief long-term driver of corporate profitability and economic growth. Productivity drives investment returns whether we recognize it or not.

Despite its foundational importance to the economy, productivity is not well understood. There is no greater proof than the hordes of Ivy League trained PhD’s at the Federal Reserve who have promoted extremely easy monetary policy for decades. It is this policy which has sacrificed productivity at the altar of consumption and short-term economic gains.

For more on the interaction between monetary policy and economic growth please read Wicksell’s Elegant Model.

What Drives Economic Activity

Economic growth is a direct function of productivity which measures the amount of leverage an economy can generate from its two primary inputs, labor and capital. Without productivity, an economy is solely reliant on the two inputs. Due to the limited nature of both labor and capital, they cannot be depended upon to produce durable economic growth over long periods of time.

Leveraging labor and capital, or becoming more productive, provides the dynamism to an economy. Unfortunately, productivity requires work, time, and sacrifice. It’s a function of countless factors including innovation, education, government policies, and financial incentives.

Labor

Labor, or human capital, is largely a function of the demographic makeup of an economy and its employees’ skillset and knowledge base. In the short run, increasing labor productivity is difficult. Realizing changes to skills training and education take time but they do have meaningful effect. Similarly, changes in birth rate patterns require decades to influence an economy.

Within the labor force, the biggest trend affecting current and future economic activity, both domestic and globally, is the so called “silver tsunami”, or the aging of the baby boomers. This outsized cohort of the population, ages 55 to 73 are beginning to retire at ever greater rates. As this occurs, they tend to consume less, rely more on financial support from the rest of the population, and withdraw valuable skills and knowledge from the workforce. The vast number of people in this demographic cohort makes this occurrence more economically damaging than usual. As an example, the old age dependency ratio, which measures the ratio of people aged greater than 65 to the working population ages 18-64, is expected to nearly double by the year 2035 (Census Bureau).

While the implications of changes in demographics and the workforce composition are numerous, they only require one vital point of emphasis: the significant economic contributions attributable to the baby boomers from the last 30+ years will diminish from here forward. As they contribute less, they will also require a higher allotment of financial support, becoming more dependent on younger workers.

Finally, immigration is also an important component in the labor force equation. Changes in immigration policies and laws are easier to amend to foster more immediate growth but political dynamics argue that pro-immigration policies and laws are not likely within the next few years.

Capital

Capital includes natural, man-made and financial resources. Over the past 30+ years, the U.S. economy benefited from significant capital growth, in particular debt. The growth in debt outstanding, a big component of capital, is shown broken out by sector in the graph below. The increase is stark when compared to the relatively modest level of economic activity that accompanied it (black line).

This divergence in debt and economic growth is a result of many consecutive years of borrowing funds for consumptive purposes and the misallocation of capital, both of which are largely unproductive endeavors. In hindsight we know these actions were unproductive as highlighted by the steadily rising ratio of debt to GDP shown above. The graph below tells the same story in a different manner, plotting the amount of debt required to generate $1 of economic growth. Simply, if debt were used for productive activities, economic growth would have risen faster than debt outstanding.Data Courtesy: Bloomberg, St. louis Federal Reserve

Data Courtesy: Bloomberg, St. Louis Federal Reserve

Productivity

Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found at the San Francisco Federal Reserve- (http://www.frbsf.org/economic-research/indicators-data/total-factor-productivity-tfp/)

The graph below plots a simple index we created based on total factor productivity (TFP) versus the ten year average growth rate of TFP. The TFP index line is separated into green and red segments to highlight that change in the trend of productivity growth rate that occurred in the early 1970’s. The green dotted line extrapolates the trend of the pre-1972 era forward.

Data Courtesy: San Francisco Federal Reserve

The graph below plots 10 year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line).

The stagnation of productivity growth started in the early 1970’s. To be precise it was the result, in part, of the removal of the gold standard and the resulting freedom the Fed was granted to foster more debt. For more information on this please read our article: The Fifteenth of August.  The graph above reinforces the message from the other debt related graphs – over the last 30 years the economy has relied more upon debt growth and less on productivity to generate economic activity.Data Courtesy: Bloomberg, St. Louis and San Francisco Federal Reserve

Demoting Productivity

Government deficit spending is sold to the public as economically beneficial. However, the simple fact that government debt as a ratio of GDP has continually grown, tells you this is a lie. Further, there is not just a financial cost to running deficits but an opportunity cost that is underappreciated or ignored altogether. The capital misallocated towards the government was not employed for ventures that may have resulted in economically beneficial productivity gains.

The government is not solely to blame. The Federal Reserve has used monetary policy to prod economic growth and deprive the economy of full economic recessions that clean up mal-investment. They have bailed out the largest enablers of unproductive debt. Their policies encourage public and private debt expansion, much of which has been unproductive as shown in this article.

We the people, also play a role. We drive bigger cars and live in bigger houses for example. We tend to spend more lavishly than generations past. Too much of this unproductive consumption is done with borrowed money and not savings. While these luxuries are nice, the economic benefits are very short-term in nature and come at the expense of the long-term benefits of more productive investment.

Summary

Given the finite ability to service debt outstanding and aforementioned demographic challenges, future economic growth, if we are to have it, will need to be based largely on gains in productivity. Current economic circumstances serve as both a wet blanket on economic growth and are clearly weighing on productivity by diverting capital away from productive uses in order to service that debt. Ill-conceived policies that impose an over-reliance on debt and demographics have largely run their course.

The change required will be neither easy nor painless but it is necessary.  Policy-makers will either need to become immediately responsive and take action to address these issues or discipline will be imposed by other involuntary means.

This is not just an economics story. Importantly, as investors in assets whose value and cash flows are dependent on these economic forces, we urge caution when the valuation of those assets is high as it is today amid such a challenging economic backdrop.

Baseball Hall of Famer and sage, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” But, as Morningstar’s Christine Benz notes, plugging in a return forecast is necessary for financial planning. Without it, it’s impossible to know how much to save and for how long. In this spirit, Benz has collected asset class return forecasts from large institutional investors and Jack Bogle, who is virtually an institution himself.

Because the forecasts are longer term, they are worth contemplating even if you can’t take them to the bank. Nobody knows what the market will do this year or next year. But it’s at least possible to be smarter about longer term forecasts. When you start at historically high valuations for stocks, such as those that exist now, it’s reasonable to assume future 7- or 10-year returns might be lower than average. In fact, the S&P 500 has returned less than 5% annualized (in nominal terms) since 2000 when it had reached its most expensive level (on a Shiller PE basis) in history. That’s only half of it’s long term average.

Below are the forecasts in table form and in bar chart form as Benz reports them. Some are nominal, and some are real; we’ve indicated which kind after the name of the institution.

At least two of the asset managers’ forecasts — GMO and Research Affiliates — take the Shiller PE seriously. That metric indicates the current price of the S&P 500 relative to the underlying constituents’ past 10-year real average earnings. When that metric is low, higher returns have tended to result over the next decade. And when it has been high, low returns have tended to result. Currently the metric is over 28. It’s long term average is under 17.

Investors should take all forecasts with a grain of salt. But when valuations are as high as they are now, it seems prudent to lower expectations.

As we are now in to day 26 of the government shutdown, the 800,000 federal employees and contractors being used as political pawns go without their first paycheck. This whole ordeal, while unfortunate, is a great reminder of what can happen to any of us: missing a paycheck:

Luckily many financial institutions have stepped up to the plate and done the right thing for the furloughed employees to modify loan agreements, waive late penalties and overdraft charges, but some may not be so forgiving.

What happens if you find yourself in this scenario? If you miss a paycheck, would life go on as you know it? The numbers say that for most, it’s doubtful. The Federal Reserve Board issued a report on the Economic Well-Being of U.S. Households last May and although most households are better off than they were a year ago, missing a paycheck could still make many cry or cringe. According to the study, only 4 out of 10 could meet a $400 emergency expense, or would do so by borrowing or selling something.

This takes us back to Personal Finance 101:

  • Spend less than you make.
  • Build an emergency fund.

We typically recommend that a dual income household have at least 3-6 months of expenses set aside in an emergency fund and a single income household 9-12 months. It always helps to know you have these funds to fall back on until things turn around. Life happens: people get laid off, companies or governments miss paychecks, and people get sick.

If these numbers seem lofty, don’t worry; they were lofty to everyone at one point.  Everyone must start somewhere. If you don’t have any savings now, start by trying to save $1,000. It’s amazing how many things that will fall into the “I need cash quick” range are under $1,000. Think about this: To save $1,000 in a year, you need to save $83 a month, or roughly $2.75 a day.  I notice that once people get on the right path to savings, they typically accumulate cash much quicker than they would have previously thought.

Do yourself and your family a favor and start an emergency fund or solidify it if you already have one. Don’t be afraid of holding cash, but also don’t leave it in an institution that won’t pay you any interest.  You can find banks that will pay you for holding your cash. Check out www.bankrate.com or www.nerdwallet.com as they are both good aggregators that will show you rates and rankings institutions that actually want your money.

Another alternative and something we have done for clients is find a money market that actually pays. We are currently finding rates north of 2%, but you have to look.  Short term bond funds, individual bonds or Treasury’s, while not as liquid, can also provide a boost to your savings with little risk.

If you have any questions, please don’t hesitate to email me.

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

ABBV – AbbVie, Inc.

  • Currently consolidating within a “pennant” formation.
  • A breakout to the upside would bring the target of $115 into focus.
  • Healthcare has been under pressure as of late as market is currently chasing momentum.
  • Position is close to triggering a short-term BUY signal
  • Short-Term Positioning: Bullish
    • Add to position: $90
    • Stop-loss is $82.50

CHCT – Community Healthcare Trust

  • Long-term trend line intact and recently bounced off that critical level.
  • Has been consolidating over last 6-months and the previous sell signal is close to reversing.
  • Short-Term Positioning: Bullish
    • Will look to add to position at $32
    • Stop-loss is currently $28
  • Long-Term Positioning: Bullish

DOV – Dover Corp.

  • Position has rallied nicely from oversold conditions.
  • Still on a sell signal currently which keeps our sell points and stop losses tight.
  • Short-Term Positioning: Bullish
    • Will look to exit the 1/2 position at $80.
    • If position breaks above resistance will look to add.
    • Stop-loss is currently $67.50

DUK – Duke Energy Corp.

  • Utilities have been under pressure as of late due to PG&E bankruptcy.
  • Trend remains very positive and support is near by.
  • Short-Term Positioning: Bullish
    • Looking to add to position if support holds at $62-64
    • Stop-loss is currently $60

JNJ – Johnson & Johnson

  • Bought 1/2 position for longer-term positioning.
  • Long-term trend support is holding.
  • Currently oversold and on a weekly sell signal. 
  • Short-Term Positioning: Cautious
    • Looking to add to position above $137.50
    • Stop-loss is currently $120
  • Longer-Term Positioning: Bullish

MDLZ – Mondelez International, Inc.

  • Stock trades in a very defined range so trading limits are tight.
  • Long-term support is holding,
  • Lot of overhead resistance at previous highs.
  • Currently on a very early sell-signal (bottom panel)
  • Overbought condition is being worked off.
  • Short-Term Positioning: Bullish
    • Sell Target: $44
    • Stop-loss is currently $38

NSC – Norfolk Southern Corp.

  • Bought 1/2 position with view to build out full position opportunistically.
  • Long-term trend line is currently resistance.
  • Sell signal is improving.
  • Currently coming off lower deviation band.
  • Short-Term Positioning: Bullish
    • Look to add to position on move above $165
    • Stop-loss is currently $140

PFE – Pfizer, Inc.

  • Long-term trend line is holding and bullish.
  • Currently on a sell signal and testing lower support.
  • Currently correcting overbought condition.
  • Short-Term Positioning: Bullish
    • Buy 2nd half of position at $44
    • Stop-loss is currently $42

VZ – Verizon Communications

  • Position bounced off support at 200-dma.
  • Currently on a buy signal. (bottom panel)
  • Short-Term Positioning: Bullish
    • Take profits at $60
    • Stop-loss moved up to $54

XOM – Exxon Mobil

  • With oil prices still trying to recover, upside remains in XOM.
  • Currently on a very deep sell-signal (bottom panel)
  • Very oversold and deviated from short-term moving average. 
  • Short-Term Positioning: Bullish (Trade Only)
    • Look to sell on a rally back to $75-77
    • Stop-loss moved up to $70

As the trumpets sound to signal the start of earnings season, the battle between fundamentals and “hope” begins. While earnings expectations have weakened markedly in recent months, the bulls remain steadfast in their belief the market correction is now over.

As I discussed in this past weekend’s missive :

“‘The stock market just got off to its best start in 13 years. The 7-session start to the year is the best for the Dow, S&P 500 and Nasdaq since 2006.’ – Mark DeCambre via MarketWatch

While headlines like this will certainly get ‘‘clicks’ and ‘likes,’ it is important to keep things is perspective. Despite the rally over the last several sessions, the markets are still roughly 3% lower than where we started 2018, much less the 11% from previous all-time highs.



Importantly, there has been a tremendous amount of ‘technical damage’ done to the market in recent months which will take some time to repair. Important trend lines have been broken, major sell-signals are in place, and major moving averages have crossed each other signaling downward pressure for stocks. 

“While the chart is a bit noisy, just note the vertical red lines. There have only been a total of 6-periods in the last 25-years where all the criteria for a deeper correction have been met. While the 2011 and 2015 markets did NOT fall into more protracted corrections due to massive interventions by Central Banks, the current decline has no such support currently. 

So, while there are many headlines circulating the ‘interweb’ currently suggesting the ‘Great Bear Market Of 2018’ is officially over, I would caution you against getting overly bullish too quickly.”

However, from a portfolio management perspective it is always a valuable exercise to analyze both sides of the argument to make a better investment decision. Therefore, let’s take a look at the technical case for the markets from both a bullish and bearish perspective.

THE BULL CASE

1) Big Rallies Happen Off Big Lows

It isn’t surprising. given the magnitude of the rally following the Christmas Eve low, the “bullish bias” would quickly return. There is precedent for such exuberance as well as recently noted by Bespoke.

As they showed in their table below, whenever there has previously been a sharp fall of more than 15% in a quarter, followed by a sharp rally of at least 10% in the following days, the markets were higher in the near future.

Such a combination of events has only occurred 12 times over the past 75 years, and the market was higher 75% of the time in 3-months and higher 83% of the time in 12-months.

But note that in some of these cases these were big rallies within the context of a bear market such as the rallies in 2001 and 2008.

2) The Fed Has Gone “Dovish”

In recent weeks, the previously “hawkish” Federal Reserve has become much more “dovish” suggesting a “pause” in monetary policy is possible if needed.

This change has not gone unnoticed by the bulls. Since Fed Chair Jerome Powell used the word “patient” when referring to the Fed’s approach to hiking interest rates, stocks went straight up. Given there had seemingly been a disconnect between the Fed, the markets, and the White House, the change was a welcome support for the bulls.

It is also believed the Fed will back off of their balance sheet reductions if needed, although Jerome Powell has not made any public indication such is an option currently.

While not really a “technical measurement,” such a change in monetary policy would certainly provide support for the bulls in the near term.

3) Advance-Decline Line Is Improving

The participation by stocks in the recent bullish advance has been strong enough to push the advance-decline line above the recent downtrend.

Such a rise in participation suggests the momentum behind stocks is supportive enough to push stocks to higher levels and should not be dismissed lightly.

Currently, as shown above, the short-term dynamics of the market have improved sufficiently enough to trigger an early “buy” signal. This suggests a moderate increase in equity exposure is warranted given a proper opportunity. However, to ensure that the current advance is not a “head-fake,” as repeated seen previously, the market will need to reduce the current overbought condition without violating near-term support levels OR reversing the current buy signal.

There is a good bit of work to do to satisfy those conditions, but things are indeed improving.

Let me be VERY CLEAR – this is VERY SHORT-TERM analysis. From a TRADING perspective, there is a tradeable opportunity. This DOES NOT mean the markets are about to begin the next great secular bull market. Caution is highly advised if you are the type of person who doesn’t pay close attention to your portfolio OR have an investment startegy based on “hoping things will get back to even” rather than selling.


THE BEAR CASE

The bear case is more grounded in longer-term price dynamics – weekly and monthly versus daily which suggests the current rally remains a reflexive rally within the confines of a more bearish backdrop.

1) Short-Term: Market Rally On Declining Volume

The recent market rally, while strong, occurred amidst declining volume suggesting more of a short-covering rally rather than a conviction to a “bull market” meme.

Furthermore, the rally which was one of the strongest seen in the last decade, barely retraced 38.2% of the previous decline. In order for the market to reverse the current “bearish” context, it will require a substantial move higher back above the 200-day moving average.

Given the economic and fundamental backdrop currently at play, such a rally will likely prove to be very challenging.

2) Longer-Term Dynamics Still Bearish

If we step back and look at the market from a longer-term perspective, where true price trends are revealed, we see a very different picture emerge. As shown below, the current dynamics of the market are extremely similar to those of the previous two bull market peaks. Given the deterioration in revenues, bottom-line earnings, and weaker economics, the backdrop between today and the end of previous bull markets is consistent. 

In both previous cases, the market peaked in a consolidation process, broke down through longer-term major trend lines, and did so on falling momentum combined with a long-term moving average convergence-divergence (MACD) “sell” signal.

3) Bonds Ain’t “Buyin’ It”

If a “bull market” were truly taking place we should see a flight from “safety” back into “risk.” As shown below, the declines in the stock-bond-ratio has been coincident with both short and long-term market corrections.

Currently, we are not seeing “risk taking” being a predominate factor at the moment. Could this change, absolutely. However, currently, despite the surge in the markets from the December lows, both Treasury yields and the stock/bond ratio have remained fairly firm.

Such continues to suggest the current market rally remains a “counter-trend rally” within the context of an ongoing correction.


What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case being built to warrant taking some equity risk on a very short-term basis. 

However, the longer-term dynamics are clearly bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the “risk” of having excessive exposure to the markets greatly outweighs the potential “reward. “

Could the markets rocket higher as some analysts currently expect? It is quite possible particularly if the Federal Reserve reverses course and becomes much more accommodative.

For now the upside remains limited to roughly 80 points as compared to 230 points of downside.

Those are odds that Las Vegas would just love to give you. 

Guest Post by Michael Kahn, CMT. 

Mike is a Chartered Market Technician (CMT), Columnist, Editor, Analyst, Instructor, Speaker and Author of three books on technical analysis.


It is always difficult for we humans to separate our gut feelings from cold, hard data. After all, the latter is why we built computers so we don’t have to worry about those silly facts. I know I personally prefer to act on whims based on my extensive life experience as they masquerade for analysis.

That is why in the midst of on-again, off-again trade wars, budget battles, political fracturing, the Fed and slowing global growth it is completely uncomfortable to look at the data and buy this market.

Is it the blood in the streets that Rothschild espoused? Or is it fearful enough for Buffet’s “buy when others are fearful?” Maybe. The VIX did reach a peak of 36 a short while ago but that’s still just run-of-the-mill fearful.

But then along comes retired institutional market analyst and technician Walter Deemer to spoil the pity party (sorry, Puddles). He’s been tracking the Lowry’s 90% day signals throughout this current market turmoil and reported several of the bullish variety in the past few weeks.

Just so you know, a 90% upside day occurs when 90% of the volume and 90% of the points happen to the upside. It’s a little hard to do on your own and most people cheat a little by using 90% of the stocks moving (advancers) as a proxy for points. But you get the idea.

Paul Desmond, the late chief at Lowry’s, published the full set of rules for this signal but in a nutshell, market bottoms are likely when a few upside days follow the downside days. It tells us there was some panicky action to sell followed by enthused action to buy. The tide rolled out (go Clemson!) and then rolled back in.

Of course, we see a lot of isolated upside days in bear markets so it is important to have a few upside signals in a cluster. Clustering is even more important when there are only 80% upside days, instead of 90%. Clustering of both kinds seems to be the case now.

And then on January 4 (a Friday), Deemer tweeted this:

‘Another 90% upside day followed by a Whaley Breadth Thrust to confirm an intermediate bottom and Breakaway Momentum to confirm a four-year cycle low.’

I am not well versed in these two indicators so here is my look-see: Wayne Whaley published his findings in 2009 for his Advance Decline Thrust (ADT) indicator. It is simply the sum of advances for N periods (usually five) over the sum of advances plus declines over that same period. A reading above 70% is pretty good but above 75% is really good.

And now for Breakaway Momentum (BAM), from Walter’s own writings:

“Breakaway momentum (some people call it a “breadth thrust”) occurs when ten-day total advances on the NYSE are greater than 1.97 times ten-day total NYSE declines. It is a relatively uncommon phenomenon.”

As you can see, they are similar. And so is the Zweig Breadth Thrust, which looks a 10-day average of advances over advances plus declines to move from a very bearish 40% to a very bullish 61.5% in a 10-day span. Here is what that indicator looks like today:

Winner, winner, chicken dinner. It makes no sense that the market is so happy but that’s a gut reaction, not a data reaction. It’s not what we expect but there it is.

I’ll close with an excerpt from Whaley’s report which really gives us a good understanding of what all this breadth trusting is all about.

“Market rallies have been appropriately compared to the launch of a rocket. In order for a rocket to have enough momentum to exit the Earth’s atmosphere, the ship must be launched with enough initial force to defy the earth’s gravity and penetrate the Earth’s atmosphere. The theory is the market has an atmosphere of boundaries as well, made up of old trading ranges, resistance lines, and the tendencies of investors to pocket short-term profits. If the market is to have a chance of overcoming its own atmospheric constraints, the initial rally must be propelled with a thrust adequate in force to send the market through the levels of resistance that thwarted previous such launches.”

The fuel for that thrust is market breadth.

Deemer says the market today is very close to a BAM signal (as of publication midday Jan. 8) but cautions that there have been near-misses before. He’s waiting for the full signal.

I’m a bit more encouraged but then again, I’ve only been at this chart stuff for 31 years. Walter has 23 years more than that.

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

Basic Materials

  • Long-term trend line is currently broken
  • Previous support from February lows has been broken and is now resistance.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being reduced. (top panel)
  • Running into downtrend resistance.
  • Short-Term Positioning: Neutral
    • Last Week: Buy with target of $55
    • This Week: Sell 1/2 Position
    • Stop-loss moved up to $50
  • Long-Term Positioning: Bearish

Communications

  • Long-term trend line is currently broken
  • Previous support from February lows was broken and is now being tested
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being worked off.
  • Running into resistance at downtrend.
  • Short-Term Positioning: Neutral
    • Last Week: Buy with target of $47
    • This Week: Sell 1/2 position
    • Stop-loss moved up to $42
  • Long-Term Positioning: Bearish

Energy

  • Long-term trend line is currently broken
  • Previous support from February lows has been broken but sector is currently sitting on very minor support.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being worked off.
  • Running into downtrend resistance
  • Short-Term Positioning: Neutral
    • Last week: Buy with target of $64
    • This week: Sell 1/2 position
    • Stop-loss moved up to $60
  • Long-Term Positioning: Bearish

Financials

  • Long-term trend line is currently broken
  • Previous support from 2017 consolidation is currently holding.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition being worked off.
  • Short-Term Positioning: Bullish
    • Last week: Buy with target of $26
    • This week: Sell 1/2 position
    • Stop-loss moved up to $24
  • Long-Term Positioning: Bearish

Industrials

  • Long-term trend line is currently broken
  • Previous minor support from late 2016 is currently holding.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition being worked off.
  • Sector pushing up into downtrend resistance
  • Short-Term Positioning: Neutral
    • Last week: Buy with target of $70
    • This week: Sell 1/2 position
    • Stop-loss moved up to $65
  • Long-Term Positioning: Bearish

Technology

  • Long-term trend line is currently broken
  • Previous minor support from 2017 is holding for now.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition being worked off.
  • Pushing up into downtrend resistance
  • Short-Term Positioning: Neutral
    • Last week: Buy with target of $64
    • This week: Sell 1/2 position
    • Stop-loss moved up to $60
  • Long-Term Positioning: Bearish

Staples

  • Long-term trend line is currently broken
  • Previous support from 2016 and 2017 is holding.
  • Currently on an early sell-signal (bottom panel)
  • Currently oversold on short-term basis.
  • Short-Term Positioning: Bullish
    • Last week: Buy with target of $54
    • This week: Sell 1/2 position.
    • Stop-loss is currently $50
  • Long-Term Positioning: Bearish

Real Estate

  • Long-term trend line is currently holding.
  • Lots of resistance at previous price peaks going back to 2016.
  • Currently on an early sell-signal (bottom panel)
  • Currently oversold (top panel)
  • Short-Term Positioning: Neutral
    • Last week: Buy with target of $31.50
    • This week: Sell 1/2 position
    • Stop-loss moved up to $31.50
  • Long-Term Positioning: Bearish

Utilities

  • Long-term trend line remains intact.
  • Previous support continues to hold.
  • Currently close to an early sell signal. (bottom panel)
  • Oversold on a short-term basis.
  • Short-Term Positioning: Neutral
    • Last week: Buy at current levels
    • This week: Buy or Add to position
    • Stop-loss is currently $51
  • Long-Term Positioning: Bullish

Health Care

  • Sector broke the longer term trend which is now primary resistance.
  • Currently on a very deep sell-signal (bottom panel)
  • Overbought condition is being worked off. (top panel)
  • Short-Term Positioning: Neutral
    • Last week: Buy on pullback to $80
    • This week: Sell 1/2 position
    • Stop-loss moved up to $84
  • Long-Term Positioning: Neutral

Discretionary

  • Long-term trend line has been broken.
  • Previous support was violated but sector is attempting to reclaim it.
  • Currently on a very deep sell signal. (bottom panel)
  • Oversold condition being reversed
  • Sector pushing into downtrend resistance.
  • Short-Term Positioning: Neutral
    • Last week: Buy at current levels with target of $110
    • This week: Sell 1/2 position
    • Stop-loss moved up to $100
  • Long-Term Positioning: Bearish

Transportation

  • Long-term trend line has been violated.
  • Previous support is holding for now.
  • Currently on a very deep sell signal. (bottom panel)
  • Oversold on a short-term basis.
  • Short-Term Positioning: Neutral
    • Last week: Buy at current levels
    • This week: Sell 1/2 of position
    • Stop-loss moved up to $54
  • Long-Term Positioning: Bearish
I was digging through some old charts over the weekend and stumbled across this gem from AlphaTrends which explains the “best time to buy stocks.”

“Is it possible to time the market cycle to capture big gains?

Like many controversial topics in investing, there is no real professional consensus on market timing. Academics claim that it’s not possible, while traders and chartists swear by the idea.

The following infographic explains the four important phases of market trends, based on the methodology of the famous stock market authority Richard Wyckoff.

The theory is that the better an investor can identify these phases of the market cycle, the more profits can be made on the ride upwards of a buying opportunity.”

So, the question to answer, obviously, is:

“Where are we now?”

I’m glad you asked.

Let’s take a look at the past two full-market cycles, using Wyckoff’s methodology, as compared to the current post-financial-crisis half-cycle. While actual market cycles will not exactly replicate the chart above, you can clearly see Wyckoff’s theory in action.

1992-2003

The accumulation phase, following the 1991 recessionary environment was evident as it preceded the “internet trading boom” and the rise of the “dot.com” bubble from 1995-1999.

As I noted last week:

“Following the recession of 1991, the Federal Reserve drastically lowered interest rates to spur economic growth. However, the two events which laid the foundation for the ‘dot.com’ crisis was the rule-change which allowed the nations pension funds to own equities and the repeal of Glass-Steagall which unleashed Wall Street upon a nation of unsuspecting investors.

The major banks could now use their massive balance sheet to engage in investment-banking, market-making, and proprietary trading. The markets exploded as money flooded the financial markets. Of course, since there were not enough “legitimate” deals to fill demand and Wall Street bankers are paid to produce deals, Wall Street floated any offering it could despite the risk to investors.”

The distribution phase became evident in early-2000 as stocks began to struggle.

While the names of Enron, WorldCom, Global Crossing, Lucent Technologies, Nortel, Sun Micro, and a host of others are “ghosts of the past,” relics of an era the majority of investors in the market today are unaware of, they were the poster children for the “greed and excess” of the preceding bull market frenzy.

As the distribution phase gained traction, it is worth remembering the media and Wall Street were touting the continuation of the bull market indefinitely into the future. 

Then, came the decline.

2003-2009

Following the “dot.com” crash investors had all learned their lessons about the value of managing risk in portfolios, not chasing returns and focusing on capital preservation as the core for long-term investing.

Okay. Not really.

It took about 27 minutes for investors to completely forget about the previous pain of the bear market and jump headlong back into the creation of the next bubble leading to the “financial crisis.” 

During the mark-up phase investors once again piled into leverage. This time not just into stocks, but real estate, as well as Wall Street, found a new way to extract capital from Main Street through the creation of exotic loan structures. Of course, everything was fine as long as interest rates remained low, but as with all things, the “party eventually ends.”

Once again, during the distribution phase of the market, the analysts, media, Wall Street, and a rise of bloggers, all touted “this time was different.” There were “green shoots,” it was a “Goldilocks economy,” and there was “no recession in sight.” 

They were disastrously wrong.

Sound familiar?

2009-Present

So, here we are, a decade into the current economic recovery and a market that has risen steadily on the back of excessively accommodative monetary policy and massive liquidity injections by Central Banks globally.

Once again, due to the length of the “mark up” phase, most investors today have once again forgotten the “ghosts of bear markets past.” Despite a year-long distribution in the market, the same messages seen at previous market peaks have been steadily hitting headlines: “there is no recession in sight,” “the bull market is cheap” and “this time is different because of Central Banking.”

Lost And Found

There is a sizable contingent of investors, and advisors, today who have never been through a real bear market. After a decade long bull-market cycle, which only seems to go up, you can certainly understand why mainstream analysis continues to believe the markets can only go higher.

What is concerning is the rather cavalier attitude the mainstream media takes about bear markets.

“Sure, a correction will eventually come, but that is just part of the deal.”

What gets lost during these bullish cycles, and is found in the most brutal of fashions, is the devastation caused to financial wealth during the inevitable decline.

Let’s look at the S&P 500 inflation-adjusted total return index in a different manner. The first chart shows all of the measurement lines for all the previous bull and bear markets with the number of years required to get back to even.

What you should notice is that in many cases bear markets wiped out essentially a substantial portion, if not all, of the previous bull market advance. This is shown more clearly when we look at a chart of bull and bear markets in terms of points.

Whether or not the current distribution phase is complete, there are many signs suggesting the current Wyckoff cycle may be entering its final stage of completion. 

Let me remind you of something Ben Graham said back in 1959:

“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’

The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound,  then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.

In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”

He is right, of course, things are little different now than they were then.

For every “bull market” there MUST be a “bear market.” 

While “passive indexing” sounds like a winning approach to “pace” the markets during an advance, it is worth remembering that approach will also “pace” the decline.

The recent sell-off should have been a wake-up call to just how quickly things can change and how damaging they can be.

There is no difference between a 100% gain and a 50% loss.

(For the mathematically challenged: If the market rises from 1000 to 2000 it is a 100% gain. A fall from 2000 to 1000 is a 50% loss. Net return is 0%)

Understanding that investment returns are driven by actual dollar losses, and not percentages, is important in the comprehension of how devastating corrections can be on your financial outcome. So, before sticking your head in the sand and ignoring market risk based on an article touting “long-term investing always wins,” there is a huge difference between just making money and actually reaching your financial goals.

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

  • Long-term trend line is currently broken.
  • Recent rally pushed above initial resistance and is now testing resistance at Oct and Nov lows.
  • Downtrend line from all-time highs is converging with 200-dma (green dashed line) providing additional downward resistance.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being worked off.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended “buy” with target of $260
    • This Week: Sell 1/2 of position
    • Stop-loss moved up to $250
  • Long-Term Positioning: Bearish

Dow Jones Industrial Average

  • Long-term trend line is currently broken
  • Recent rally pushed above initial resistance and is now testing resistance at Oct and Nov lows.
  • The 200-dma (green dashed line) providing additional resistance at the Oct and Nov lows.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being worked off.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended “buy” with target of $240
    • This Week: Sell 1/2 of position
    • Stop-loss moved up to $232.50
  • Long-Term Positioning: Bearish

Nasdaq Composite

  • Long-term trend line is currently broken
  • Recent rally pushed above initial resistance and is now testing resistance at Oct and Nov lows.
  • Downtrend line from all-time highs is converging with 200-dma (green dashed line) providing additional downward resistance.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being worked off.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended “buy” with target of $160
    • This Week: Sell 1/2 of position
    • Stop-loss moved up to $150
  • Long-Term Positioning: Bearish

S&P 600 Index (Small-Cap)

  • Long-term trend line is currently broken
  • Recent rally pushing into downtrend line from all-time highs
  • 200-dma (green dashed line) providing additional overhead resistance to rally.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being worked off.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended “buy” with target of $65
    • This Week: Sell 1/2 of position
    • Stop-loss moved up to $62
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • Long-term trend line is currently broken
  • Recent rally is pushing into initial resistance at the Oct and Nov lows.
  • Downtrend from all-time highs and the 200-dma (green dashed line) are providing additional downward resistance.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being worked off.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended “buy” with target of $325
    • This Week: Sell 1/2 of position
    • Stop-loss moved up to $310
  • Long-Term Positioning: Bearish

Emerging Markets

  • Long-term trend line is currently broken
  • Recent rally pushed above initial resistance and is now testing the highs of the bottoming process over the last several months.
  • Market has broken above the downtrend line from last-years highs
  • The “sell signal” is close to being reversed (bottom panel)
  • Currently pushing back into very overbought conditions. (red circle)
  • Short-Term Positioning: Bullish
    • Last Week: Recommended “buy” with target of $41
    • This Week: Sell 1/3 of position and look for pullback which does not violate the downtrend line to add back, or initiate, a position.
    • Stop-loss remains at $38
  • Long-Term Positioning: Bearish

International Markets

  • Long-term trend line is currently broken
  • Recent rally pushing into resistance at the Oct and Nov lows.
  • Downtrend from all-time highs is converging with 200-dma (green dashed line) providing additional downward resistance.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is almost fully reversed.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended “buy” with target of $62
    • This Week: Sell 1/2 of position
    • Stop-loss moved up to $60
  • Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

  • Long-term trend line is currently broken
  • Recent rally pushing into resistance at top of 3-year channel.
  • Currently on very deep sell-signal (bottom panel)
  • Oversold condition is being worked off.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended “buy” with target of $60
    • This Week: Sell 1/3 of position
    • Stop-loss moved up to $50
  • Long-Term Positioning: Bearish

Gold

  • Long-term trend line has been recovered.
  • Recent rally is pushing into resistance at previous minor tops. More resistance at 3-year highs.
  • Currently on “buy” signal (bottom panel)
  • Overbought on short-term basis. Needs pullback to allow for better entry point.
  • Short-Term Positioning: Bullish
    • Buy On Pullback To $120
    • Stop-loss is currently $119
  • Long-Term Positioning: Improving From Bearish To Bullish

Bonds (Inverse Of Interest Rates)

  • Long-term support continues to hold at $111.
  • Currently on a buy-signal (bottom panel)
  • Recent pullback is reducing overbought condition. (top panel)
  • Resistance currently overhead at $124.50
  • Strong support at the 720-dma (2-years) (green dashed line)
  • Short-Term Positioning: Bullish
    • Last Week: Set “entry point” at $121
    • This Week: Reducing “entry point” to $119-120
    • Stop-loss remains at $117
  • Long-Term Positioning: Bullish

Are technology stocks cheap? It seems like a strange question to ask as the market drops on news that Apple has indicated weaker future sales. I also doubted whether Facebook’s price reflected its business value in the middle of this past summer. I thought fair value for the business was around $140 per share assuming it could grow its free cash flow by a robust 6% annually over the next decade. The stock is now in the $130 range after pushing higher than $200 in the early summer.

But technology isn’t just the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google). And at least two important firms – DoubleLine and GMO – think the sector is at least relatively cheap. Here’s why.

First, technology is trading cheaply on a Shiller PE basis, shown by the fact that the DoubleLine Shiller Enhanced CAPE Fund (DSEEX) holds the sector. By using a bond portfolio as collateral, this fund gains exposure to an equity derivative that delivers exposure to four of the five cheapest S&P sectors (tossing the one with the worst one-year price momentum) on the basis of their Shiller PE ratios — and technology is one of those sectors currently. The Shiller PE, as a reminder, is the current price of a stock, sector, or index relative to its past decade’s worth of real, average earnings. Right now (and for more than a year) technology has come up as one of the four sectors the fund owns, meaning its Shiller PE is lower relative to its own historical average than other sectors’ Shiller PEs are to theirs. The other sectors the fund owns currently are Healthcare, Consumer Staples, and Communication Services.

This mechanical application of the Shiller PE may not satisfy investors looking for more a more absolute definition of value, but, relative to other sectors, technology is cheap on a serious valuation metric. If you’re going to be allocated to U.S. stocks in some way, shape, or form, this is a reasonable way to achieve that allocation.

Second, GMO, which is also a fan of the Shiller PE metric, and uses it in its asset class valuation work, also likes technology stocks. The Boston-based firm just published a white paper, written by Tom Hancock, the head of the firm’s Focused Equity Team, arguing that technology stocks were attractive. The firm’s “Quality” strategy has 45% of its assets in technology stocks, “including positions in three of the five FAANG stocks.” Alphabet (Google) and Apple are the two largest holdings of the firm’s Quality mutual fund (GQETX), managed by Hancock.

Rather than relying on traditional valuation metrics when picking individual stocks, the firm looks at how Alphabet, for example, invests in R&D, and how that investment can translate into higher future revenues. In other words, R&D isn’t properly counted as an expense that will never yield future revenue and earnings growth. On the basis of accounting adjustments like this, GMO views Alphabet as a cheap stock.

Hancock notes that GMO’s Quality portfolio doesn’t trade at traditional valuation multiples that are different from the broader market. But, “in an expensive market, quality companies typically trade at higher P/E’s than most ‘value’ investors would like.” Higher multiples are justified for companies with resilient margins and strong business models, and Hancock thinks the strategy can produce returns of 5% in excess of inflation.

Quality companies in the U.S. are also cheaper than those outside of the U.S., and Hancock surmises that’s because of a kind of scarcity value. Companies with consistently high margins and returns on invested capital are less prevalent outside of the U.S., so they trade at dearer prices.

Moreover, the U.S. technology sector consists of a diverse group of stocks. Only one of the FAANGs – Apple – is in the top-10 of the S&P 500 Information Technology Sector. Some of the largest constituents of that sector are the darlings from the technology bubble of nearly 20 years ago – Microsoft, Intel, Cisco, and Oracle. They turned out to be good businesses that were just overpriced then. Hancock lists Microsoft’s virtues as being in the cloud growth business and having a lock on the consumer. Qualcomm, by contrast, has a unique position in the smartphone supply chain, while Oracle provides legacy software and benefits from high switching costs. Finally, Visa and Mastercard are “borderline tech” companies, but, nevertheless, find themselves near the top of the S&P 500 Information Technology sector.

So, despite being known for top-down asset class valuation calls, the GMO Quality strategy is bottom-up and fundamentally oriented. And, just like the more mechanical, single-factor approach of the DoubleLine fund, it also finds technology stocks cheap – or cheaper than their brethren in other sectors.

B

Both the DoubleLine Shiller Enhanced CAPE fund and the GMO Quality III fund are worthy of investors’ consideration. Beware that the latter is for institutional investors, given its $10 million minimum. Get in touch with us if you have questions about portfolio construction, asset management, or financial planning.


  • Bull Rallies & Market Tops
  • Sector & Market Analysis
  • 401k Plan Manager

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Bull Rallies & Market Tops

Last week, we discussed the fulfillment of our expectations for a bull rally. While the rally was attributed to the rather “dovish” stance taken by Jerome Powell and commentary from the White House on potential progress on resolving the “trade war” with China. The reality is it had little to do with those headlines but was simply a reversal of the previous “exhaustion extreme” of sellers during November and December. 

The rally, as we laid out two weeks ago, continues to work within the expected range back to 2650-2700. 

Importantly, the previous deep “oversold” condition which was supportive of the rally following Christmas Eve has now been fully reversed back into extreme “overbought” territory. While this doesn’t mean the current rally will immediately reverse, it does suggest that upside from current levels is likely limited. 

Nonetheless, the rally from the December lows has been impressive. However, I want to caution investors from extrapolating a deeply oversold bounce into something more than it is.

Beware The Headlines

“The stock market just got off to its best start in 13 years. The 7-session start to the year is the best for the Dow, S&P 500 and Nasdaq since 2006.” – Mark DeCambre via MarketWatch

While headlines like this will certainly get “clicks” and “likes,” it is important to keep things is perspective. Despite the rally over the last several sessions, the markets are still roughly 3% lower than where we started 2018, much less the 11% from previous all-time highs.


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Importantly, there has been a tremendous amount of “technical damage” done to the market in recent months which will take some time to repair. Important trend lines have been broken, major sell-signals are in place, and major moving averages have crossed each other signaling downward pressure for stocks. 

While the chart is a bit noisy, just note the vertical red lines. There have only been a total of 6-periods in the last 25-years where all the criteria for a deeper correction have been met. While the 2011 and 2015 markets did NOT fall into more protracted corrections due to massive interventions by Central Banks, the current decline has no such support currently. 

So, while there are many headlines circulating the “interweb” currently suggesting the “Great Bear Market Of 2018” is officially over, I would caution you against getting overly bullish too quickly. 

Tops Are A Process

 As my friend and colleague Doug Kass wrote previously:

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

He is correct.  

There have been several suggestions as of late that last years slide from October into December was simply a correction. Here is Mark Hulbert’s take:

“The stock market’s recent correction has been more abrupt than you’d expect if the market were in the early stages of a major decline.

I say that because one of the hallmarks of a major market top is that the bear market than ensues is relatively mild at the beginning, only building up a head of steam over several months. Corrections, in contrast, tend to be far sharper and more precipitous.”

However, I disagree.

I think Mark’s mistake is in simply looking at the plunge from the mid-year highs rather than the entire topping process which started in November of 2017. 

After a record breaking number of positive months in 2017 with extremely low volatility; 2018 was a year where volatility returned as prices consolidated in a very broad range. Notice there was important price support being built by the markets by repeatedly testing price levels over time before giving way. 

“So…is the bear market over OR is it just starting?”

The honest answer is “I don’t know.”

But, anything is certainly possible. 

However, a look back through history at previous “bear market beginnings” can certainly give us some things to consider.

1974 

After two previous bear market declines, as I discussed just recently with respect to “Secular Bear Markets,” the S&P 500 broke out to all-time highs convincing the “bulls” the worse was over. 

It wasn’t.

Over the next several months the markets continued in volatile trade,  retesting support several times before breaking down. 

But, at this point, it was still believed just to be a correction.

The change occurred when the market rallied, and failed, at the previously broken support line.

That “failure point” marked the beginning of the “1974 Bear Market.”

1999

After the “Long-Term Capital Management” and the “Asian Contagion,” the market regained its footing and began a rampant run to all-time highs in 1999. The bulls were clearly in charge, and despite concerns of “Y2K,” stocks continued to press new highs. 

While Jim Cramer was busy publishing his list of the “Top 10 Stocks For The Next Decade,” the market begin to struggle to make new highs as volatility rose.

The early decline from “all-time highs” was only considered a correction as the demand by the bulls to “buy the dip” rang out loudly. 

“I think you’ll see healthier and broader advances in the market. Now is the time for optimism,” said Bill Meehan, chief market analyst with Cantor Fitzgerald (4/14/2000)

It wasn’t.

In early 2001, the market broke the support line that had contained the market over the last 24-months. 

Not to worry, it was simply just part of the “correction process” and many commentators on CNBC at the time were suggesting it was a “buying opportunity.” 

It wasn’t. 

The market rallied back, and failed, at the previously broken support line. 

That point marked the end of the topping process and the beginning of the “Dot.com Crash.” 

2007

In 2006, the market was rallying as “real estate” was going wild across the country. Firms were hocking every type of exotic mortgage derivative they could find, leverage being laid on without concern, and pension funds were being pitched “high yield” opportunities. 

As the market broke out to new highs, there was little concern as there was “no recession in sight,” “subprime mortgages were contained,” and it was a “Goldilocks economy.”

Over the next year the market repeatedly hit new highs. Each new high was followed by a decline which tested broadening support giving the bulls repeated opportunities to call for “dip buying.” 

It was believed the year-long consolidation process was simply the “set up” for the continuation of the bull market. 

In early 2008, the running support line was broken as “Bear Stearns” failed sending off alarm bells to which few listened. The market rallied backed, and failed, at the previously broken support line. 

That point marked the end of the topping process and the real beginning of the “Financial Crisis.” 

By now, you should realize the similarities between all of these previous market tops and what is happening currently. However, it wasn’t just price movements that each of these previous bear markets had in common with the market today. 

Fundamental similarities existed also:

  • Valuations were high
  • Dividend yields were low
  • Federal Reserve was hiking interest rates
  • Economy was believed to be strong
  • Earnings were expected to continue to grow
  • Corporate balance sheets were believed to be strong
  • Yield curve was flattening
  • “There was no recession in sight.” 

The Big Test

 Over the next couple of weeks, the market is going to face the “test” that has defined the “bear markets” of the past.

With the markets already back to very overbought conditions, multiple moving averages just overhead, and previously broken support; the market is going to have its work cut out for it. 

However, if the bulls can regain control and push prices back above the November highs, then the “bear market correction of 2018” will officially be dead. 

But such is only one possibility out of many others which pose a far greater risk to capital currently. 

With the Fed continuing to extract liquidity, economic data slowing, and earnings likely to be weaker than expected, the current bounce is likely to be just that. 

As we have continuously repeated, if you didn’t like the November-December decline, it is simply a function that you have built up more uncontrolled risk in your portfolio than you previously realized. 

Use this rally to rebalance risk, sell losers and laggards, and add to fixed income and cash. 

Conclusion

We noted previously that we remain long many of our core holdings and in November and late December added positions in companies which had been discounted due to the market’s downdraft.

This past week, we did reduce our equity exposure by 6% to remove some positions which have not been performing as well as expected. 

The risk to the market remains high, but that doesn’t mean we can’t make money along the way.

Until the bullish trend is returned, we will continue to run our portfolios with a bit higher level of cash, fixed income, and tighter stops on our current long-equity exposure. 

We are excited about the opportunity to finally be able to add a “short book” to our portfolios for the first time since 2008. It is too early in the market transition process to implement such a strategy, but the opportunity is clearly forming. 

See you next week. 


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


ETF Model Relative Performance Analysis


Sector & Market Analysis:

Sector-by-Sector

This past week:

Discretionary, Communications, and Health Care all climbed above their respective 50-dma’s and are currently holding support. Volume has dried up over the last several trading days, so it will be important for these sectors to maintain their current support without breaking back down. Stops are $102, $$43.50, and $87 respectively.

Technology, Industrials, Materials, Energy Staples, and Financials each rallied on declining volume last week but have failed to get above their 50-dma’s currently. That overhead resistance is going to be challenged next week and it will be important, for the overall market, that these sectors make a move higher. Otherwise, I suspect we are going to see a correction evolve.

Current Postion: Staples 

Utilities and Real Estate Last week, Utilities bounced off the 200-dma which sets up a decent trading opportunity with a trailing stop at the 200-dma. Real Estate, also bounced and recovered back above its 200-dma. With rates coming back down, real estate can be added for a trade on a pullback to $31.50 that holds.

Current Positions: XLU added to Equity Trading Portfolio.

Small-Cap and Mid Cap – both of these markets are currently on macro-sell signals but did rally last over the last couple of weeks with the rest of the market. Currently, both are on short-term “buy signals” but are now back to very overbought. Take profits following last week’s trading call. 

Current Position: None

Trading Position: Close Trading Positions From Last Week

  • SLY – Target: $64.50 – Close Position
  • MDY – Target: $324 – Close Position

Emerging and International Markets -Emerging markets are once again trying to climb above its 50-dma…again. This has been consistently a trading trap over the last year. With the market very overbought, I would wait to see a better set up before adding exposure back into portfolios. 

International markets still look terrible and no real improvement is being made with the recent rally still confined to a very strong downtrend. With major sell signals in place currently, and very over-bought short-term, there is no compelling reason to add either of these markets to portfolios at this time.

Current Position: None

Dividends, Market, and Equal Weight – Not surprisingly, given the rotation to “defensive” positioning in the market, dividend-based S&P Index continues to outperform other weighting structures. The overall market dynamic remains negative for now and important supports are being tested. We are looking to sell our cap-weighted position entirely during this rally and reduce back to just our core, long-term, holdings of Equal and Dividend-Weighted indices.

Current Position: SDY, VYM, IVV

Gold – After having been out of Gold since early 2013, the metal is now improving to the point to where the risk/reward is now much more favorable for a longer-term hold. We are looking for two things to confirm a longer-term buy: 1) the 50-dma to cross back above the 200-dma, and 2) a pullback to the 200-dma for an entry point. With Gold very overbought short-term a continued short-term rally in the market over the next month will likely pull the froth out of the metal. If our conditions are met we will add a position to our portfolios. 

Current Position: None

Trading Position:

  • GLD – Buy Target: $119.00, Sell-Stop: $117

Bonds – Let me just repeat what I wrote two weeks ago:

“As we have been repeatedly suggesting since the beginning of the year, bonds would be the ‘GO TO’ haven when ‘SAFETY’ became a real concern. Look for a rally in the markets going into the new year which will likely pull some of the froth off of 10-year treasuries. Pullbacks to support should be bought.

Current Positions: DBLTX, SHY, TFLO, GSY

Trading Position: (Adjusting Buy Target Higher)

  • TLT – Buy Target: Moved up to $120, Sell-Stop: $119

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:

No real change from last week as the market rally continues. With only our “core” equities currently remaining we will look to reduce equity exposure further during the month if things don’t begin to markedly improve. While the bullish trend, longer-term, remains intact, the bearish backdrop continues to mount. We will continue to use rallies to reduce risk, buy bonds, and maintain higher levels of cash for now.

As noted in the “Portfolio Positioning” section above, it is not yet viable to short the broader market. However, while that opportunity may be coming, shorting the market has capital risk just like being long. Given the recent uncertainty of the market, the best “hedge” remains cash for now.

Given the pullback in the market and the recent rally, we did take the opportunity to deploy some cash. 

  • New clients: We added 1/4th of our “core” long-term equity holdings and bond positions. We will continue to add to these positions on weakness. 
  • Equity Model: We sold 5-positions last week that technically have not been performing as well as we expected. We sold MSFT, CDW, AXP, MDT and UNH. Stops across all positions have been dramatically tightened up. This raised about 6% in cash with this rally and gives us an opportunity to add back positions on the anticipated retest of support.
  • Equity/ETF blended – Same as with the equity model. 
  • ETF Model: We will hold current holdings for now.

As we noted last week:

“There are certainly some catalysts which could reverse the current ‘bearish’ backdrop of the market in the short-term such as Powell backing off tightening monetary policy further and Trump backing of the ‘trade war’ with China.”

Not surprisingly, we have seen just that happening as of last week. While these actions certainly improved the short-term outlook, the longer-term backdrop remains negative simply from the length of the current economic and market cycle. However, we are into the seasonally strong period of the year so we are giving the bulls the benefit of the doubt for now. 

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


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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

401k-PlanManager-AllocationShift

Rally Runs Into Resistance

As I noted last week:

“Well, we finally got the rally we were looking for which could possibly extend into next week. However, as I have stated previously, with sell signals triggered on both a weekly and monthly basis, these ‘clearing rallies’ should be used to reduce equity risk to the markets.

In the coming weeks, any rally that takes the markets back to short-term over ‘bought’ conditions will be used to lower equity exposure to 50%, or a target or 30% equity in our 60/40 model.”

This week, the market is indeed pushing up into short-term overbought levels and is testing the underside of important previous resistance. 

One thing to note in the chart above is the horizontal dotted line that I have had drawn on the chart for the past 18-months. I noted originally that the markets break above the long-term trend channel would eventually be challenged. The recent correction has challenged that important level, if we break that confluence of support, we will be in a much more important bear market cycle. 

On Monday, take some action with respect to the following, if you haven’t already:

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

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

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

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

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


Current 401-k Allocation Model

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

401k Choice Matching List

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

401k-Selection-List

Throughout the market sell-off of the past few months, I’ve been showing key technical levels to help determine if further downside was likely or if the rout was truly over. In late-December, the S&P 500 broke below an important support zone from approximately 2,550 to 2,650 (which formed at the early-2018 lows), which represented a very important technical breakdown. The post-Christmas market bounce, so far, is simply a re-test of this zone, which is now a resistance. If the market bumps its head here, another wave down should be expected. If the market can close back above this zone in a decisive manner on the weekly chart, however, then it will have negated the December breakdown.

The weekly chart shows how two major technical breakdowns occurred in recent months. The current bounce has not resulted in a close back above the 2,550 to 2,650 resistance zone, so the S&P 500 is still in a downtrend.

Why I am worried about further downside? Because the market is still quite overvalued, among other reasons (global debt is up by $75 trillion since 2008 – no big deal!). The chart below of the Shiller PE ratio (cyclically-adjusted PE ratio) shows that the U.S. stock market’s valuation is still in rarefied territory. It’s going to take much more than the decline since early-October to unwind this bubble.

For now, I am watching if the S&P 500 can close back above the 2,550 to 2,650 resistance zone on the weekly chart or if it bumps its head and embarks on another leg down.

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

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

CNBC just published a piece about how venture capital spending hit an all-time high in 2018, surpassing the dotcom bubble record:

Venture capital just had its highest spending year in history.

The amount of money firms spent on private companies hit a new all-time record in 2018— well above the previous watermark from the dotcom boom.

Last year, venture capital firms spread roughly $131 billion across 8,949 deals, according to data published by Pitchbook and the National Venture Capital Association Thursday. The previous record was a $100 million total notched in the year 2000.

Although the dollar amount jumped by more than 57 percent from $83 billion last year, the number of deals went down. Deal count fell by about 5 percent this year from a roughly 9,400 total last year.

Cameron Stanfill, Pitchbook venture analyst who co-authored the report, said sky-high price tags for start-ups accounted for the new record total despite having fewer deals.

“There is a lot of money competing for a finite amount of companies, and that’s pushing prices up,” Stanfill told CNBC in a phone interview.

Though most people look at record VC spending as a sign of a strong, healthy economy, my research has found that the current VC boom is the result of another tech bubble that inflated due to the Federal Reserves ultra-stimulative monetary policies of the past decade (read my recent article about this). Unfortunately, this tech bubble is going to end just like the late-1990s dotcom bubble did – in another disastrous bust.

The chart below shows the monthly count of global VC deals that raised $100 million or more since 2007. According to this chart, a new “unicorn” startup was born every four days in 2018.

The chart below shows the Nasdaq Composite Index and the two bubbles that formed in it in the past two decades. Lofty tech stock prices and valuations encourage the tech startup bubble because publicly traded tech companies have more buying power with which to acquire tech startups and because they allow startups to IPO at very high valuations.

In the chart below, I compared the monthly global VC deals chart to the Nasdaq Composite Index and they line up perfectly. Surges in the Nasdaq lead to surges in VC deals, while lulls or declines in the Nasdaq lead to lulls or declines in VC deals.

Please watch my video presentation to learn why the U.S. stock market (and, therefore, the VC and startup arena) is experiencing a bubble. Though this presentation is a couple months old and the market has fallen since then, it’s still relevant for understanding how the bubble inflated and why much further downside is still ahead.

Now that the Nasdaq has fallen sharply, it wouldn’t be surprising to see VC activity wane. Unfortunately, I believe that we’re only in the early stages of the stock market and tech bust – a bubble that took nearly a decade to form does not disappear in a mere three months!

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

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

Wall Street glorifies companies that beat quarterly estimates by arguing that the long-term comprises a lot of short-terms. But beating earnings estimates for a few consecutive quarters doesn’t necessarily lead to long-term greatness. It assumes that significant changes to the business are visible in the reported numbers.

This is likely what General Electric executives rationalized as they destroyed the company’s protective shareholder “moat” and its respected corporate culture. Their short-term thinking focused on “beating earnings” on a quarterly basis, thereby insuring seemingly endless analyst upgrades. Except GE’s short-term success that was seen by the market came at the expense of unseen damage to its moat, balance sheet, and corporate culture.

Conversely, consider Apple reporting what analysts considered “disappointing” numbers for eight sequential quarters (three lifetimes on Wall Street) leading up to 2007. During that time, Apple is pouring every ounce of its resources into R&D and coming up with the iPhone. It cannot hire the right engineers fast enough and thus must pull in engineers who had been working on the Macintosh (then Apple’s bread and butter), which results in delaying the introduction of new computers by a few quarters (this did happen). Did those negative short-term results subtract from the value of the company, or were they instrumental in adding trillions of dollars of revenue to Apple?

Quarterly misses and beats show only what is seen, but true investors are able to see the unseen.

With the luxury of hindsight, I picked two examples, GE and Apple, that seem to prove that earnings misses are great and beats are bad — but they are neither. They are part of the vocabulary of the semi-staged reality game show on business TV — which I choose not to participate in. Facebook for example, was recently accused of using casino gaming psychology to get their users to keep coming back to see if their posts or family pictures were “liked.” Quarterly “beats” and “misses” are not much different; they add casino excitement to investing and turn unsuspecting investors into gamblers.

This doesn’t mean that an investor should completely ignore what happens in the short run, but quarterly earnings should be always looked in the right context — the context of the long run.

Long-term thinking should be deeply embedded in your stock analysis. A discounted cash flow (DCF) analysis model forces you to value a company the way you’d value a private business, bringing cash flows that lie decades in the future into the present.

But DCF analysis, though grounding, is a crude model that is most useful at the extremes of a company’s valuation, when a company is wildly overvalued or undervalued. This is why it makes sense to estimate a company’s value based on earnings multiples. In my process, I look at a company’s expected earnings three- to five years out and then discount it back (convert to today’s dollars). This is the key: By looking at a company’s earnings this far out, you muffle the noise of quarterly earnings — the “what have you done for me lately?” hysteria — and focus on the future.

What a difference a year makes. In 2017 stocks went up in almost a straight line and volatility remained amazingly low throughout the year. In 2018 stocks got dinged early but quickly recovered. For a time, it looked like things were getting right back on the same track, but in September stocks started reeling and weren’t able to recover by the end of the year.

This break leaves investors with a big question: Were the last four months of 2018 a short-term aberration that should be overlooked, or an early indication of worse things to come? The dramatic and violent nature of price swings added to the urgency of the question. The short answer is yes, things have changed, and in ways that will be very good for some investors and terrible for others.

For investors who don’t watch markets every day, the notion that “volatility returned” doesn’t begin to capture how dramatic price swings became. The Financial Times described one such interlude [here]:

“On December 24, US equity markets posted their biggest recorded crash for a Christmas Eve. But on Wednesday [the day after Christmas] they recorded their biggest rally for almost 10 years.” 

The broader return of volatility was captured by Zerohedge [here] by comparing the number of days the S&P 500 rose or fell by one percent or more.

“In the fourth quarter there were 28 such days which was well above the Q4 average of 14 since 1958. The fourth quarter tally was also considerably higher than that for the entire year of 2017 which hit a new post-recession low of 8.”

Turmoil in the markets also co-existed with turmoil in news flow. The FT listed several captions of concern [here] such as “De-Faanged”, “Turkey meltdown”, Italian alarm”, “Red October”, “Oil’s spill”, and “December mayhem”. Zerohedge also captured the chaos of the quarter with a chronology of headlines [here]. Amidst the turmoil one thing remained clear: Market action in the fourth quarter was a lot different than anything exhibited in a long time. 

While all these items helped to unsettle markets, one of the most distinctive characteristics of the fourth quarter was how few managers were able to navigate the turmoil successfully. Almost every investment strategy failed. One quant hedge fund executive lamented [here], Honestly, nothing’s working.

Indeed, one might have expected hedge funds to make hay amidst the volatility. Bloomberg described [here],

“Wide swings in prices, a waning bull market and rising rates were seen as the elixir that the $3.2 trillion [hedge fund] industry needed to overcome years of subpar performance.” 

Arvin Soh, a New York portfolio manager at GAM Holding AG, explained,

“Big picture, hedge funds are strategies that are meant to deliver during periods of uncertainty and profit from dislocations, which we have seen plenty of this year.”

Nonetheless, Bloomberg reported,

“Hedge funds got pummeled in last month’s market swoon and are headed for their worst year since 2011.”

In addition to almost universally bad performance, another unique characteristic of the fourth quarter was that the value style outperformed growth for the first time in a long time. Historically, value outperforms growth and is one of the most robust relationships in finance. For the last 10-, 5-, 3-, and 1-year periods, however, growth outperformed value, and by a considerable margin. That relationship flipped back in the last quarter.

These phenomena suggest that the fourth quarter was about more than just price fluctuations. Something important changed. Mohamed El-Erian captured the development in the FT [here],

“[A] better way of thinking about what is unfolding relates to a broader change in the major determinants of asset values and stability. Investing is no longer primarily about taking advantage of massive deployment of liquidity that lift all financial boats.”

This is a fairly powerful statement with important consequences. Lindsay Politi from One River Asset Management describes [here] what happened under the massive deployment of liquidity:

“The environment [of quantitative easing] causes some strategies to flourish and multiply, while others die off. The abnormally long, QE-fueled bull market killed off anything that wasn’t, at its core, a short volatility strategy. Now, whether it’s risky credit, levered equities, or risk parity, almost all strategies are taking similar risks. QE has done something much more damaging than the Fed could have imagined. It changed the very nature of the market, destroying the diversity of the market ecosystem, and making it incredibly vulnerable to the smallest change in the macro environment.” 

Mark Tinker of Axa Investment Managers provided a similar assessment [here],

“The fact that a decade of quantitative easing has produced a lot of products that rely on spread, carry and leverage has left financial markets vulnerable to an unwind of these strategies.” 

One manifestation of the market monoculture that developed was that price discovery became impaired. Bloomberg, for example, declared at the beginning of 2018 [here],

“The stock market never goes down anymore” – (h/t David Collum from his Year in Review [here]).

Indeed, the persistent upward march of stock prices became imbued in popular culture. The FT noted [here] ,

“…the bestselling T-shirt on StockTwits, a website for day traders, shows a basketball player dunking on a bear, emblazoned with the acronym BTFD — or “Buy The F***ing Dip”. The design is meant to underscore “how shrugging off temporary sell-offs has repeatedly proven a winning [though not particularly thoughtful] strategy.” 

Another manifestation was that several investment strategies including contrarians and value investors and fundamental investors were effectively “killed off”. Ben Hunt captures the dynamic [here]:

“All those buy-side analysts and PMs finding ‘alpha’ from their 30 worksheet-long FCF [free cash flow] models and their oh-so sharp questions posed to management at 1×1 meetings and their oh-so observant site visits to this facility or that facility have, in fact, been fired. All of these Masters of the Universe like Lee Cooperman and Stan Druckenmiller have turned their hedge funds into ‘family offices’. Not because they WANTED to. Because they HAD to.” 

Now that liquidity tailwinds are diminishing, however, a starkly different investment environment is emerging. Merryn Sommerset Webb described in the FT [here],

“The surprising thing here is not so much that markets have tanked, but that given that they [markets] are supposed to be discounting mechanisms, taking in and reacting rationally to all available information, it didn’t happen sooner. Investors have to start focusing properly on cash and valuations.” 

Further, investors also have to pay more attention to risk and uncertainty. To date, investors have been able to take President Trump, to whom Grant’s Interest Rate Observer regularly refers as “the avatar of tail risk”, in stride. As Ed Luce highlights in the FT [here], that situation is changing too:

“It is only a slight exaggeration to say that Jim Mattis, the outgoing US secretary for defence, was the last grown-up in Donald Trump’s ‘axis of adults’.”

The net result is a double-whammy for stocks. Just at the same time that the buoyant effects of liquidity are diminishing, several tangible risks and uncertainties are increasing. The potential for significant revaluations is high.

Perhaps nowhere are these dynamics more apparent than in the technology sector. Richard Waters noted [here],

“One [factor affecting tech stocks] was a reaction to the prospect of rising interest rates, and a sense that the benign economic and financial conditions that had supported the tech-led bull market were drawing to a close. The other [factor] was caused by the opening of a trade war with China in which some tech companies stood to find themselves in the front line.”

Almost as if to prove the point, Apple started off the new year by preannouncing lower than expected revenues. Kevin Hassett, chairman of the White House Council of Economic Advisors, made it clear that Apple’s experience was not just an aberration. He indicated [here],

“There are a heck of a lot of US companies that have sales in China that are going to be watching their earnings being downgraded until we get a deal with China.”

A key point for investors to appreciate, then, is that the market paradigm has changed. El-Erian describes as well as anyone what can be expected for the foreseeable future [here]:

“While some investors may hope for a return to calmer times, a more probable outcome for 2019 is that it is framed by a trifecta of an uncertain global economic outlook, technically unsettled markets and central banks less able to counter the added instability associated with political developments.

Having been shielded by central banks’ monetary largesse for so long, markets will continue to unwind some of the excesses that had developed.”

In particular, this is likely to involve more wild swings in the market. John Hussman describes [here]:

“In stocks, I continue to believe that the market is positioned for rather violent losses over the completion of this cycle, though undoubtedly punctuated by periodic rebounds that are fast, furious, and prone-to failure. These tend to emerge in the form of what I call ‘clearing rallies,’ which relieve short-term oversold conditions. They should be used to make any needed portfolio adjustments.”

Recognition of, and adaptation to, these changes will present a difficult challenge for many. As John Hussman describes,

“My old friend Richard Russell once said that every bear market has a ‘hook’ – something that investors believe, but isn’t true, and encourages them to keep holding and hoping all the way down. Believing that Fed easing creates a ‘put option’ under the market is one of those hooks.”

For those who can adapt, risk management will be a crucial exercise. El-Erian recommends [here]:

“Critically, having more cash in investment portfolios goes beyond building resilience for the multitude of transitions facing the global economy and markets. It also offers investors who are so inclined both the option to take advantage of the technical overshoots that inevitably occur during indiscriminate sell-offs and volatile trading markets.”

Risk management will also take the form of rediscovering investment discipline. When stocks always go up, you can come up with any narrative you want to explain why. Strong economic growth, transformative technology, disruptive innovation. It doesn’t matter. Take away the ability of central banks to control instability, however, and edge and odds become extremely important.

Ben Hunt describes such an analysis in regards to the trade dispute between the US and China [here]:

“You have no edge in this game. You don’t know the odds of this game. Not because you’re not smart enough and not because you’re not trying hard enough, but because the edge and odds in a game of Chicken are unknowable. And anyone who tells you otherwise is lying to you and/or lying to themselves.”

Hunt’s suggested response represents a clear break from the recent past, “I’m saying that when large institutional portfolios see more uncertainty in markets – not greater risk, but more technical uncertainty – they do not buy dips and they do sell rallies. They rebalance by selling winners, not by adding to losers. They take down their book.

“Finally, you should, too. And you should do it first.”

The unwinding of excesses is also likely to affect investment strategies, not the least of which involves outperformance of the growth style relative to value. Morgan Stanley analysts noted [here],

“Markets are on the cusp of regime change where willingness to pay for growth stocks will be damped by rising interest rates. We think there is a major leadership change occurring from growth to value which could be more long-lasting than most appreciate”.

In addition, the unwinding of excesses is also likely to affect the nature of market opportunities in other ways. While rising tides lift all boats, in the absence of such tides, boats are left to rise or fall on their own. As Sommerset Webb pointed out, the new environment “should also be absolutely thrilling to the active investment industry.”

The changing market paradigm also creates an opportunity to re-evaluate expected returns and investment horizon. The last 36 years comprise all or most of the practical experience of most investors but stand out in history as being unusually kind to investors. It is a great time to ensure that return expectations through one’s investment horizon are appropriately grounded. Politi’s advice regarding data models is also appropriate for establishing return expectations: “Success will come not to those who build the best machines but to those who make the best assumptions.” 

John Hussman shared a similar perspective:

“Look, my interest is in making sure that investors have positions that they are able to hold through the complete cycle… If they’re carrying more risk than they could endure through the course of a bear market, they should cut back now. I’m not going to wave my arms around about doom and gloom, but I think it’s a crucial time for investors to think about the risk they’re taking.”

In summary, sometimes prices go down and they are normal fluctuations. Sometimes big, violent price declines reveal something deeper is going on. In this sense the fourth quarter brought in a brand new day for investors and one in which they are no longer “shielded by central banks’ monetary largesse”. This is likely to create all kinds of problems for investors who are overly optimistic about what stocks are likely to return and are too complacent to revisit their assumptions. It will also provide a fresh, new start, however, for long term investors who have been waiting patiently for better opportunities. Those opportunities are not overwhelming yet, but they are coming.

J. Bradford Delong wrote a very interesting article discussing the trigger for the next recession. 

“Three of the last four US recessions stemmed from unforeseen shocks in financial markets. Most likely, the next downturn will be no different: the revelation of some underlying weakness will trigger a retrenchment of investment, and the government will fail to pursue counter-cyclical fiscal policy.

Over the past 40 years, the US economy has experienced four recessions. Among the four, only the extended downturn of 1979-1982 had a conventional cause. The US Federal Reserve thought that inflation was too high, so it hit the economy on the head with the brick of interest-rate hikes. As a result, workers moderated their demands for wage increases, and firms cut back on planned price increases.

The other three recessions were each caused by derangements in financial markets. After the savings-and-loan crisis of 1991-1992 came the bursting of the dot-com bubble in 2000-2002, followed by the collapse of the sub-prime mortgage market in 2007, which triggered the global financial crisis the following year.”

While I agree with Bradford’s point, I think there is a disconnect between the crises he points out and repeated behaviors which lead to those events.

Let’s review some basic realities about the economy that seems to be lost on the mainstream media. 

First, this is NOT an economic cycle:

This is:

Despite the hopes the economy will continue into an everlasting expansion, such has historically never been the case. The current economic expansion, which has been driven by massive infusions of liquidity, extremely accommodative interest rate policy, and a surge in debt accumulation, is just 4-months away from setting a new record. 

Secondly, while the recession prior to 1980 was driven by a super-aggressive Fed rate tightening policy, since 1950 we can find fingerprints of monetary policy in every event.

I am not saying that just because the Fed hikes rates, that a recession, or crisis, will be triggered.

What I am saying is that over the entire rate cycle, the Fed has fostered the credit driven expansion and laid the groundwork necessary for a crisis to be born.

Let’s revisit Bradford’s three specific crises.

The S&L Crisis

The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of 1,043 out of the 3,234 savings and loan associations in the United States from 1986 to 1995.

However, just looking at the event we miss the bigger picture.

If we go back in time before the crisis began, we find an environment where the Federal Reserve had drastically lowered the overnight lending rates in order to spur more borrowing and economic activity coming out of the back-to-back recessions of the late ’70s and early ’80s.

Of course, in a capitalist-driven economy, as demand for loans for cars, housing, businesses, etc. rose; bankers figured out ways to continue to extend credit in order to maximize their profitability. As is always the case, greed over took prudence and many bankers relaxed risk management protocols which would ultimately cost them their jobs and in many cases the bank.

Of course, in 1979, when the Federal Reserve hiked the discount rate from 9.5% to 12%, ostensibly to quell inflation pressures, it also slowed the economy. Since the S&L’s had issued long-term loans at fixed rates lower than the now higher rate at which they could borrow the rise in rates combined with rising default rates, led to insolvency.

Probably the most famous example from the S&L Crisis period was
that of financier Charles Keating, who paid $51 million financed through Michael Milken’s “junk bond” operation, for his Lincoln Savings and Loan Association which at the time had a negative net worth exceeding $100 million.

The Dot.Com Bubble

While the “dot.com” bubble is often thought of as a one-off event caused by speculative excess, there was actually much more going on at the time.

Many have forgotten the names of Enron, WorldCom, Global Crossing, and other booming tech companies which were riff with financial shenanigans at the time which ultimately led to the passage of the Sarbanes-Oxley Act.

However, again, we can’t look at just the event itself but need to go back prior to the event to understand the groundwork that was laid.

Following the recession of 1991, the Federal Reserve drastically lowered interest rates to spur economic growth. However, the two events which laid the foundation for the “dot.com” crisis was the rule-change which allowed the nations pension funds to own equities and the repeal of Glass-Steagall which unleashed Wall Street upon a nation of unsuspecting investors.

The major banks could now use their massive balance sheet to engage in investment-banking, market-making, and proprietary trading. The markets exploded as money flooded the financial markets. Of course, since there were not enough “legitimate” deals to fill demand and Wall Street bankers are paid to produce deals, Wall Street floated any offering it could despite the risk to investors.

Of course, it wasn’t long until the Federal Reserve, again concerned about the prospect of rising inflation and an overheating economy, started hiking rates. As monetary policy became more restrictive, the cost of capital rose, and the economy slowed.

It wasn’t long before the system came unglued.

The Great Financial Crisis

In response to the “Dot.com” crisis, the Federal Reserve once again drastically lowered interest rates to spur economic growth.

This was also the point where the Bush Administration, along with the Alan Greenspan headed Federal Reserve, decided that “everyone” should own a home. Lending standards were relaxed and a variety of new mortgage structures were introduced by Wall Street in the quest to make money.

Over the next several years, as lending rates declined, and everyone wanted to buy into the surging housing market, Wall Street packaged mortgages into exotic instruments allowing them to sell the mortgages to investors. The cycle continued with ever increasing demand from home buyers and demand from investors.

As the housing market boomed, the stock market fully recovered from the “dot.com” crash, and with the economy booming, the Federal Reserve, now under the leadership of Ben Bernanke, decided to start tightening monetary policy in the belief that inflation was an imminent threat from an overheating economy.

But there were no pressing concerns as it was believed that “subprime mortgage loans were contained” and the ongoing “Goldilocks economy” would continue uninterrupted.

They weren’t and it didn’t.

If you are interested in this crisis we urge you to read or watch The Big Short by Michael Lewis

The Common Threads

While each of these events were much more complex than what I have outlined here, there were many others along the way like the Russian Debt Default, The Asian Contagion, and Long-Term Capital Management, which all shared important commonalities between them.

In each case we find that prior to the event the Federal Reserve was loosening monetary policy to spur economic growth following a preceding economic downturn. They did this to halt the downturn but in doing so failed to allow the system to clear itself over time.

Looser monetary policy, and continuing relaxation of regulations led to excessive greed by the primary players in the market which was supported by a rising level of speculative frenzy and easy access to capital by investors.

In other words, instead allowing the system to clear the previous build up of excesses, the Federal Reserve intervened to keep that process from happening. As a result, each crisis has been worse than the one before it because the debt and leverage in the system continues to mount.

As shown in the chart below, whenever the Federal Reserve previously loosened monetary policy, debt as a percentage of the economy surged. Naturally, when monetary policy was reversed, things tended to go bad…and generally very quickly.

Since 1980, the eventual and inevitable unwind of an overly levered system was met by a drastic drop in the Fed Funds rate to stimulate debt induced consumption and spur economic activity. The problem, is that each effort by the Fed to limit the impact to the system has required a lower interest rate than the one that preceded.

With rates near the lowest level on record still, the next event will once again require dramatic measures to stem the unwinding of a decade long, debt supported, economic cycle.

But this is where Bradford gets it absolutely right about the cause of the next recession.

“Specifically, the culprit will probably be a sudden, sharp ‘flight to safety’ following the revelation of a fundamental weakness in financial markets. “

Of course, such has always been the case when it comes to the financial markets.

However, the risk of a recession has continue to rise in recent months with plenty of warnings already showing up from a near-inverted yield curve, declining economic momentum, low nominal and real bond yields, and struggling stock prices

The problem, as Bradford notes, is the next financial cataclysm may well fall outside of the capability of the Federal Reserve and Government to neutralize.

“If a recession comes anytime soon, the US government will not have the tools to fight it. The White House and Congress will once again prove inept at deploying fiscal policy as a counter-cyclical stabilizer; and the Fed will not have enough room to provide adequate stimulus through interest-rate cuts. As for more unconventional policies, the Fed most likely will not have the nerve, let alone the power, to pursue such measures.”

As a result, for the first time in a decade, Americans and investors cannot rule out a downturn. At a minimum, they must prepare for the possibility of a deep and prolonged recession, which could arrive whenever the next financial shock comes.”

He is absolutely correct in his assessment of the impact of the next fiscal problem. When it comes, it will be totally unexpected, unanticipated, and unprepared for by investors. Such has always been the case through out history.

But there is one thing that all these crises have in common.

A belief by the Federal Reserve that inflation is going to be problem and that they can control inflation through monetary policy.

This time will be no different.

Most investors know what the “FAANG” stocks are – Facebook, Apple, Amazon, Netflix, and Alphabet (parent of Google). These stocks have had big runs over the last few years, and they’ve struggled more than the market over the past few months. That’s typical behavior for growth or glamor stocks – higher than the market when it goes up, and lower when it goes down.

Of these stocks, which one has the best long-term prospects? If you had to own one for the next 10 or 15 years, which one would it be? I think all of them, except for possibly Netflix, have strong business models, but I would pick Alphabet (Google). Here’s why.

Although I’m not sure he means to, Jonathan Tepper lays out the case for owning Google in his recent book, The Myth of Capitalism: Monopolies and the Death of Competition. When I was reading this book, I found myself enraged at how the tech giants have managed to become monopolies, but also wondering how much of my money I could stuff into their stocks. Google stood out to me as being a particularly bad actor, but also one whose future profits the selfish part of me wanted to own.

Tepper begins his story about Google by reciting what the search juggernaut did to a firm called “Foundem.” Foundem gave users the ability to search for the best price on a desired product. Somehow, although Foundem enjoyed an initial wave of success with shoppers rushing to use the site, “suddenly, after the second day, users never came back,” as Tepper tells it. It turned out that by the second day Foundem had dropped 170 pages down when shoppers searched for it after being at the top of the search list initially. Google removed Foundem from its organic search results and also prevented Foundem from purchasing ad placements via Google AdWords. Google “disappeared” Foundem, the way people get disappeared in totalitarian regimes. Google had its own product search service that it wanted to promote, and Foundem presented unwanted competition.

Google has done similar things to other companies in its ambition to grow its basic search business through ancillary “verticals” or searches in specialized areas – real estate listings, local business directories, legal filings, price comparisons, images, etc…., according to Tepper. For example, Google noticed that searches like “where’s the best nearby steakhouse” were becoming popular, so it decided to appropriate Yelp’s reviews. That meant Google users could see the Yelp reviews on Google, and bypass Yelp entirely. Yelp complained, eventually to the F.T.C., but Google’s response was that Yelp’s only alternative was to remove its content from Google altogether, according to this NYTimes article.

Google did similar things to other review sites such as TripAdvisor, and Cityserach, and it also allegedly provided pressure on cellphone manufacturers Samsung and Motorola to prevent them from using a navigation system in their phones called Skyhook. Google also adjusted how it displayed images so that its users could see and download Getty Image’s photographs without going to Getty’s website. The Times article quoted Getty’s attorney, Yoko Miyashita, saying he received a response from Google to Getty’s complaint that basically argued, “’Well, if you don’t agree to these terms, we’ll just exclude you.’” Miyashita said that wasn’t really a choice because if you’re not on Google, you basically don’t exist.

Over the past decade, Tepper calculates that Google, Amazon, Apple, Facebook, and Microsoft have collectively purchased 436 companies, mostly without antitrust interference.  It’s possible that the tide is turning against Google, and that it won’t be able to do to rivals in the future what it has done to them in the past – buy them, appropriate their content, or prevent them from appearing in searches. But, according to Tepper, Google already controls nearly 90% of search advertising. Advertisers want to be there because that’s where search is happening. Searchers want to be there because that’s where they’ll find what their searching for.

So far, Google has managed the neat trick of censoring or manipulating what people search for without offending them or incurring the wrath of the Justice Department. At some point the firm gave up its “Don’t be Evil” motto, perhaps realizing it couldn’t live up to that. But that means if you want to bet on one FAANG stock for the next decade, and you can swallow your moralism, Google probably has the best shot at continuing to deliver high returns.

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

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

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

Also, it is entirely possible that our long-term themed equity model could be long a position which could show up on the “short-idea” list temporarily. Trading and investing, while having many commonalities, are different based on time frames and objectives and are not always handled exactly the same.

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

LONG CANDIDATES

AAP – Advanced Auto Parts

  • Long-term trend line is currently intact
  • After selling off with the market last year, AAP has rallied off its bullish trend line.
  • Short-Term Positioning: Bullish
    • Buy: $165
    • Stop-loss is $154

BLL – Ball Corp.

  • Bullish trend line held during recent sell-off
  • Short-Term Positioning: Bullish
    • Buy with target of: $50
    • Stop-loss is currently $45

DE – Deere Co.

  • Long-term trend line is holding
  • Previous support from February lows has held.
  • Currently close to turning back onto a weekly “buy signal.”
  • Short-Term Positioning: Bullish
    • Buy with initial target of $160, Add to position @ $162
    • Stop-loss is currently $135

DG – Dollar General

  • Long-term bullish trend line held during sell-off.
  • Close to new highs which should turn current “sell signal” back onto a  “buy.”
  • Short-Term Positioning: Bullish
    • Buy on “breakout” to new highs: $117
    • Stop-loss is currently $100

SHORT CANDIDATES

AMD – Advance Micro Devices

  • AMD sold off after making a “blow off” top last year. 
  • Currently, running into down trend resistance.
  • Support is current running at $15 with a target of $10
  • Short-Term Positioning: Bearish
    • Short @ current levels
    • Stop-loss is currently $22

DEO – Diego Plc

  • Failed at overhead resistance withing a longer-term consolidation range.
  • Long-term trend line has also been violated.
  • Short-Term Positioning: Bearish.
    • Look to short DEO on any rally back to $142.50
    • Stop-loss is currently $145

DLR – Digital Realty Trust

  • DLR recently broke support after failing at overhead resistance.
  • Long-term trend line has been broken and currently remains on an important “sell signal.”
  • Short-Term Positioning: Bearish
    • Short on any uptick in price toward $103
    • Stop-loss is currently $105

ORAN – Orange

  • Previous bullish trend was broken and ORAN has now established a downtrend channel currently. 
  • Recent rally attempt failed at top of downtrend channel.
  • Short-Term Positioning: Bearish
    • Look to short ORAN on any uptick toward $16
    • Stop-loss is currently $16.75

 

The Bond Rally Was No Surprise, published December 13, 2018, described how the long-term economic and demographic trends along with the burden of excessive debt all but ensure that interest rates will not rise much further.

While there is little room left for interest rates to fall in the current environment, there is no ability for rates to rise before you push the economy back into recession. Of course, you don’t have to look much further than Japan for a clear example of what I mean.”

This sad dynamic reminds us of the arcade game Whack-a-Mole. Higher rates are a drain on the economy which stymies growth, lessening demand to borrow, and as a result, rising interest rates get hammered back down.

In addition to the level of economic growth and activity, the rate of inflation is also a key determinant of demand for money and therefore plays a large role in influencing the level of interest rates.

The Value of Money

Milton Friedman, Nobel Laureate, once famously stated: “Inflation is always and everywhere a monetary phenomenon.

In The Fed’s Mandate To Pick Your Pocket we provide an example of what Milton Friedman is conveying.

To better appreciate this thought, let’s use a simple example of three people stranded on a deserted island. One person has two bottles of water, and she is willing to sell one of the bottles to the highest bidder. Of the two desperate bidders, one finds a lonely one-dollar bill in his pocket and is the highest bidder. But just before the transaction is completed, the other person finds a twenty-dollar bill buried in his backpack. Suddenly, the bottle of water that was about to sell for one-dollar now sells for twenty dollars. Nothing about the bottle of water changed. What changed was the money available among the people on the island.

As we discussed in What Turkey Can Teach Us About Gold, most people think inflation is caused by rising prices, but rising prices are only a symptom of inflation. As the deserted island example illustrates, inflation is caused by too much money sloshing around the economy in relation to goods and services. What we experience is goods and services going up in price, but inflation is actually the value of our money going down.

The last sentence bears repeating as it is the truest understanding of inflation. Inflation is not the price of things going up but the value of money going down.

Before we explain how the price (interest rates) and value of money are affected by inflation, the graphs below put the relationship between interest rates and inflation in a statistical context.

The first graph compares CPI and the two-year U.S. Treasury yield. The difference shaded gray, is what is known as the real rate, or the yield after inflation.  The second graph plots the same data in a scatter plot format. As shown the R-squared is .5708, which denotes that 57% of the change in the two-year U.S. Treasury is attributed to changes in the CPI.

Data Courtesy: St. Louis Federal Reserve

Supply and Demand for Money

A high rate of inflation is beneficial to those with fixed-rate debt. In such a scenario the value of assets rises while the cost of the debt stays the same. To put this in personal terms, think about how the value of your house tends to rise while the amount of the mortgage payment stays fixed. The ability to pay off the mortgage and take capital gains becomes easier due to inflation At the same time, that environment is detrimental for prudent savers who choose to live within their means and do not incur debt. Their value of their savings deteriorates as the value of the dollar declines.

A deflationary environment has the opposite effect as the burden of debt rises relative to stagnant or falling prices. Those conditions are unfavorable for borrowers (households, corporations, and the government) especially when debt is not used for productive purposes which aim for investment returns greater than the inflation rate. Because most outstanding debt is not productive today, sinister perceptions of deflationary conditions are peddled by the Fed and the government.

Given the effects mentioned above of inflation or deflation on the borrower, the demand for money rises when the current and expected rate of inflation is greater than the cost of money or interest rates. Conversely, demand declines when the level of interest rates is greater than the current and expected rate of inflation. This is due to the expectations of borrowers. Holding interest rates below the rate of inflation pulls demand forward which helps explain the inclination of central bankers and the government in a world that desires “growth at all cost”.

To help with this concept, we show basic supply and demand curves below. The first graph shows a hypothetical scenario in which the level of interest rates and the rate of inflation are in equilibrium.  The second graph shows the same curves, along with the shift in the demand curve when the rate of inflation is lower than interest rates. As shown by the yellow equilibrium points, the price of money, or interest rate, declines in this scenario. The third graph highlights the opposite effect when the rate of inflation is greater than interest rates.

The Federal Reserve aims to maintain steady economic growth. It accomplishes this by manipulating the supply of money via their Fed Funds interest rate policy (monetary policy). Since the financial crisis, they have used monetary policy to push interest rates lower than economic growth rates and inflation to stimulate borrowing. This can be seen in the negative real rate as shown in the first graph.

As we showed in the last supply/demand graph above when interest rates are below the level of inflation and expected inflation, demand for borrowing rises. This pulls demand forward and encourages the consumption of goods and services today which temporarily boosts economic growth.

Summary

Habitually using the Fed Funds rate to spur current levels of economic growth causes debt to grow faster than the natural economic growth rate of the economy. The risk is that debt growth eventually eclipses the pace of economic growth. That is precisely the current circumstance in the United States. As such, the marginal effectiveness of new debt in spurring economic growth declines as the burden of servicing that debt rises. To foster similar levels of growth in such an environment requires that the Fed be ever more aggressive in lowering interest rates. As we see in the U.S. economy, weaker growth resulting from rising levels of debt is self-reinforcing.

Thus far the Fed’s actions have not caused observable levels of inflation to rise in a manner that would cause concern among policy-makers. Traditional measures of price inflation such as the consumer price index (CPI) remain benign. However, the manifestation of their control over the price of money is showing up other ways. For instance, inflation in financial asset prices, as opposed to real assets, has never been higher. The visual evidence shows up in a chart of the ratio of stock prices to crude oil, copper, cotton or a dozen other “real assets.” Those with access to leverageable capital choose to speculate in stocks and bonds as opposed to investing in productive projects that would help the economy grow. Not surprisingly, when speculation appears to produce easy and predictable returns, the incentive to invest in productive ventures is weak. As such the current dynamic will likely continue to produce low levels of traditional inflation and allow the Fed to rationalize artificially low-interest rates.

If, however, the economy slips into a recession and low, or even negative, interest rates are not enough to generate growth, the Fed may take even more extreme measures to combat the downturn. In what would be yet another advancement of extraordinary monetary policy, the Fed may elect to print money for direct distribution into the economy. Although the effect may be temporarily beneficial for a struggling economy, such a move would be more likely to eventually cause inflation over which the Fed could easily lose control.

In that instance, we will be fortunate if a bottle of water only costs $20.